Metrics for Banks and Banks for Australians

By Joe Magyer and Gaby

On this episode of Industry Focus: Financials, Joe Magyer, the chief investment officer of Lakehouse Capital in Australia, joins Gaby Lapera to chat about leverage -- a frequently overlooked banking metric that is essential for diagnosing a bank's health. They also cover return on assets, a metric that should really be used with context but is frequently cited as a stand-alone figure. Afterwards, Mr. Magyer takes what we learned about metrics and applies it to Australian banks to give a comprehensive view of the banking industry in that country.

A full transcript follows the video.

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This podcast was recorded on Sept. 15, 2016.

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Gaby Lapera: Hello, everyone!Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You arelistening to the Financials edition, tapedtoday on Thursday, September 15th, 2016. However, you are listeningto this on Monday, October10th at the earliest. Who knows, this show mightstand the test of time, so maybe you're listening to this in 2025, whichI totally hope.

Joe Magyer: And it depends on what country you're in. If you're in Australia, this whole thing is just blown up.

Lapera: In case you'rewondering who that sultry voicebelongs to,it is Joe Magyer, thechief investment officer and a portfolio manager forLakehouse Capital inAustralia, which is somehow related to The Motley Fool, butlegally I don't know exactly how, so we'regoing to skip over that.

Magyer: It'sowned by The Motley Fool.

Lapera: OK, sounds good! How's it going, Joe?

Magyer: Going really well, I'm back at Fool HQ for thefirst time in two years. It's been way too long. It's great meeting peoplethat I haven't met before,including you, and catching up with peoplelike Chris, who I haven't spent nearly enough time with.

Lapera: Oh, hey, Chris Hill. He'swaving at us. Just in case you're wonderinghow you ended up on this show,Chris Hill walked by my desk,and he did one of these classic,taking off my glasses, you know who you should talk to? You should talk to Joe, Uncle Joe. He likes banking metrics. That's what you sound like, Chris Hill.

Magyer: That's such a good Chris impression. He'sshaking his head. That's pretty strong.

Lapera: So,now that I revealed the purpose of the show --banking metrics -- I hear thatyou have a couple that you think investors should look at thatpotentially they don't really think about too much.

Magyer: Yeah.I'm a nerdin many facets. But around financials, I think people tend to gloss oversome of the more important metricswith banksin particular. People get caught up in some of thefiner points and metrics,like net interest margins. They get really excited about it,and they can sometimes miss big things,like the amount of leverage in a bank,the returns on equity and assets,and how those variables all move together. They're actually not complex. It's not rocket science. But most people just pass by it,and I think that's a missed opportunity on their part.

Lapera: Yeah,that's really sad. That's a little bit like missing the forest for the trees or missing the trees for the forest.

Magyer: Yeah, or the pine needles. A clean example is,people will look at returns on equity for a bank asbeing the best measure of how the bank is doing in terms ofcreating value for shareholders. That's basically rough cutting yournet profit over your equity that you have at a bank. Generally speaking, that's a really good proxyfor how much value a bank is creatingand how much they're earning againstequity. But,there's another variable there,which is leverage. I think a lot of people neglect thisto their detriment. They don't appreciatethe amplification and the importance.Basically, there are two levers here. There's return on assets, gross leverage,that leads to return on equity. Your gross leverageis the actual amount of assetsrelative to your equity. This is all in the balance sheet. You don't need to be a rockstar analyst or get anyfancy designations to find thisstuff. It's all right there. Total assets over equity. Doing that will allow you to find out how levered theoverall business is. Andwhen you multiply that by return on assets, that gives you return on equity,which is a very helpful way to understandthe overall economics. But when you just unpack those two numbers,it gives you more of a sense of what is creating value. Is it operational excellence? Returns on assets? Or is it just straight up leverage?

Lapera: Let'stake a quick break to talk aboutwhat leverage is,because I have discovered through angry emails, onoccasion, to the show, that some people really wantsome very basic terms defined.

