Understanding Companies

Investment Thesis – US Bancorp

Warren Buffett / Charlie Munger’s Four Filters + Risk Factors

  1. Understand the Business
  2. Enduring Competitive Advantages
  3. Able and Trustworthy Managers
  4. Risk Factors
  5. Bargain Price = Margin of Safety (I will not explore this as everyone should devise their own fair value)

1. Understand the Business

US Bancorp engages in 4 businesses:

2. Enduring Competitive Advantages

US Bancorp’s Competitive Advantages stem from the following sources:

  • Low Cost Efficiency Ratio
  • High Asset Quality
  • Well-Capitalized
  • Low Derivative Exposure

Low Cost Efficiency Ratio, High Asset Quality and Well-Capitalized constitutes a positive reinforcing cycle:

US Bancorp Business Model.png

By being cost efficient, US Bancorp is able to be well-capitalized (retaining liquid capital that isn’t lent out) whilst being profitable. This ensures US Bancorp can play in the game of lending to companies with great credit rating and only engage when the interest rates are good since US Bancorp would still be profitable even at the extremely low interest rates that US Bancorp can charge to these companies whilst US Bancorp can afford to not make loans if it doesn’t make business sense.

By statistics, companies with great credit rating default much less than those without, which thus builds resilience to profitability as US Bancorp is expected to keep raking in the net interest income regardless of economic cycle.

This then further drives / maintains the low cost efficiency ratio since as long as expenses don’t increase faster than growth of profits, the resilience in profitability allows for the profit side of profit / expense to drive / maintain the cost efficiency ratio down.

I further deem having a low derivative exposure to be another key competitive advantage. The reason is simple, it’s extremely hard to decipher the real value of derivatives on a balance sheet, so the more derivative exposure a bank has, the higher the catastrophe risk. Whilst competitors are potentially blowing up left and right, US Bancorp’s low derivative exposure allows it to stay profitable throughout economic cycles.

And when you look at the derivative exposure of the Top 5 US Banks in Asset Size, you’ll understand what I mean by US Bancorp having a low derivative exposure:

Rank – Bank – Asset Size – Derivative Exposure $ – Derivative Exposure X

1 – JPMorgan Chase – 2.42 trillion48.76 trillion – 20.1x

2 – Bank of America – 2.15 trillion40.20 trillion – 18.7x

3 – Citigroup – 1.77 trillion53.47 trillion – 30.2x

4 – Wells Fargo – 1.75 trillion5.83 trillion – 3.3x

5 – US Bancorp – 0.42 trillion0.18 trillion0.4x (!!!)

3. Able and Trustworthy Management

Ever since former CEO John F. Grundhofer brought Wells Fargo’s playbook of simple banking, disciplined loan underwriting, and low cost efficiency over to US Bancorp in 1990, he and his successor Richard Davis has been diligently focusing on 5 priorities only:

And the results demonstrate management’s ability, since US Bancorp is now the best US bank in terms of ROA, ROE, Cost Efficiency Ratio, and 2nd place in terms of Charge-Off Ratio.

US Bancorp’s track record also demonstrates management’s trustworthiness of focusing on its 5 priorities over the 20+ years as US Bancorp has stuck to growing 4 pretty much the same core businesses, driven down cost efficiency ratio to be the best, never exceeded 2.4% net-charge offs even during 2008=2009 financial crisis, improved credit rating to be the best, and kept all of the aforementioned metrics on target whilst acquiring many institutions.

4. Risk Factors

I find US Bancorp to be extremely low risk if risk is defined as destroying shareholder value.

There are however 2 ways I can see US Bancorp destroying shareholder value.

One way is if US Bancorp starts destroying shareholder value is if it abandons its current 5 priorities. As long as it suddenly decides to change direction in just one of the 5 priorities (eg. aggressively grow investment banking business or being less disciplined in cost control, asset quality, being well-capitalized and acquisitions), then the positive reinforcing cycle mentioned above will fall apart. The scary part of this is that any change in culture will be hard to observe, so being tipped off by a delay in deterioration of metrics could already be too late as there’s going to be a delay between cause and effect.

