Monday, May 01, 2006

Do All Banks Have Moats?

  
Morningstar, Jim Callahan, 1 May 2006

You might be surprised to hear that nearly all banks have a sustainable competitive advantage--an economic moat. Warren Buffett and Charlie Munger were surprised, too. Buffett once remarked, "Charlie and I have been surprised at how much profitability banks have, given that it seems like a commodity business."

At Morningstar, we've long recognized the moats of banks, and it's nearly impossible to understate their importance. Without a robust analysis of a company's competitive advantage and the sustainability of that advantage over time, investors run the risk of buying one-hit wonders that burn out fast…along with shareholders' money.

At Morningstar, we begin each new analysis with the idea that a company has no economic moat until one is proven. But our financial services team believes that the banking industry offers an exception to the rule. We would argue that every bank has, at a minimum, a narrow economic moat.

To review some fundamentals, an economic moat represents a company's ability to earn returns above its cost of capital and defend its ability to do so over time. After confirming that a company's historical returns on invested capital exceed its cost of capital--the easier task--one must assess the likelihood of those surplus returns persisting in the future, and here's where mistakes can be made.

Below is a table of the most common sources of wide economic moats, a brief description of each, and their application to the banking industry. We will then get into some of the more important moat sources for banks.

The Beauty of the Deposit-Gathering Business

We believe that the true value in the banking industry is in the deposit business. The cost of banks' deposits can vary widely, ranging from market-rate-bearing deposits to non-interest-bearing deposits. This is because deposits, unlike any other form of debt, can generate revenue. (Imagine being paid to take out a mortgage!) When factoring in the income generated from deposit service fees (think ATM charges or overdraft fees), some banks are actually getting paid to hold depositors' funds.

Consider this: Banks can borrow money more cheaply than the U.S. government. The U.S. government is known as a risk-free borrower and, therefore, should command the lowest interest rates on its borrowings in the market. Of the largest banks by asset size, we found a five-year average effective deposit cost (interest costs net of deposit service fees) of 1.14% compared to a 2.13% average short-term Treasury bill over the same time period. In fact, a full 87 of the 113 banks (77%) we analyzed boasted average effective deposit costs below that of Uncle Sam's borrowing rate since 2000, while six banks actually generated deposit fees in excess of their deposit interest costs. Some of the more attractively funded banks we cover, as measured by their average cost of deposits over the last five years, include TCF Financial, Provident Bankshares, and Cullen/Frost Bankers.

The Advantage of Regulation

We believe that the heavy regulation of the past provided many banks a head start toward their dominant market shares. After the Great Depression, the banking industry became highly regulated. Banks were essentially granted government licenses to operate their depository and lending operations within a specified state or even county.

Further, banks were required to pay depository insurance, allowing the government to guarantee bank customers security from bank runs. The result was that, for any given operating area, one bank dominated the market, had barriers protecting it from new entrants, and was given below-market funding due to the risk-free nature of the deposit business. As long as the bank's borrowers didn't default, it was almost guaranteed a profit based upon the spread earned between the cheap funding and the interest rate on its loans. (Further, since the industry became highly fragmented, numerous banks--each operating within their own small market--often had loan officers and customers that developed deep relationships that lasted for years.)

Over the decades, of course, things have changed. Banks can apply for a charter to operate in any state and can engage in many nonbanking businesses, such as investment banking, asset management, and insurance brokerage. But the foundation upon which the industry was formed is still present. The banks that dominated certain cities 75 years ago remain (in various forms) today. Think of Wells Fargo in San Francisco, Fifth Third in Cincinnati, and Washington Mutual in Seattle. We believe that this stems from banks' integral roles within their respective communities: In assessing risk, they must know a borrower well, and in making loans, a bank is essentially financing the growth of a community over time.

Switching Costs

On a related note, we'd highlight the surprisingly high switching costs in the industry. Now, at first glance, it would appear easy enough to switch accounts from one bank to another. However, on average, deposits have proven to be fairly "sticky."

The development of alternative distribution channels--first ATMs, then in-store branches, then Internet banking---have made banks more accessible to customers. This availability lowers the chance of a customer leaving simply because a competing bank's branch is more convenient to, say, the workplace or school. Online bill payment and automatic direct deposits further increase a deposit account's "stickiness." It can be tedious setting up payees and dollar amounts upon initiating an online bill payments, making the thought of switching to another bank and having to go through the process again somewhat of a mini-barrier to exit. (We say mini-barrier because, as we speak, various technology firms are developing software to help transfer such information from one bank to another with the simple click of a button.) The bottom line is that the average life of a deposit account is surprisingly long, offering banks more opportunities to earn the spread between its borrowing and lending activities.

A Caveat: International Banks

The U.S. market is somewhat of a special case. Our comments thus far have focused on the U.S. banking industry, and the biggest difference when looking beyond the domestic banking market is that, unlike in the U.S., many countries' banking industries are largely consolidated. In fact, the U.S. ranks as one of the most fragmented banking industries in the world. Although the moat characteristics we've described broadly apply to the international banks we follow, there are exceptions to the rule, and we'd advise thorough research prior to investing internationally. (See our two-part article from January on how we approach investing in international banks.)

Conclusion

Banks are good businesses because of their fundamental design. Although many believe that banking is a commodity business, we believe that the basic business of banking and the industry's average profitability tell investors something different. Simply put, the proof of the industry's narrow economic moat is in the numbers: The average bank over the last 15 years has generated a 13%-14% tangible return on equity, above our 10%-11% estimated cost of capital. Those are the kind of numbers that turned the heads of Buffett and Munger.

A quick review of Morningstar's bank coverage reveals 59 domestic banks and 29 international banks. Of the domestic banks, 49 have narrow moats and 10 have wide moats. Currently, we believe the best investment opportunities are in large-cap, wide-moat banks, and we encourage investors to take a closer look.
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Sources of Economic Moats:

1. Factor: Intangible assets (brands, patents, government licenses, etc.)

Description: Unique non-physical assets that limit competition or allow a firm to charge higher prices.

Application to Banks: Regulation played a more important role historically, and we believe that the industry will continue its long-term trend of deregulation.

2. Factor: Cost advantage

Description: Important for commoditylike industries in which pricing power is nil. This advantage is often created through economies of scale.

Application to Banks: How a bank funds its loans plays a big role in its profitability-- banks have access to lower-cost funding than most other businesses.

3. Factor: High customer switching costs

Description: When customers are willing to pay higher prices for their convenience or because they can't easily get serviced elsewhere.

Application to Banks: Banks have surprisingly high switching costs.

4. Factor: Network effect

Description: A rare factor most often seen in technology industries, this is the widespread adoption of a first-mover's product or service until it becomes the standard.

Application to Banks: Not applicable to nearly all banks.
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