FREE KIC - NO. 23 AUG  07

I WANT BANKERS THAT “KISS”

(Keep It Simple Stupid)

When I am looking for new investment ideas I will always look at a list of companies with the highest dividend yields. I have come to see this as one of the best starting points to narrow down the thousands of shares listed on global stock markets.
In recent years I have found that this list has a large number of banks and financial services companies. The following list covers the Irish market alone but it highlights the phenomenon I am talking about:
Table
This list of the highest yielding Irish equities contains four financial companies. If I looked at lists from other countries I would find something similar.

So why is it that there are so many high yielding bank shares? I have been asking myself that question for a number of years and it inevitably has led me to spend a lot of my time researching bank shares.
In theory a bank should be a relatively easy business to understand. It takes in deposits at one rate and lends that money out at a higher rate and as long as they don’t suffer too many bad debts and keep their own costs under control it can be a very profitable arrangement. Selling other financial products generates additional fee income. If you add in the fact that customers tend to stay with the one bank for many years one would be forgiven for thinking that banking is an easy industry to analyse.
The irony of all of this is that in reality it could be that simple. A bank could just do the above and be seen as great franchise investments. In fact some banks do stick to this “KISS” (keep it simple stupid) approach and that is why I believe that Warren Buffett has been a long-term investor in bank shares. He invested in Wells Fargo many years ago. He owns some M&T Bank (as does AIB) and he has recently invested in Bank of America.
If banks tended to keep things simple I would have invested more of my savings in them (given the generous yields available) but at the back of my mind there has always been this doubt about what is going on behind the scenes. Having worked in a bank I have seen the tendency of bankers to get caught up in doing whatever is the fashionable thing of the time. History suggests that banks often end up getting involved in things that they do not understand or have not set up sufficient controls to manage the underlying risks.
With the current turmoil in markets we are now beginning to see that some of the banks have done it again. Some of them have not stuck to the “KISS” principle. Some of them have got involved in this whole area of sub prime. Perhaps I am now getting an answer to the question as to why there are/were so many high yielding banks.
With the benefit of hindsight I can say that I saw some of the warning signs. In the last couple of years I have read about the explosive growth in the derivatives markets, in the asset backed securities markets and in Collateralised Debt Obligations (CDOs). The FT has regularly written about the chaos in the back offices of so many investment banks as they have tried to keep up with the explosive growth.
Going back further in time I think that the first time I looked at the CDO market was about five years ago when a colleague of mine raised them as an issue of potential concern. This was around the time equity markets were falling in response to the bursting of the internet bubble. At the time there was some concern that a number of insurance companies were getting into difficulty. This colleague was worried that the insurance companies might have invested too much in CDOs. At the time we attempted to do some basic research on the CDO market. We attempted to find the total amount in issue, the assets behind them and who were the ultimate owners. We must have been well ahead of our time because we struggled to get any answers to these questions. This certainly was a warning sign because when we could not get a few simple answers it made us feel that there might be something getting out of control.
The next time a specific example came to my attention was early 2005 when I accompanied a relation of mine to a meeting with a leading Irish stockbroker. My relation had some money to invest and at the meeting the stockbroker suggested that 10% of the money should be invested in a CDO. They mentioned that they expected a 15% return from this investment. When I asked them to explain the mechanics of the product I was given a one page document that was not written in plain English. This was an anticipated nine-year investment with no exit mechanism before the nine years ended. In the small print I noticed that there was a 2% up front commission payment to the stockbroker and so it made me wonder whether that was part of the motivation for recommending the investment.
If an Irish stockbroker was recommending CDO based products well then I knew that most financial institutions would be involved. I think that this was part of the decision making process that consciously meant that I decided to stay away from banks that were heavily involved in investment banking. I tried to stick to banks that were more heavily retail focused and where it was likely that any involvement would be fairly insignificant. In other words I did what I always believe is the best way to invest. I tried to pick individual companies based on my knowledge of the company. Warren Buffett obviously thinks that way. I don’t know if he knew the extent to which M&T Bank was involved in some of the problem loans but at least it appears that it is a relatively small part of their business.
At the moment everyone is frightened because even retail banks have dipped their toes into these products. For example I would have thought that Deutsche Postbank would have been one of the least likely to be involved because they are so retail focused. I would have thought that if any back stuck to the “KISS” principle it would have been a post office bank. Little did I think that they would be at the centre of so many rumours and the problem at the moment is that rumours are flying all around the market (I have not invested in Deutsche Postbank but it has been recommended to me in the past).
On the face of it the Irish banks have not been heavily involved in this mania. The Irish banks are probably falling for a different reasons linked to concerns over the property market and economy. Those concerns are not the subject of this opinion piece but I have suggested that concerns over the short-term competitiveness of the economy are overblown in my opinion but there are some longer term concerns that need watching. (See opinion pieces on benchmarking and education).

In conclusion I want to highlight that I will continue to invest in banks that “KISS” as I think that in the long run this will increase the valuation that investors put on these banks. I will leave the financial institutions that play around in these more complex instruments to other people as I feel that the risks are too great.
(In a later opinion piece I might get around to writing about some of the banks I love because they know how to KISS !!!)

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Directors: Kenneth Power (Managing) B.Comm, MBS, ASIP, Regular Member of the CFA Institute.
Siobhan Power