Gabriel Solomon is a vice president at T. Rowe Price and portfolio manager of the T. Rowe Price Financial Services fund (PRISX). We spoke recently about what investors should look at when analyzing the stocks of banking, insurance and investment companies.
—Charles Rotblut

Charles Rotblut (CR): Let’s start with a basic overview: How do the financial companies differ from other companies, such as manufacturers or retailers, in terms of their financial statements?

Gabriel Solomon (GS): There are some key differences to the business models that are somewhat unique to a number of financial services companies. These differences influence how the financial statements are set up and how investors should look at them.

A lot of the financial services companies need liquidity. The banks get funding through deposits or debt in order to have liquidity to extend as loans or invest in securities. This is how they make their spread income. A lot of the operations for investment banks also require access to capital markets, and that’s really what created the biggest problems in 2008 and 2009. The access to liquidity was shut off as the economy slowed, and there were concerns that there wasn’t the same access to liquidity.

Another key difference is that, because it’s a very highly regulated sector, especially with respect to capital, financial companies don’t have the same freedom to use their capital as many other industries do. For example, banks cannot just go and buy back stock, increase dividends, or make an acquisition. They need to work with the regulators to get approval in order to make those decisions.

Lastly, in other industries that you mentioned—specifically retail and manufacturing—inventory is really a key analysis factor, but it’s less of a factor for financial services companies. As a result, what’s more important is understanding the credit quality and the value of what financial companies have on their balance sheet.

CR: You mentioned the role of regulators, but before we get into a discussion of the Tier 1 capital measure used by regulators, could you elaborate on the business model for banks? Everyone realizes that banks pay on deposits and lend out money, but could you explain how a bank actually makes money?

GS: Sure. Banks make money through a combination of spread income and fee income. The mix between those two varies, largely based on the size of the bank. The smaller or medium-sized community banks will earn the vast majority of their income as spread income. They have approximately, on average, 80%/20% in terms of spread to fees. For larger banks it could be all the way up to half and half, and many larger ones are at least 40% fee.

If we try to look at what each of those components is, starting with the spread income, we see that banks borrow money, essentially from fixed-income markets through short-term and long-term debt and from customers via deposits. Then they take that capital that they’ve borrowed and lend it out to customers. A yield is earned on those loans. For the money that they’re not lending out, they will create a securities portfolio—an investment portfolio—that will largely be composed of fixed-income type of securities with generally short durations (low levels of interest rate sensitivity). The spread income is the difference between the yield that the banks earn on loans and invested assets and the cost of funds, such as the amount that they’re paying for the debt.

CR: Taking it a step farther with the emerging regulatory standards, regulators are looking at the quality of the debt that the banks are holding onto, right?

GS: When you say the debt that they’re holding onto, do you mean the invested assets, or do you mean the loans?

CR: Both, correct?

GS: Tier 1 capital is common stock plus preferred stock minus intangibles. Tier 1 common is just the common stock minus intangibles. So the Tier 1 common is the key one for the capital tests and capital ratios. The denominator of the ratio is the risk-weighted assets. That’s the amount of common, clean capital that’s held against some assessment of—and this is what you’re getting at—the assessment of the amount of risk that’s on the balance sheet, i.e., the assets. So, that is both the invested assets, the securities that they buy and then also the loans.

The Federal Reserve or the regulators are looking at the quality of banks’ lending and also the types of loans that banks are making, the types of customers that they’re lending to, the criteria that they are basing their lending on, as well as just the types of securities that they’re buying. The regulators then assess risk weightings to determine how much of the numerator is required, or how much capital is required, in order to hit their goals.

CR: For an individual investor looking at this, is there a certain number on the Tier 1 to look for? Because I’m guessing the focus should be on the Tier 1 ratio and not what’s comprising it, correct?

GS: Yes. The answer is that it varies and it’s a moving target. So that’s been the $64,000 question: What number do you need to manage to? What is the right number to get to? For the largest banks, the capital requirements have just been increasing dramatically, and we don’t even know what the final rules are going to be yet. For the smaller banks, it’s a little less onerous.

The best way for individual investors to go about it is to compare the capital ratios. For a smaller bank, you’re not going to have the denominator, which is the risk-weighted assets. So, what’s really important is the TCE ratio, or ‘tangible common equity,’ which is just basically taking the same tangible common and then dividing it by total assets. Compare that TCE with how peers are capitalized, and how other banks outside of the core peer group are capitalized, in order to get a sense of how the bank is capitalized, relative to its peers.

Now, I’d also say, you need to understand the whole picture in order to make an assessment, because you need to understand that some companies—for example, those that are lending in more heated, more risky areas such as commercial real estate, leveraged lending, auto lending—are taking more risks. Therefore, you want them to have more capital. The companies with great track records, with very conservative lending standards, in theory are taking less risk. But investors should be careful not to paint with too broad of a brush.

