Banks are incredibly complex businesses in many ways. But they can also be very simple from an investment perspective. Legendary investor Warren Buffett cut to the chase in his inimitable fashion in an interview on CNBC in 2012.
"The profitability of banking is a function of two items. Return on assets [ROA] and assets to equity [financial leverage]," he said. "If you have 20 times leverage and you're getting 1.5% on assets, you're making 30% on equity [ROE] ... Banks were earning 25% on tangible equity not so many years ago. And really, that's kind of a crazy number. You know, for a basic semi-commodity business."
The reason it's a crazy number? As Buffett said, prophetically, in 1990: "When assets are 20 times equity -- a common ratio in this industry -- mistakes that involve only a small portion of assets can destroy a major portion of equity."
A tale of two banks
The tables below show ROA, financial leverage and ROE in 2007 (ahead of the financial crisis) and recent years for Lloyds(LSE: LLOY) and what I'll call for the moment 'Mystery Bank'.
Financial leverage (average) (%)
Financial leverage (average) (%)
As you can see, in 2007 Lloyds flaunted the kind of 'crazy' ROE referred to by Buffett. This was created from a pedestrian ROA and a crazy level of financial leverage.
Meanwhile, Mystery Bank had a much superior ROA, far more conservative leverage and a lower ROE. While the financial crisis virtually wiped out Lloyds' shareholders, Mystery Bank's shareholders fared infinitely better -- even continuing to enjoy dividends. It's the very model of a bank that can deliver value for its shareholders through the economic cycle.
Mystery Bank revealed
Lloyds will be a safer bank going forward but with stricter capital surplus requirements and mainstream banking more competitive than ever (challenger banks, online-only etc), achieving even its pre-crisis ROA of 0.94% will be difficult. This means it will always have to use higher leverage to achieve the same ROE as a bank with an ROA of 2%, or use the same leverage and deliver a lower ROE. Either way, in this respect, Mystery Bank is a fundamentally superior investment proposition. And for this reason, I'd always prefer to buy a slice of this business than of Lloyds.
Mystery Bank is FTSE 250-listed Close Brothers(LSE: CBG) -- a long-established and leading UK merchant banking group providing lending, deposit-taking, wealth management services and securities trading. It's trading on 12 times earnings, with a prospective dividend yield of 4%.
It's been taking a cautious line in some areas of its business lately -- notably motor finance where Lloyds is continuing to expand -- so I do have concerns we may be entering a less profitable period for banks in the economic cycle. As such, I'm inclined to rate Close as a 'hold' at this time, while I see Lloyds as a stock to avoid.
G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.