Another way is pure bad luck. US Bancorp for all its conservatism could still be ruined by large scale debt defaults since it is currently 9.8x leveraged [1]. This is always an inherent risk that comes with the banking business.

As a result of these two key risks, I would at most allocate a 1/3 position size to US Bancorp based on Charlie Munger’s diversification rule of “In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich“.

[Footnotes]

[1] Reference – https://infogr.am/bank_comparison-4

14.3% ROE and 1.46% ROA implies 9.8x leverage as only through that leverage is US Bancorp able to juice up returns from 1.46% to 14.3%.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

Understanding US Bancorp – 1993 10-K

By Taber Andrew Bain from Richmond, VA, USA (US Bank  Uploaded by xnatedawgx) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

In 1993, First Bank (predecessor namesake to US Bancorp) had 181 banking locations and 24 non-banking offices in:

  • Minnesota (23% deposit share, rank #1)
  • Colorado (19% deposit share, rank #1)
  • Montana (14% deposit share, rank #1)
  • North Dakota (9% deposit share, rank #1)
  • South Dakota (5% deposit share, rank #2)
  • Wisconsin

Its Core Businesses are:

  • Retail and Community Banking (60.5% of Total Net Income from 56.12% in 1992)
  • Commercial Banking (28.1% of Total Net Income from 32.07% in 1992)
  • Trust and Investment (11.5% of Total Net Income from 11.81% in 1992)

What immediately stood out to me was the clarity of CEO John F. Grundhofer’s strategy, which  was to increase Market Share and Long Term Profitability through (in no particular order):

  • Growing Core Businesses
  • Being Disciplined in Cost Control
  • Being Disciplined in Asset Quality
  • Being Well-Capitalized
  • Being Conservative in Acquisitions Favorable in Location and Price

This seemed like taking a page from Wells Fargo’s playbook (simple banking, disciplined loan underwriting, low cost efficiency), and it’s not surprising consider John F. Grundhofer was Vice Chairman and Senior Executive Officer of Wells Fargo before being CEO of First Bank in 1990.

And taking a page from Wells Fargo’s low cost efficiency playbook really showed. In terms of Cost Control, John F. Grundhofer helped drive Cost Efficiency Ratio from nearly 80% (!!!) in 1989 to 59.8% by 1993 through:

  • Centralizing Bank Office
  • Standardizing Products
  • Investing in Technology
  • Re-Engineering Operations to Improve Productivity, Customer Service and Cross-Sell Ratio
  • Create Culture of Cost Control through Incentive System that Focuses on Relentless Cost Reduction, Strongly Encouraging Senior Management to Own 1x-5x Their Salary in Shares within 5 Years, and also Accountability of Expenses through Internal Fund Transfer Pricing System

The target set in 1993 was to reduce Cost Efficiency Ratio down to mid-50s within 2 years (1995) and eventually stay at low-50s. In comparison, 2015’s average Cost Efficiency Ratio of US Banks was 60.45% [1]. Overall, the Cost Efficiency Ratio of the different Core Businesses were:

In terms of Asset Quality, Non-Performing Assets was only 1.20% of Total Gross Loans. In comparison, 2015’s average Non-Performing Assets to Total Gross Loans of US Banks was 1.50% (as of 16th Jul 2016). To achieve this:

  • First Bank always evaluates its own credit risk through factors like evaluating composition of loan portfolio (as diversified as possible by industry classification, size and type of loan), level of allowance coverage, macroeconomic concerns (eg. level of debt in public / private sector), and effects of domestic / regional / international issues.
  • First Bank also manages credit through centralized credit policy and underwriting criteria whilst large loans or any loans that experience deterioration of credit quality is reviewed quarterly by management.
  • First Bank also has been decreasing exposure to Highly Leveraged Transactions (commercial loans involving buyout, recapitalization or acquisition of an existing business)

For Well-Capitalization, First Bank targeted and achieved Well-Capitalized status as defined by Federal Deposit Insurance Corporation of all bank subsidiaries [2]. It also had Provision for Credit Losses of 2.25%, 1.9x more than Non-Performing Assets to Total Gross Loans.

