Why LBA Avoids Investing in Banks
The banking failures of 2023 have been dominating headlines for weeks and have prompted many clients to ask about Lowell Blake’s exposure to banks. Our investment strategy intentionally precludes us from investing in companies like banks, and we’d like to explain why.
We are fundamental, bottom-up investors with a long-term investment horizon; we focus on purchasing durable, underlying businesses that benefit from persistent trends and shifts.
Our Goal: Resilient Demand
We avoid cyclical businesses because we want our businesses to perform well and grow in both strong and weak economies. Certain industries, such as banking and commodities, are cyclical—demand for them rises when the economy is booming, and falls when it’s not. (We don’t invest in commodity businesses (excepting energy companies) because it is difficult to generate a compelling return in the sector, which usually boasts a multitude of competitive—but undifferentiated—offerings.)
At the highest level, banks do not qualify as attractive candidates for LBA investment because their business model does not align with our investment philosophy. Companies that boast steady, growing demand for products and services appeal to us. These companies can be found in many sectors; Johnson & Johnson, for example, sells medical equipment essential to patient care, and providers will need it regardless of what’s happening in the economy. In technology, demand for Microsoft’s business software—critical to the operations of so many companies—will remain strong and resilient even when the economy slows. Procter & Gamble’s staple consumer products, like paper towels, will always be needed (people don’t stop spilling when the economy’s in decline!). These companies (and many others) can grow market share and sustain revenue even when the economy is not doing well. Banks, on the other hand, cannot. They are limited, to a large degree, by external factors such as the actions of the Federal Reserve, the economic outlook, and increasing regulation. LBA seeks to invest in growing businesses, those that are constantly innovating and taking advantage of dynamic opportunities in their respective industries.
Risky, Debt-Based Growth
LBA manages risk in portfolios by investing in companies with consistent demand. Banks, however, are cyclical by nature of their business. Banks engage in what is fundamentally a spread game: they receive capital from customers (depositors) by paying them low, short-term rates and lend that capital over longer terms at higher interest rates. As short-term rates increased in 2022, it became more expensive for SVB and other banks to pay interest on the deposits they held. Because they had already issued many long-term loans with low rates, and what they paid on deposits increased in 2022, their profit spreads decreased.
Heavy debt is a severe competitive handicap, especially in a weak economic environment. Banks hold only a portion of their deposits on hand and are allowed to lend the rest out (i.e., for every dollar of deposits, a bank can lend more than one dollar to borrowers). In addition to this inherent leverage, banks employ other debt-based strategies to amplify returns, because those generated by bank lending are typically quite small. Bank leverage is regulated, however, and very close attention has been paid to leverage ratios since the Great Financial Crisis. That said, current regulations still allow banks—particularly those with assets below $250B—to use leverage at significantly higher rates than companies in most other industries.
Banks are essential components of the US financial system but, as we’ve detailed, are not businesses in which we will invest. They are inherently risky: they employ significant leverage; they assume interest rate, credit, counterparty, and regulatory risks; and they are naturally exposed to the whims of business and economic cycles.
This article was published as part of the LBA Spring 2023 Reflections & Observations.