Do Not Invest In Bank Stocks For Retirement

Regarding dividends, the famous professor and investor Phil Fisher once said:

“This brings us to what is probably the most important but least discussed aspect of dividends. This is regularity or dependability. The wise investor will plan his affairs. He will look ahea to what he can or cannot do with his income. He may not care about immediately increasing income, but he will want assurance against the decreased income and unexpected disruption of his plans that this can cause.”

When it comes to dividend suspensions, cuts, and erratic policies, there is no sector that is quite as flighty over the long-term as bank stocks (with the possible accompaniment of tech stocks). If you review the recent financial crisis, you will see a litany of cuts from the big names in banking: Bank of America and Citigroup slashed their dividends to a penny, and the dividend payouts still have not recovered five years later. JP Morgan, US Bancorp, and Wells Fargo faced political pressure to cut their dividends, and so they did. Wachovia, Lehman Brothers, and Bear Stearns don’t even exist anymore.

This happened in the 1930s, this happened in the mid-1970s, this happened in the late 1980s, and this happened in the late 2000s. These events happen with just enough frequency to be considered normal, but are rare enough that investors can be lulled into thinking “this time is different” and spend years acquiring bank stock and reinvesting dividends, only to see their efforts result in 80% net worth declines and substantial dividend cuts when the next financial crisis arrives.

The reason why bank stocks are so susceptible to this behavior (i.e. you don’t see a consumer staple stock bust every generation with Coca-Cola, Pepsi, Colgate-Palmolive, and Procter & Gamble) is because debt and leverage determine returns, and in good times, the more risk taken results in better earnings growth. If you are a stodgy old bank growing by 3% here and 5% there in the late 1990s, you are going to become the mockery of the banking industry. Investors will be ticked; all the other big banks are growing their earnings per share at rates north of 10%, and slow growth is not generally respected by shareholders in good times.

This cultural defect incentives banks to take on more risk—the more leveraged you make your bank, the higher the net profits you can report to shareholders and reverse stagnant growth quite quickly. It makes sense; for every $100 in capital that a bank is sitting upon, the bank that chooses to lend out $1,500 to turn into productive loans is going to create more wealth than the bank that chooses to make $700 in loans on that same $100 in capital. If times are good and loans are getting paid and depositers are stuffing money into their accounts, then the riskier banks get all of the acclaim.

And when things are going well for extended periods of time (1993 through 2007), it is easy to get used to taking on more risk and make more aggressive loans, because that is the only way that you can deliver the growth necessary to satisfy the expectations of Wall Street. If you are running your bank conservatively in the 1990s and early 2000s and humming along with 3-4% annual growth, you will lose your job because you will be seen as incompetent when it appears that all of your banking stock peers are outperforming you.

Buffett’s famous quip is that “you don’t learn who is swimming naked until the tide comes out.” With lending risk in the banking industry, the public only learns who has taken excessive risk once every generation or so.

This is why you don’t want to put yourself in the position of needing to rely on bank dividends to make your ends meet. The business model is like a loaded gun that goes off every two to three decades. Just infrequent enough to lull you into a sense of complacency, but frequent enough that relying on bank dividends for the duration of your retirement will ensure that you will encounter a banking crisis over the course of 20-30 years.

High debt to equity is a dangerous thing. It happens slowly enough over time, that even otherwise shrewd investors can find themselves being like the frog in boiling water. By the time you reach retirement, you want rock solid income. I don’t think banks should be the vehicle to get you there. They should be treated as cute satellite holdings, mere accoutrements to the blue-chip stocks in other sectors that you want to rely upon for steady income.


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9 thoughts on “Do Not Invest In Bank Stocks For Retirement

  1. scchan_2009 says:

    I think a difference with tech and banking stocks are tech companies are far less leveraged than banks. Clearly, they are just as sensitive, but there have no been more limited collapse of tech companies (excluding the silly dot coms) and collateral of tech company collapse is more narrow.

    If I remember correctly, during 2007/8, Lehman's leverage on mortgage debt investments are more than 20 times (!?!?). Anyway, investors are at fault of encouraging banks to take dangerous moves, and are as much fault in directly investing securities which are linked directly to high risk debt (bank loan funds, mortgage-backed securities). Lately with government and high rated corporate debt having low yields, junk bonds and repackaged ("securitized") bank loan funds are making a big comeback. Oh, business development companies (BDC) are popular too. It sounds like many have short memory to what happened just less than half of decade ago.

  2. matthewriedle says:

    scchan_2009matthewriedle Yes, agreed.  In Canada, the banks were started, in large part, by Scottish arrivals and were modeled in a conservative fashion that has prevailed to this day.  Banks need to play the long game – when they do, they do well.  Witness the gradual dominance of Canadian banks in the US.
    Perhaps Australian Banks share some characteristics of the Canadian banks?

