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.