Table 1. Performance of the T. Rowe Price Financial Services Fund (PRISX)

	Total Return (%)		Annual Total Return (%)			Yield (%)	Exp Ratio (%)
	YTD (%)	2014 (%)	Last 3 Yrs	Last 5 Yrs	Last 10 Yrs
T. Rowe Price Finc’l Servs (PRISX)	1.2	9.2	17.7	10.8	5.3	1.0	0.88
Financial Sector Category Average	0.3	6.1	15.5	9.8	2.9	0.8	1.11
Editor’s Note: Solomon became the sole portfolio manager on July 31, 2015; he has served on the fund’s investment advisory committee since 2005. Source: AAII’s Quarterly Low-Load Mutual Fund Update, April 2015. Data as of March 31, 2015.

CR: Is there anything else that investors should be looking for beyond the obvious growth ratios and, I guess, even efficiency? By efficiency I mean how well the bank’s performing in terms of operating its business and controlling expenses.

GS: Clearly, in addition to those, credit is very important: Just understanding how the management has performed in other cycles, how well they have managed through other cycles without incurring significant credit losses. The real way an investor can get hurt with a bank is buying a bank that is going to end up having credit losses, because there’s so much leverage inherent to the balance sheet that that’s really the area that you have to make sure you understand. How do you do that? It’s tricky, is the answer.

Beyond just looking at the track record, as I mentioned, I would suggest reading conference call transcripts, looking at their marketing presentations on their investor relations parts of their websites, and just trying to understand where they’re growing and how they’re growing. Are they growing in their core footprint, are they trying to go into new markets or new products, which, obviously, generally incurs more risk, or are they sticking to their knitting? Additionally, do they have a cogent strategy or do they just seem like they’re operating in a commoditized world and don’t really do anything different than any other bank?

CR: Let’s move on to insurance companies. Could you explain how their business model works and what an investor should pay attention to when analyzing them?

GS: Absolutely. Let’s focus on property and casualty insurance. I think life insurance is very difficult for any investor, because they have very opaque balance sheets and business models. Structurally, I tend to prefer property and casualty. Property and casualty companies sell coverage and take in premiums as revenue. They also take some sort of liability for whatever the coverage is that they’re selling. As they do that, they have to make an assessment of what they think the ultimate profitability will be of the premium they just sold. So, they’re making an educated guess on what the losses will be for that policy, and that is their initial starting point of profitability. They then also take the money that they received as premiums and invest it into a securities portfolio, enabling additional money to be made through the investments.

The best measure of profitability is the combined ratio. The combined ratio is the expense ratio, or operating expense ratio, which tells you the operational efficiency of the insurance company. It’s non-insurance loss-related expenses divided by premium revenue, plus the loss ratio, which is the actual incurred losses or expected-to-be-incurred insurance losses divided by those premiums. As a result, the combined ratio gives you a sense of the total losses.

The trick with insurance companies—and I started out as an analyst here covering insurance—is this strange wrinkle that they’re bringing in the revenues today, but have no idea what the cost of goods sold is going to be. In fact, in some situations, longer-tail liabilities—meaning liabilities that take longer to emerge such as directors’ and officers’ insurance, medical malpractice, or workers’ compensation—could take many, many years. As an investor, you don’t really have an accurate snapshot of what the ultimate profitability is going to be. Therefore, you want to pay a lot of attention to some of the similar things as we talked about with banks.

One, what’s the track record of this company, how did they do in the last cycle, has the company consistently made an underwriting profit, or have profits been very lumpy with a lot of money being made in some years and a lot of money lost during others? I would generally value consistency.

Second, what is the strategy of the company? Typically, if you’re a really good insurance underwriter, you can make a lot of money in little niches, little areas that aren’t commoditized where you’re taking on risk that other companies don’t really understand. It’s when companies grow outside their footprint or try to get aggressive in other areas that they can run into trouble. It’s especially because of this dynamic that I mentioned before that you don’t know what your cost of goods sold is for many years.

Third, I’d say, understand whether the company is growing and, if so, whether now is the right time to grow. For example, right now the pricing environment is okay, it’s coming off of a really solid several years, but pricing has stopped going up. You wouldn’t want to see any of the insurance companies really growing too much over the next couple of years. If they were, you’d really want to be circumspect with respect to how good the risk management is and think through whether you want to be taking that risk.

CR: What about the brokers and investment banks? Is there a way to group them together or are they just too different or complicated, such as the case of JPMorgan Chase (JPM)?

GS: They’re all really different. You have the universal banks: JPMorgan, Citigroup (C), Bank of America (BAC) and Wells Fargo & Co. (WFC). Then you have investment banks: Morgan Stanley (MS) and Goldman Sachs (GS). They all have different business mixes, but a lot of the things we discussed in terms of lending apply to the universal banks, less so to the investment banks.

But, then, all of these companies also have some degree of capital markets revenue and the investment banks have a lot of it. Capital markets income comes from merger and acquisition (M&A) advisory fees and fixed-income or FICC (fixed-income, currencies and commodities) trading. Fixed-income trading tends to be a very volatile line of business because it tends to track pretty closely with volatility and with the degree of interest rate spreads. In time periods like the last few years, when spreads are tight and there isn’t much volatility, it’s a huge drag on those banks’ income statements. But, in periods of time when there’s more volatility, it can swing hard in the other direction.