Combination of Cost Efficiency, Asset Quality and being Well-Capitalized meant that First Bank’s Net Interest Margin was 5.07%. In comparison, 1993’s average Net Interest Margin of US Banks was 4.51% [3].  At the same time, these factors helped First Bank improve its credit rating (Moody = A3 -> A2, S&P = A- -> A, Thomson Bankwatch (Fitch) = A+).

[Reference / Footnotes]

[1] (As of 16th July 2016) – http://www.bankregdata.com/allIEmet.asp?met=EFF

Couldn’t find data from 1992, so used 2015 as comparison

2015Q1 – 60.97%

2015 Q2 – 59.77%

2015 Q3 – 60.80%

2015 Q4 – 60.27%

[2] FDIC Well-Capitalization definition is:

  • Tier 1 Capital Ratio – >=6%
  • Total Risk-Based Capital Ratio – >=10%
  • Leverage Ratio – >=5%

[3] https://fred.stlouisfed.org/series/USNIM

1993 Q1 – 4.51%

1993 Q2 – 4.51%

1993 Q3 – 4.52%

1993 Q4 – 4.49%

[Disclosure]

I currently own US Bancorp (USB) stocks, and intend to keep increasing my position size of USB.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

Understanding T.Rowe Price

By Dean Biggins, U.S. Fish and Wildlife Service [Public domain], via Wikimedia Commons

Warren Buffett / Charlie Munger’s Four Filters + Risk Factors

  1. Understand the Business
  2. Enduring Competitive Advantages
  3. Able and Trustworthy Managers
  4. Risk Factors
  5. Bargain Price = Margin of Safety (I will not explore this as everyone should devise their own fair value)

1. Understand the Business [Updated Oct 17th 2015]

T.Rowe Price is an asset management firm that serves individual and institutional clients mainly in the form of US mutual funds and other investment portfolios (separately managed accounts, subadvised funds, collective investment trusts, target-date retirement trusts, Luxembourg-based funds for non-US investors, variable annuity life insurance plans etc.). Of the 746.8 billion USD assets under management (AUM) as of 2014 Dec 31, Mutual funds currently occupy 63.95% while other investment portfolios occupy 36.05%.

In terms of investment strategies, T.Rowe Price only focuses on equities and fixed income, providing options that range from purely equity or fixed income to a mix between both. Of the 746.8 billion USD AUM as of 2014 Dec 31, stock and blended asset occupy 77.65% while fixed income portfolios occupy 22.35%.

2. Enduring Competitive Advantages [Updated Oct 21st 2o15]

T.Rowe Price’s biggest competitive advantage is its Reputation, with most of its related competitive advantage derived from its Reputation. The other significant competitive advantage T.Rowe Price has is its Disciplined capital allocation.

One competitive advantage that derives from T.Rowe Price’s Reputation is an extremely happy customer base (National Association of Retirement Plan Participants ranked T.Rowe Price as “most trusted” retirement plan provider in 2014, and 86% of customers would recommend T.Rowe Price to friend / relative for one to one consultation), which helps with customer stickiness through thick and thin as clients stay put with a brand they are familiar with during times of uncertainty.

T.Rowe Price’s Reputation also helps it grow its AUM, which helps gives it scale for cost efficiency as the 26th largest asset management firm globally. Its AUM growth rate (using Dec 31 2014 as cut off date) is 7.89% (1 year), 15.13% (3 year CAGR), 13.81% (5 year CAGR) and 12.25% (10 year CAGR).

This Reputation also helps T.Rowe Price attract and retain a fund management team that have an average of 19 years of investment experience and 13 years’ tenure with T.Rowe Price and contributed to 74% of its mutual funds outperforming comparable Lipper average on total return for a 3 year period and have 82% of assets given a four to five star rating from Morningstar.

All three of these Reputation related competitive advantages creates a virtuous cycle that continually feeds each others’ increasing strength.

Another competitive advantage that cannot be ignored is T.Rowe Price’s Disciplined capital allocation. T.Rowe Price has rarely engaged in acquisition activities, and has a shareholder friendly dividend policy that has seen its dividend grown year on year for 29 consecutive years.

3. Able and Trustworthy Managers [Updated Oct 1st 2015]

One aspect of T.Rowe Price’s management was explored in the aforementioned “Disciplined capital allocation” section below “2. Enduring Competitive Advantages”.

