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[Music] do you want to learn how to manage your all investments are you ready to stop paying investment management fees and start building wealth the DIY investing podcast is dedicated to providing you with the knowledge skills and resources you need to be a better investor learn how to make investments through the use of fundamental analysis mental models and business management insights here's your host value investing expert Trey Henninger hello and welcome to the DIY investing podcast my name is Trey Hannigan and I'm your host however you are listening to today's podcast please be sure to subscribe the listening on You Tube hit the like button and if you're listening on a podcast platform your 5 star rating and review is much appreciated thank you for your support in today's episode I want to discuss banks and the banking industry's business model specifically we're going to focus on why banking is an attractive industry today's episode is a follow-up episode in my banking series which began in episode 79 how banks make money if you haven't listened to that episode you don't need to listen to it before listening to today's episode but I would highly recommend listening to that episode as well after listening to this one today we'll continue with a focus on why banking is an attractive industry so let's discuss some key characteristics of the banking industry I'm going to first list off what these characteristics are that I think make it attractive for investors and we're going to go into detail on each one some of the key characteristics that I think are important for investors to consider on why I believe banking is an attractive industry are first and foremost there have been fewer banks over time in the United States second the number of new banks being created has fallen nearly to zero there are high retention rates in the banking industry low competition and as an industry banking efficiency is improving over time banking is also a durable industry and the business is very simple so let's dive in on each of these items and talk in detail about why I think banking is a good industry to put some money in to work as an investment so first and foremost banks are becoming fewer in the United States over time now I don't have data on the rest of the world but I wouldn't be surprised if this standard is holding true and much of the developed world I don't like that term but let's just say much of the European economies that banks may be declining over time but it might be that in other parts of the world the number of banks are increasing but specifically for our US investors and those foreign investors who are investing inside the United States this is a very key component and that's that there are fewer banks over time in the United States if we look back to 1966 there were 23,000 commercial banks in the United States yet by 2002 that number had dropped to seven point eight thousand and as recently as 2018 there were less than five thousand FDIC insured commercial banks in the United States so you've seen a drop of about 80 percent and the number of banks in the country based upon just the numbers going down each year since the mid-1960s now that's very important as the number of banks in the United States is decreasing those are less banks you have to compete with for business usually when the number of competitors in an industry starts going down that's good for those banks that stay and this is seen all around in other industries the airline industry used to be a terrible industry but it became much more attractive to invest and once there were only four major airlines in the United States that was why and a big part of the thesis why weren't Buffett eventually made an airline investment even though he had first sworn doing so for decades now we all know that in recent days that hasn't worked out as well as he had to sell for a loss on many of those in Airlines as they faced problems with the coronavirus but the basic idea was that the airline industry as a whole was much more attractive once she went from dozens and dozens of airlines to only three four or five all competing for the same amount of business because each airline that's left had a lot more business per airline for them to split up and have high market share the same as thing is true in any industry as the number of competitors Falls closer to 1 or 0 the remaining companies become a lot more profitable now banking in the United States at least has always been a widely diversified industry when you're talking about 20,000 competitors in a country that's a lot of banks that's a lot of competitors and certainly the current four point seven thousand or 4,700 banks that are left as FDIC C insured commercial banks is still a very large number but it is substantially smaller than what it used to be and this is an attractive phenomenon to see in an industry it means also that we shouldn't be surprised if the number of banks continues to decline in the future and that's actually what's most important is that this trend continues because as the number of competitors continues to fall you should see improving economics for the remaining banks this leads me to my second point which is that the number of new banks being created in the United States has fallen close to zero in recent years before the 2008 financial crisis about 146 new banks were created each year on average when you come now the number of banks continued to fall because you'd have about 300 banks disappear each year and so you'd have a pretty consistent drop in banks over time and there's bit bank disappearances a lot of times or because they're being bought out and murders and acquisitions um some would fail but for the most part banks are less likely to fail and more likely to simply be acquired when they're not making an economic return on their money so before the crisis of 2008 you had about a hundred and fifty banks per year going away that's the difference between the 300 that were going away each year plus 150 ish that were being created but since the financial crisis only about one new bank per year has been created this has been a substantial decline since 2008 now this can be due to a lot of reasons you can come up with your own reasons it could be because the bank is much less attractive in terms of the prestige of the industry some people have started to consider banking evil some people can have seen the destruction that has been blamed on the banking industry correct or otherwise there has been a stain on the industry since the 2008 financial crisis um interest rates have