I think the general dynamics that we discussed for the other groups apply here, too. I would just add that these companies are even more constrained in terms of how they can use their capital. So it’s really understanding how much excess capital they have, how high the capital hurdles are going to be—which, unfortunately, we don’t know yet and it’ll still take some time to settle out—and what the companies’ management teams are going to do about it. Now, the good news is that these companies are much better run today than they were in the last cycle. When they were making acquisitions, they were growing and they were just really focused on revenue growth. Now these companies are focused on managing expenses, returning capital to shareholders, increasing dividends, buying back stock to the extent they’re allowed to by the regulators. Deals are certainly off the table, like acquisitions. They’re much better run, which argues for some expansion of valuation multiples over time.

CR: In terms of valuations, I’ve read that it’s not recommended to use a price-to-sales ratio with financial companies because the revenue streams are different. What do you use, as a fund manager, to determine whether a financial stock is cheap or expensive?

GS: First, on the price-to-sales ratio, there’s another element there, another reason not to use it, and that’s that sales growth—and sales, in general—isn’t always good; revenue isn’t always good for financial services companies. This is probably another way that financial companies differ from a lot of other industries. For example, it really applies to both banks and insurance companies. If an insurance company or a bank is growing much more quickly than its peers, that’s usually not a good thing. Companies can compete on price, compete on their terms and conditions; they can be more lax on their lending standards or how they’re underwriting their insurance policies and can grow significantly that way, only to incur big, big problems later on. This is why you almost want to be more circumspect about companies that are growing.

As to your question “what do I use?,” I use a combination of price to reported book value and price to tangible book value, thinking about both of those relative to the return on equity and return on tangible equity. I like to look at different time periods in terms of a price-earnings perspective. For example, today I’m looking at 2016 and 2017 earnings, but for companies that have some headwinds and might not be reaching the earnings power of their franchise I am also trying to think about the price-earnings ratio from normalized earnings. I’m trying to adjust for what those normalized earnings might be. For some of the companies that we didn’t discuss, but some of the more services-oriented companies, like an insurance broker or some of the credit card networks, thinking about some sort of a discounted cash flow-type of analysis is often helpful to include as an arrow in the quiver.

The bottom line, I think, is that it’s important to not over-rely on any one metric, but rather try to understand the overall picture of how all of those metrics look. For example, there may be two insurance companies. One has the lowest price-to-book ratio in the group and the other one may have the highest price-to-book ratio in the group. But what matters is understanding the profitability and the return of equity (ROE) of each of those companies. The stock that has the high price-to-book ratio may have materially higher ROE, better earnings growth opportunities, a better-run franchise, a cleaner balance sheet and may use its capital more effectively. So, there are any variety of reasons why you don’t want to just look at valuation on its own, in isolation. You want to think about it within the bigger picture.

CR: For someone looking for growth, should they focus on the earnings and net income and ignore the top-line growth, or just be suspicious if it seems overly high?

GS: It depends. There are some areas of structural growth within financials where you can focus on top-line and bottom-line—the networks, for example, Visa (V) and MasterCard (MA). But for the most part, for the companies that we’ve discussed, like the banks, insurance companies, investment banks, you really don’t want to invest in them with a growth thesis. It’s more likely that you’ll find opportunities for cyclical growth—where coming out of a downturn, there may be cyclical growth—but, otherwise I would focus more on the earnings growth, the potential for ROE expansion, rather than revenue growth.

CR: Regarding the tangible equity numbers, is that a matter of just subtracting intangibles from total assets and then adjusting book value? Or do the financial companies usually report tangible book value?

GS: Yes, they do, and there may be some other minor adjustments, but if you just take the book value and subtract out the goodwill or any other intangibles that are outlying on the balance sheet, that basically gets you there.

CR: ROE’s a measure you pretty much focus on for a lot of these companies?

GS: Yes.

CR: And it’s mostly a comparison to their peers?

GS: Yes. I also like to think about each sector, each group, and then each company as a story, in thinking about what the intrinsic value is. I try to do very little relative investing. I try to avoid looking at the 10 large insurance companies and saying “which is the most attractive?” Rather, I devote time to figuring out what I think the value of each stock should be and then trying to figure out which of those stocks have the most upside to those intrinsic values.

CR: When looking at return on equity numbers, should people look at them absolutely or relatively?

GS: You should look at them relative to history and then relative to peers, and relative to what you intuitively think this business model should be earning. That’ll help determine whether the company’s being run efficiently, are there opportunities to make it more efficient, etc.

CR: Is there anything else I haven’t asked that we should bring up?

GS: If there’s one point that I would want to come across, it’s just that I think it’s a mistake to try and pick any one metric or benchmark, like the price-to-book ratio, and then benchmark it against a company’s peer group.

There’s so much more going on with any of these companies that what would better differentiate a really good long-term investment from a bad one is often understanding just those nuances. What are management’s incentives, are they going to make the right decisions in terms of returning capital, etc.? I guess it’s just looking at the overall picture.

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