The other aspect of T.Rowe Price’s management is Financial prudence, which is different to disciplined capital allocation in a sense that I view capital allocation as offensive (deploying capital to generate more capital) while I view financial prudence as defensive. As of 2014 Dec, T.Rowe Price’s zero debt and dividend payout ratio of 38.20% provides huge margin of safety for T.Rowe Price to navigate unforeseen negative circumstances.

4. Risk Factors [Updated Oct 19th 2015]

The biggest risk to T.Rowe Price is purely on its ability to recruit and retain talents that can continuously succeed in the world of investing.

Making matters more difficult, T.Rowe Price is heavily exposure to US Equities, which accounts for 69.40% of its total assets under management (685.18 billion USD in US Equity and 61.62 billion USD in int’l Equity), arguably the “most transparent, efficient and competitive (stock market)… in the world“. The implication is that T.Rowe Price needs to recruit and retain the absolutely best talents available in order to outperform not only its competitors, but also the extremely efficient US stock market.

And as of Oct 19th 2015, there is concern about T.Rowe Price’s ability to differentiate itself admist competitors in the war for talent.

Compared to its direct competitors as listed in Yahoo Finance and top 3 biggest competitors as listed in Morningstar (namely Fidelity Investments, The Vanguard Group and American Century Companies and BlackRock, Bank of New York Mellon, and Blackstone Group), T.Rowe Price’s Glassdoor score is 3.5 versus Fidelity’s 3.7, Vanguard 3.3, American Century’s 4.0, BlackRock’s 3.6, BNY Mellon’s 2.8, Blackstone Group’s 4.0 (Competitor average score of 3.57).

Another significant risk to T.Rowe Price is that most of its business is done in the form of mutual funds. Actively managed mutual funds are structurally designed to have a hard time beating the market due to over-diversification, high fees vs passive funds, mandatory cash on hand, closet indexing, and high taxes due to turnover rate. It’s a reason why 86% of actively managed mutual funds fail to beat the market.

If T.Rowe Price fails to keep beating the market and peers due to limitations of the mutual fund structure, it would seriously deteriorate its reputation and any competitive advantages that come with it (customer attraction, customer stickiness, talent recruitment, talent stickiness and scale).

Understanding ExxonMobil

By Financial Times [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

Warren Buffett / Charlie Munger’s Four Filters + Risk Factors

  1. Understand the Business
  2. Enduring Competitive Advantages
  3. Able and Trustworthy Managers
  4. Risk Factors
  5. Bargain Price = Margin of Safety (I will not explore this as everyone should devise their own fair value)

1. Understand the Business [Updated Sep 29th 2015]

ExxonMobil is a primarily oil and gas company, involved in upstream, downstream and chemicals activities.

Upstream involves “the searching for potential underground or underwater crude oil and natural gas fields, drilling of exploratory wells, and subsequently drilling and operating the wells that recover and bring the crude oil and/or raw natural gas to the surface“, and as of its 2014 Annual Report, generated 78.92% of its Earnings after Income Taxes before deducting Corporate and Financing.

Downstream involves “The downstream sector commonly refers to the refining of petroleum crude oil and the processing and purifying of raw natural gas, as well as the marketing and distribution of products derived from crude oil and natural gas“, and as of its 2014 Annual Report, generated 8.72% of its Earnings after Income Taxes before deducting Corporate and Financing.

Chemical Activities involves collecting chemical feedstock from the Downstream oil refineries to produce polymers and chemicals & fluids. The reason why this is important is because when ExxonMobil’s Downstream oil refineries collect petroleum (aka crude oil), not everything refined from the petroleum can be used for energy carriers such as gasoline, jet fuel, diesel fuel, so the production of petrochemicals with what’s left of the petroleum is a natural fit for ExxonMobile considering being the largest oil refinery naturally yields large sources of chemical feedstock while also providing further diversification from a purely upstream company with full exposure to the cyclical nature of commodities. As of its 2014 Annual Report, Chemical Activities generated 12.36% of its Earnings after Income Taxes before deducting Corporate and Financing.