been rock bottom profitability in the industry is much lower when interest rates are low so the attractiveness of starting a new bank is much lower and you have regulations which are much higher so since the 2008 financial crisis there's been a lot of new regulation on the banking industry and any time you have regulation on a business it causes less businesses to be created because it's harder to compete as a start-up in an existing industry when regulation is high depending upon your political bent or your you know your preconceived notions you might pick up on many one of those and describe more world towards it than others but I think the main point is that there's a multitude of reasons why this phenomena has occurred in the past and that the last 10 years you've seen a substantial reduction in new banks being created in the United State and not only that but you could probably expect that same stance to continue on in the future for some of these reasons continue to be true you still have low interest rates you still have high regulation on the banking industry specifically for the largest banks in the United States you have the Federal Reserve can determine whether the bank is allowed to pay dividends or pay or make share repurchases and there's these regulations are global you affect many banks whether you're small or large and you're told how much capital you have to have and all sorts of things not enough complying with these regulations is expensive and specifically for small banks it can be onerous to try and comply with regulations so you have very few banks being created each year but you still have a numerous multitude that are going away each year for all the reasons that that's always existed bigger banks are gobbling up smaller banks because they're more efficient and that is likely to continue over time so we're expecting in the future that you're going to continue to have fewer banks in the United States and this is largely driven in part because the normal erosion of the number of banks isn't being fixed by a replacement with new banks this leads me to my next point which is there are high retention rates in the banking industry and there's two reasons for this the relationship-based and there's low competition in general so what I mean by relationship-based well when you look back in some other movies about banking there'd be you know your local community bank and a couple of bankers there and you go there and you might know the person from church you might know this person their kids might know your kids you might interact with them and you would have a personal relationship with your banker now for a lot of people nowadays it's not true it's a little bit more impersonal but certainly this still holds true for some people you know especially if you own a local business you might work with a dedicated banker that banker might know you they might help you out they've evaluated your loan applications you've talked with them you may still know this person and local community you know seen them at your kids soccer games that sort of thing well that relationship is a means by which a bank can retain a customer and prevent them from switching to another bank there's a means by which beyond making a payment to that customer beyond paying them interest can secure that customer for a longer period of time the other aspect of this is for like those local business owners are also likely to hold more than business loans with the bank so they might have a business account with the bank then I have a business loan with the bank a credit line of credit that sort of thing but because they own a business they might also have you know their personal household accounts with that thing they might have their mortgage their college savings funds their checking accounts their savings accounts all with the bank and all of this contributes to building a really big strong relationship with that bank that makes it hard for them to consider moving to another competitor you see because the thing that a bank has an advantage on is that each type of account or loan you have with a bank increases the stickiness of that customer so think of this like a grocery store if you go to a grocery store and the only thing you buy from that grocery store is milk and you have another grocery store where you buy all the rest of your goods so you have one grocery store you buy milk at and one grocery store where you buy your fresh vegetables your fresh meat your packaged goods your household goods but you don't buy milk from them which of those two grocery stores is has a more sticky relationship with you well I think it's quite obvious that the one where you do 95 percent of your business with it's gonna have a stickier relationship than the one that you do five percent of your business with the same is true with banking if the bank were here let's move an example the grocery store the one that your have just milk business with if they're able to also steal your meat business and so you're buying your meat now at that grocery store well now they have a stronger relationship with you they're selling you both milk and meat and if they're able to steal the vegetable business now they're selling you meat milk and vegetables and now that they have all of that business there are a stronger relationship with you it's harder and harder for you to decide to change because now you're doing multiple forms of business with them the same is true at a bank if you have just a checking account at a bank it's relatively easy for you to switch there are thousands of banks have already covered that that are willing to offer you a checking account free checking account paid checking account interest checking accounts there's plenty of them out there so if you only have a checking account it's very easy to say well why don't I just open up checking account at this other Bank they're offering a nice $100 signup bonus maybe I'll switch but if you have a checking account at your bank multiple savings accounts a debit card a credit card a mortgage and a car loan it's much harder for you to switch away from using that Bank if you have these eight or ten different types of accounts with a single bank and another Bank comes along and offers you a higher interest rate in their savings account you could take it and open up another savings account you transfer some money over there but now your life's gotten a little more complicated now you have to work with two different banks because you're not gonna move your mortgage over you're not gonna move your car loan so you're still gonna have some accounts with the old