Margin of safety and banks

I recieved an email from Rohit shah. I am posting the email and my reply to his question below

Hi Rohit,

When you have some time, I request you to elaborate on ‘Margin of Safety’ principle as propounded by Ben Graham and strongly followed by Warren Buffett. What constitues margin of safety and how does one gauge it?

To give an example, I am trying to apply Margin of Safety principle on my Yes Bank investment in the below way.

My average cost of 115 Vs. CMP 150+. Last 200 Days avg. is 144.

40 Branches now
Target
100 by Mar 08
250 by Mar 2010.
(I am applying a 20% discount here as they don’t have good track record on Branch Expansion)

Currently the valuations are running ahead of performance, as Adj. PBV is around same as HDFC, ICICI & UTI Bank though the Branch expansion, higher retail portfolio and higher CASA % will help to improve NIM which is around 2.5/2.7% per last q results.

In 2010 Banking will start getting de-regulated. Yes Bank is positioned as an attractive takeover target due to (1) A greenfield bank with a knowledge driven banking approach (2) Zero levels of Net NPA.

Is this a right way? Are there any other criterias? Need your help with generic thoughts on this, per your convenience.

(I know Buffett perhaps wan’t invest in Banking businesses as Capital requirement of 12/13 % means just 1/8 of advances turning bad can have v significant impact. I however like the business model being perpetual in nature + due to my work experience, I have partial eligibility for ‘Circle of Competence’ principle)

Cheers
Rohit (Shah)

Hi rohit

Good to hear from a fellow value investor. The concept of margin of safety is actually very simple, but takes a lifetime of learning to apply effectively.

The concept is that one should buy a security at a discount to its conservatively calculated instrinsic value

The key words in the definition are ‘conservatively calculated instrinsic value’. There are multiple ways of calculating intrinsic value with DCF being a key one. Other ways would be to use relative valuation techniques or any other valuation approach which suits you.

The other key word is ‘conservatively’. In the end any price can be justified via a DCF if one makes aggressive assumptions in terms of growth and duration of the growth. So a prudent approach is to analyse the company which is in your ‘circle of competence’, be realistic about the growth and duration of growth assumption and use a probabilistic approach (please see the valuation spreadsheets which I have loaded on my website)

Banks unfortunately do not fall easily in the DCF approach (I have expressed my thoughts on banks on my blog earlier here and here and here).

Frankly I have not analysed ‘Yes’ bank till date. It is a new bank and should definitely grow. However the business risks are higher and I would not value it similar to HDFC bank which has a much longer operating history. At the same time I do not have a background in the banking industry and do not know how good the ‘Yes’ bank management is. However if you personally have an insight into the management quality, then it may be worth the bet.

Frankly my own analysis of banks is that by the very nature of the business, management quality is far more important in case of banks than any other business and as you pointed out, a management error can easily wipe out the bank . Also with a high leverage, even a few errors can be fatal especially for a new bank. So in the case of ‘Yes’ bank I would assume that the margin of safety will reside in the quality of the management and their ability to achieve the stated growth plans (profitably). I would personally not look at the option of the bank being a takeover candidate in the future. That may turn out to be icing on the cake, but I would not use it as a key valuation factor.

Additional thoughts

1. I look for additional margin of safety in case of banks. The biggest unknown for me is the quality of loans by a bank. NPA’s represent only a partial picture and usually a goes up with a lag if the loan quality is bad. Banks like ICICI bank and others have agressively expanded their retail loan portfolio in the past few years. Are they provisioning adequately? I am not sure but I think the bad debt risk in the retail segment is being under reserved by most banks

2. Management quality make a lot of difference in case of banks. I think by the basic nature of the business, competivitive advantages are weak and high returns are made by those banks which have good management. Bad or over aggressive management can sink a bank very quickly

update : 21st see this article on rising bad loans in retail