2. Enduring Competitive Advantages [Updated Oct 1st 2o15]

There are 4 competitive advantages I believe make a huge difference for ExxonMobil: Legacy low cost assets, Disciplined capital allocation, Oil reserves, Triple A credit rating

Currently, ExxonMobil’s legacy low cost assets has allowed it to produce oil/gas at $20 USD / boe (barrel of oil equivalent), as compared to the $60 USD / boe average of US upstream industry.

Combined with a management team (Rex Tillerson and co) and company culture that has a track record of disciplined capital allocation of investing only in projects that provide good return on invested capital and returning excess capitals in the form of growing dividends consecutively for 33 years. There maybe questions posed on Tillerson and co’s ability of disciplined capital allocation with XTO, but they have been quick to “dramatically cut U.S. natural gas production, divested lower-margin assets, and exited from fixed fee per barrel contracts“.

Disciplined capital allocation’s effect is further magnified by ExxonMobil’s oil reserves of 92 billion boe and a Triple A credit rating. With a combination of legacy low cost assets producing at a third of the industry’s cost and a 92 billion boe reserve (worth $3.7 trillion USD using a 10 year low of $40 USD / boe), it allows ExxonMobile enormous amount of leeway to be patient and make only the best capital allocation decisions over an extremely long time horizon.

The ability to tap into Triple A credit ratings for low cost loans also present ExxonMobil an advantage to be aggressive in acquisitions of low cost oil / gas fields at cheap valuations when there’s a recession or cyclical oil market crash. This is important since I deem ExxonMobil to not have any significant advantage in obtaining low cost oil / gas fields at cheap valuations unless competitors or partnership governments are forced to sell assets at a discount due to liquidity issues.

3. Able and Trustworthy Managers [Updated Oct 1st 2015]

One aspect of ExxonMobil’s management was explored in the aforementioned “disciplined capital allocation” section below “2. Enduring Competitive Advantages”

The other aspect of ExxonMobil’s management is financial prudence, which is different to disciplined capital allocation in a sense that I view capital allocation as offensive (deploying capital to generate more capital) while I view financial prudence as defensive. As of 2014 Dec, ExxonMobil’s 0.11 Debt to Equity (~10% of assets is debt) and dividend payout ratio of 33.20% provides huge margin of safety for ExxonMobil to navigate unforeseen negative circumstances.

4. Risk Factors [Updated Oct 1st 2015]

There are three risk factors I deem able to decimate ExxonMobil: Boe Replacement Difficulties, Trend of Gas > Oil, New Energy Sources, Financial Health Deterioration

It is no secret that days of easy Boe Replacement are long gone, with most “Western oil-producing companies… finding most accessible oil fields… tapped long ago, while promising new regions are proving technologically and politically challenging.” This issue is exacerbated by the fact that ~40% of the world’s crude oil supply is controlled by OPEC, meaning that the scramble for Boe Replacement will only get costlier as supplies outside of OPEC deplete and upstream companies play an increasingly negative sum game to bid for newer supplies.

The Trend of Gas > Oil is also worrying, since “gas sells for less than the equivalent amount of oil“, which may see ExxonMobil’s margins to suffer permanently if the quantity of gas recovered doesn’t offset the eventual decreased quantity of oil recovered.

New Energy Sources due to technological advances may also pose a grave threat to ExxonMobil if they cannot participate in profiting from such sources. Even though it seems unlikely that oil and gas would be displaced as the dominant energy source of choice overnight (best case scenario is 100% renewable energy source in 40 years), it is definitely something to be wary of for ExxonMobil.

Financial Health Deterioration is also a potential time bomb. As of 2014 Dec, Exxon Mobil’s Current Ratio, Debt to Equity and Dividend Payout Ratio has been deteriorating over the past 5 and 10 years. Exxon Mobil’s Current Ratio of 0.88 is worse than its 5 year average of 0.91 and 10 year average of 1.17, Debt to Equity of 0.11 is worse than its 5 year average of 0.06 and 10 year average of 0.06, and Dividend Payout Ratio of 33.2% is worse than its 5 year average of 27.4% and 10 year average of 25.52%. Although the Current Ratio, Debt to Equity and Dividend Payout Ratios are all currently on manageable levels, it’s hard to say the same if the trend continues.