bank you're still gonna keep your checking account so you can make the payments on those loans you might still keep a savings account there because why would I get rid of it it's just I can just keep it and it's really hard to steal that business away because once you have all of these accounts with that first bank the bank's likely to keep you it's just a pain and there's no clear benefit here and this is the key problem with low competition in this industry it's not that there aren't thousands of bangs out there because there are and there's a lot of competition for new customers between bangs everyone's trying to offer you the best interest rate ones trying to offer you the best service they have a good deal on credit card so they have a really nice debit card or they put your sports team logo on the card so then you have their your local sports team on your credit card all of these are ways to get you to move your money to that bank or to get you in as an initial customer and there's high competition for initial customers but there's low competition to actually steal a customer from another bank most of the competition is for young people people that don't have banking relationships people in college people that are 18 years old can just now sign up for a credit card these are people being targeted for competition if you're 40 years old or 50 years old you probably already have a bank winning relationship and you're not really interested in changing because what does it mean to change well now you have to spend the whole day going down to the new bank signing up creating a credit card account creating a debit card creating a savings account creating a checking account and after you do that with one bank you either have to spend a few hours on the phone with the old bank trying to get everything transferred or you have to go in person to get everything transferred to pull out your money or maybe they have a website and you can try and transfer it online but maybe then you have to get on the phone and call for a few hours to cancel those accounts can't what about all the bill pay that you have set up on those old accounts well now you got to cancel those bill pays and transform to the new ones or any automatic credit card payments that all has to be cancelled and transferred to the new credit card that's a pain it's time-consuming it's difficult and from a customers and aspect there's very little benefit for doing so now the bank wants you to do it but it's really hard to convince someone to spend all that time when there's not a huge difference maybe you have a slightly higher savings account rate you're going to get 2% interest on your savings account instead of 1% now how much money is that anyway he said an extra hundred dollars a year well you have to have a lot of money in your account to save an extra hundred dollars a year from one percent interest rate say you know change a lot of money's are sitting there you're not investing well how much is a hundred dollars of your time
orth you know are you really paying yourself that well to save that money if you spend ten hours to get that hundred dollars it's ten dollars an hour some people that's good some people that's bad it depends on your situation but think about that you're not going to do that often let's say you do change that and you spend 10 hours changing from one bank to another are you gonna do that every year I'm gonna do that every six months are you more likely to do it once a decade and I think you're closer to changing banks once a decade than you are once a year and I think that is what the key point is with banking it's low competition because it's hard to scale a customer now if you read a 10k on a bank they're gonna say it's a very high competition industry they compete on interest rates they compete on all these things but the truth is is that many banks are able to retain their customers and it's hard to steal them away and the easiest way to analyze this is to understand your own behavior as a customer what do you do now that can be a trap if you're always relying on what you do because not everyone is the same as you but it is a helpful insight at least for me I'm very unlikely to switch banks once I've made that decision I've done it in the past but I like who I'm with now I have multiple accounts with them and it'd be a pain to switch now when I transferred to my current bank they had the highest interest rates I could find they still have pretty high interest rates but there might be someone a little better maybe half a percent more a quarter of a percent more but that's not worth my time it's not worth the hassle because the problem is is maybe in a year or two years the new bank doesn't have the highest interest rate either and my old bank does I can't predict that in advance at this point my current bank has built a relationship with me even though I don't interact with any one person with that Bank I do almost all my interactions online this leads to high retention rates in the higher retention rate you have in an industry the more recurring revenue you have and that's really important um for the profitability of an industry and so let's talk about how all these things are covered so far affect the profitability of this industry you see as an industry bank efficiency is approving over time with fewer commercial banks in the United States it means there's less competition and this is in part becoming those through the weaker banks the ones that are failing or being acquired so you have these small community banks that are failing or they're merging with other banks so they're being acquired by their banks and those deposits at those banks are transferring from low return on equity banks to higher return on equity banks this is a slow and subtle shift that year-by-year is improving the return on equity of the banking industry in the United States because what's happening is you have the banks that are doing poorly being acquired that Bank by banks that are better and more efficient better competition better understand how to invest that money better understand how to make loans profitably all these things that mean that there's this trend line that as fewer commercial banks in the United States exist you're having lower competition and higher profits in addition it's not just about the number of banks in the industry there's also fewer bank branches and as the number of bank branches declines in United States you're going to see a higher concentration of deposits per branch Jeff Gannon of the focuses compounding podcast loves to talk about deposits per branch as a sign of efficiency