    In any case, I agree with Tim, I will never invest in American banks.  I will continue to do so in Canadian one's however.

  3. scchan_2009 says:

    matthewriedlescchan_2009 I think US banks can be fixed if there is political will to do reform the financial system – just like what happened during Great Depression. I do think the Bush/Obama administration did act quickly to patch short-term holes after the crash (much quicker than its European counterpart). However, the fundamental problems have not be addressed with over-leverage and big bonus and gambling culture have not been addressed strong enough (it is somewhat better before 2008, but it is not good enough). More dangerously, now we have the rise of shadow banking (BDCs, mortgage REITs, even hedge funds that make money off credit spreads). Such shadow banks have no FDIC backstops, and are poorly regulated.

    You have to give Canada and Australia the credit that they escaped mostly undamaged after 2008; oh don't forget this apply to Scandinavia as well. If you rewind a few decades, Canada was battling the mess with Quebec and most of Scandinavia industries were in shambles, but they get together to clean it up. Now it is time for US and Europe to do the same thing with their financial industry.

    While I think some greed is important to drive economic growth, but the current financial system is too greedy and over the top. The search for unsustainable profit must cease.

  4. Owner5524 says:

    Im a bit confused with this article, seeing as how US bankcorp, JP Morgan and Wells Fargo are listed on your master list of stocks. Wells Fargo is even listed as a premium BOLD stock. Are you saying these stocks on your master list should not be bought? I think most of us are into dividend growth investing as a means for safe and reliable income during retirement, which is one of the reasons why it's conservative aspects are so attractive to us.

  5. matthewriedle says:

    Hi Tim

    I would suggest you look into Canadian Banks – they are a breed apart.  In fact, the Bank of Nova Scotia has been paying a dividend every year since 1832 – before KO was a glimmer in Asa Grigg’s eye.

  6. scchan_2009 says:

    matthewriedle I think Australian banks are reasonably managed and well regulated. As a bit of a moral-relativistic defence to US banks, many European banks shared many similar bad characteristics as US banks. The problem of modern banking goes beyond leverage, the culture of industry is the problem – the leverage is just a symptom.
    Bankers are at once well respected profession. Now we called them “banksters”, and that “bankster” name ain’t for nothing.

  7. Elle_Navorski says:

    Good article. I like that it counsels only retirees to avoid bank stocks. Those with a 30-year or more horizon should check for long-term returns of banks like WFC, BAC, and C and consider a small position in banks in a well-diversified portfolio. Ben Graham’s view seems relevant:

    — “We have no very helpful remarks to offer in this broad area of investment [financial companies, in particular banks and insurance companies] – other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments.” The Intelligent Investor, 1949 

    — “”The securities analyst, in discharging his function of investment counselor, should do his best to discourage the purchase of stocks of banking and insurance institutions by the ordinary small investor.” Securities Analysis, 1934, as quoted at a certain Seeking Alpha article.

  8. says:

    Owner5524 Owner5524  The question is: What are you trying to accomplish? If your intended goal is income that will increase every year straight until 2065, I’m not so sure you’d want to be looking at a bank because they tend to get overleveraged every generation or so, and that loss of income and steep decline in price is a source of (what could easily be avoided) pain for someone *needing* that dividend income.

    If you’re trying to build a collection of high-quality assets, and aren’t wedded to the notion that the dividend has to rise every year into perpetuity, then I think US Bancorp, Well Fargo, and JP Morgan make sense as part of a well-rounded blue-chip portfolio. 

    The three banks I mention are currently high-quality assets, but if they have poor management, the consequences can be extraordinarily painful. The consequences of bad management at, say, Procter & Gamble wouldn’t be nearly as bad.

  9. scchan_2009 says:

    TimMcAleenanOwner5524 One thing I want to note about US Bancorp and Wells Fargo: If I have not mistaken: Bancorp, WFC, and together with PNC are the three top rated US bank in post-2008 stress tests. Here are few other interesting facts about Bancorp, WF, and PNC:

    1) Berkshire H has substantial holding in both Bancorp and WF – this is generally considered something positive

    2) PNC owns 20-some% of BlackRock – I guess is this a good or bad thing depends on who you ask, but there is some pressure for PNC to sell its BlackRock stake (anyway, that big stake in BlackRock does make the PNC balance sheet quite complicated)

    I have shares in WF and PNC. The former is a kind of stupid but legitimate strategy – buy what Warren Buffett buys; I have been PNC customer for like 15 years, and PNC does emerges from 2008 a somewhat strong position (except that stupid BlackRock thing on the balance sheet).

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