and profitability for the banking industry if you don't listen to a focus common pounding podcast highly recommend it I have an interview with Jeff Gannon in my podcast feed you can look back on but one of the things he likes to talk about is that the more deposits you have at a branch the more efficient your cost per deposits are and deposits are the driver of profitability I talked about that in my episode 79 where I discussed this when I first introduced banks as an investing industry we're going to look at there's this idea that if you have ten million dollars or deposits per branch they're going to be less profitable than if you have a hundred million dollars per deposit per branch because all the costs involved with running the branch get divided over more deposits your deposits per rent check are higher your deposits per per employee salary are higher their deposits per electricity are higher let's make all of these things lead to economies of scale that mean the fewer brand big branches there are the more concentration to deposit through our per branch and the more profitable the remaining banks are so let's talk about how high retention rates playing well higher retention rates means that there's a large amount of recurring revenue now software as a service companies love to high bond recurring revenue they have 80 percent recurring revenue 60 percent recurring revenue these are companies these are businesses or customers that are locked in with contracts so in the year to year they're recurring revenue well banks might have retention rates at 90 percent plus 95 percent plus because customers aren't changing if a customer changes banks once every 10 years that's a retention rate of 90 percent if they change banks once every 20 years that's a retention rate of 95 percent in some ways retention rates of banks can exceed the retention rates of many popular software as a service company [Music] you know how often do you switch your that's bad example I'm just gonna skip that own but the key point is is that you can have basically recurring revenue you're not changing to new banks very often which mean the banks can depend upon your deposits this leads to a highest ability of those deposits and stable deposits I mean that the bank has a reduced risk of liquidity problems in the future one of the big concerns of a bank is even though they're just loaning out money at high interest rates and bringing in money from deposits and paying low interest rates is a mismatch and the timing of their cash needs deposits are a short-term form of funding in general technically you can go to your bank and withdraw all your money today if you want to if it's in a checking or savings account that means that bank needs to have that money available but if every bank customer did that on the same day it'd be a bank run and the bank would run out of money before they could pay everybody in practice this isn't a problem because there's never a day where everyone wants their money at the same time most people like having their money in the bank they like being learned interest on their money they're never all spending it on the same day and if they're only spending in it instead of cashing it out then they're just transferring it to another bank and all the money stays in the banking system and rotates around and it all Nets out pretty well now if the customer is stable that means deposits are stable and it's not necessarily likely that those deposits are going to leave the bank then which means the bank can depend on that deposit being they're not simply overnight till tomorrow for being there five years from now or ten years from now which means they now have the confidence to be able to loan out money for three years five years ten years because the problem with a bank is most of their loans have a duration a fixed duration like five years but their source of those loans the deposits has a fixed duration of like one day or less but in practice those deposits have a duration much longer which is why the banking system works so there's another problem I haven't touched on here but ties into this improving banking efficiency which is that financial service companies in the internet are lowering costs needed to serve customers if you have a website it's easier for a bank to serve its customers to show them what their bank balance is to allow them to transfer money from one account to another to allow them to transfer money or to make bill payments all of that has become much cheaper for banks to pull off with the internet of being available having a website it reduces the need for branches it reduces the need for employees it reduces the need for wire transfers it reduces the need for checks it reduces the need for all of these costs that are embedded in the business model and it's lowering those costs over time that's means that there's more profit per dollar of deposits for the banks that are left so all that wraps up the little section that's saying banking efficiency is improving over time you're having higher returns on equity you're having higher profitability because there's fewer banks fewer bank branches high retention rates and the Internet has allowed lower costs across the board so I have two more points the first of those two points is that banking is a durable industry what does that mean durability of industry is very important and durability of a company is very important when you're making an investment for the long term when you're buying a stock and saying I want to buy a stock in this business and owned it for 10 years for 20 years for 30 years well that's only valuable if the company is still around 10 20 30 years from now well if a company is to be around 10 or 20 years from now then the first thing that needs to be around is that industry needs to be around it needs to be a long-term durable industry it needs to be a valuable industry that will always provide a valuable service to customers this might seem like a weird question but the durability is very important because if you focus simply on the financial metrics you might buy stock in a company that's not going to exist ten years from now Kodak investors thought they were invested in a company that was very strong well when the iPhone came out there's no more need for Kodak when you have digital cameras there's no more need for Kodak and so Kodak failed not because um because the film camera industry was no longer viable it was not a long-term industry and you could say the photograph industry is maybe longer term maybe but again I don't want to go too deep down that example or another industry would be like the horse and buggy manufacturers now if you say transportation is a long term industry I'd agree with you but the form of transportation might change and so investing in a horse and buggy manufacturer was great up until cars were invented and the form of transportation changed to a new form well banking is durable banking as it exists today as it existed for thousands of years and will likely continue to exist for thousands of more years in its current form in its current form is very simple and this is my last point banking as a business is very simple you collect deposits and you make loans now the part that's changing is the need and necessity of branches is going down over time we're having fewer branches but we're serving more people per branch more deposits per branch more money and profit per branch and you could look into a future with the advent of online banks that the necessity of physical branches is dropping over time but the underlying business model of banking is staying the same you're bringing in deposits you're making loans on those deposits and you're earning a spread on the interest rate and when we focus on commercial banking this simplicity of the business model is very important and it simple businesses are attractive to investors not simply because they're easy to understand but for many other reasons and I think there's a few that I want to touch on here in banking there's no need for our D you're not developing a new product you don't have to come up with the new iPhone you don't have to invent the Apple watch you don't have to come up and figure out what the customer of tomorrow is going to want the customer of a bank tomorrow is going to want banking services and those services are the exact same services that they receive today they're gonna want the ability to take out a loan they're gonna want the ability to put a posits into the bank and receive a return on their money it's a very simple product it's existed for thousands of years and it will exist for thousands of years more maybe the things that you buy put you take out loans on will change instead of buying a car maybe you're buying a hovercopter or an automated vehicle or something along those lines maybe the form of credit cards might change but the form of banking is not going to change banks exist and they're serving a vital service to the community they take in deposits from people that are saving money and they lend them out to people that want to borrow money it's a valuable long-term service but there doesn't require R&D you don't have to come up with any new products which means the bank doesn't have to spend money on figuring out all this stuff and there's no risk of obsolescence this is because product innovation is unnecessary now some product innovation occurs there's better ways to evaluate loan applications there's better ways to improve efficiencies but you're not having a banks at there one day and loan out money and then in a few years there's zero use to ever need to take out a loan ever again I don't anticipate that as a future now if I'm wrong it'll be an interesting future to be in but it's hard to imagine a future where no one wants to save money and no one wants to borrow money it could happen but in that case there's probably also need no need to worry about investments so you're probably fine another key point is there's no inventory in many businesses they have to hold inventory especially in like a manufacturing and business or other capital intensive businesses you have to produce a product hold it on your books and then try and sell it there's no inventory for bank that can expire worthless if you're buying clothes is a fashion retailer well if the season changes and you're stuck with it a bunch of fur coats in summer well no one wants them we're a bunch of bathing suits in winter well no one wants them so their value has gone from whatever you paid for it twenty thirty dollars you were hoping to sell it for a hundred and now it's worth zero you don't have this problem as a bank there's no inventory you simply hold cash make loans and that's valuable all year round so banking is very simple and that makes it easier for management to manage the company they can focus on a few key things they focus on risk management they focus on bringing in deposits they focus on figuring out how to lower costs I like it when a business is simple because it means a management can be focused and I don't have to worry about them being extremely intelligent to come up with the new far-seeing feature you don't need a Steve Jobs to run a bank and that's very attractive as an investor so in summary banking is an industry with characteristics that are quite attractive too long to investors properly evaluated a bank can make a great investment there's high retention rates low comp lower competition over time and the durability of the industry or what attract me to bank investing I hope you have enjoyed listening to this podcast the forceful notes for this episode including my outline today's podcasts are available at DIY investing dot org slash episode 82 fear at the listener to please remember this is a listener supported podcast at 15 down in today's content please consider supporting different show financially as a big team you can become a patron at DIY investing that works rusty 80 ra in the goal and providing value to you is that you can find ways to learn from this content and learn how to make more money for yourself I ask you that if you're successful or not if I'm able to have provided that value to you consider supporting the show so that I can continue to provide value to you in the future and also provide value to others thank you for listening and until next time stop paying fees start building bro [Music] thank you for listening to the DIY investing podcast please visit our website and subscribe to our email list at DIY investing org or guides videos and resources to help make you a better investor [Musi
] the DIY investing podcast is presented for general informational and entertainment purposes only I have not considered your specific situation or risk profile and I have not provided investment advice the information presented on the DIY investing podcast should not be construed as investment advice the views and opinions expressed on the DIY investing podcast or those of the participants and do not necessarily reflect those at the show's host or sponsors DIY investing its producers sponsors and hosts Trey henagar al not be liable for losses resulting from investment decisions based upon information or viewpoints presented on the DIY investing podcast