Magyer: Gotcha. Sure. Overall leverage, the math istotal assets divided by total equity. Inpractical terms, talking about what the bank actually does, banks makevery small amounts of money,pound-for-pound,for how much is actually in the business. They'll make, maybe,1% on every dollar that they get in assets in the business. Theway that they make that workis the lever up a lot. So, they'll take your deposits, and they'll lend it out to people and make loans. And they do thatin a big way that will help them growand make up for the overall narrow marginsin the business. That's the leverage that's baked into the model.

Lapera: Right. Andthis can become a problem ifit's used irresponsibly.

Magyer: Yes. Flashingback in time, the major investment banks inAmerica had leverage above 30 times, back heading into what theAustralians call the GFC, theglobal financial crisis. Here, we just call itthe financial crisis, because we're Americans, and it's just our financial crisis. Ifyou're not familiar with these numbers, you might be like, that doesn't mean anything to me. But imagine if you had a house. You borrow moneyto buy the house. How much you borrowagainst how much you put down is,essentially, your leverage. So, if you buy a houseand you put down 10% equity, your levered 10:1.

The thing is, with a house,it's a pretty steady investment.(laughs) If I'd said that in 2006,that would have been pretty embarrassing. Over time, though,it's pretty steady. You are slowly putting more equity into it. That's a pretty low risk degree ofleverage. But if you'redoing the same thing with liquid assets and you're making loansthat are illiquid,but you have liquid deposits and people can take money out of your bank,you can have a bank run, and that can come in different forms. Basically, the more levered you are,the more important it is that you are rightand you don't make bad loans, and the more at risk you are that yourcapital goes out the doorone day, and you'll just have to wave a white-flag there,like what happened withMF Global orLehman Brothers. It happens. Not often, but it happens.

Lapera: Could you give an idea of how leveraged, on average, big banks inAmerica are today?

Magyer: They used to be high,but it's gotten a lot lower.Wells Fargo's(NYSE: WFC)total assets to equity now is below 10. It wassubstantially higher than that before. They've always been more conservative,except when they're creating a couple million accountsfor people who don't know about it,thousands of employees were doing that. In Australia, it's more like around 15, which is a good bit moreaggressive. That's a combination of more friendlylocal regulation, but also confidencein demand. Wells Fargo has said this for a while --there just isn't enough demand for loansfor them to go out and lever up more. They would be happy to do it,but there hasn't been that demand. Another thing,regulators have been pushing back on banks and saying, "You need to lower your overall leverage..."

Lapera: U.S. regulators have been pushing on U.S. banks.

Magyer: Yes. People are still pretty stungabout having to bail out the banks. With less leverage, you'remuch less likely to blow up. If you do, there will be much less of aneeding hand. Andoverall, it lowers a bank's returns on equity, but it also lowers the systemic risk to the overall common. Specifically, the bank lowers their risk as well. There are pros and cons to it.

Lapera: As with everything in life.

Magyer: Indeed.

Lapera: I feel like we've covered leveragepretty well. Do you want to talk a little bit aboutreturn on assets?

Magyer: Yeah. Leverage can mask bad operations. Return on assets ishow much you'regoing down in profitagainst your actual assets. That's more ofa pound-for-pound versionof how your back is doing. Historically, you'll see banks dosomething between 1%-1.5%. Before the GFC, you saw some banks,particularly Irish banks, hadnumbers that were just mind-blowing. I want to say they were above 2%, just from memory. I remember looking at them and thinking -- without accusing that anything was wrong,it just seemed unnatural. It was extremely unnatural,that turned out to be the case. What you usually see is, a strong bank will have cross-cycle returns. So, say, over a period of 10 years, an average return on assets of maybe 1.5. A bad bank will be south of one. Banks that are south of one willtypically sell at lower multiples than the ones that are higher,because they're not as good of a business. Wells Fargo has historically beenon the higher end of that.Citigrouphas historically been on the lower end of that.

Lapera: One thing that ourlisteners might not realizebecause it's not the most intuitive thing is that a bank's assets are its loans out to people. It's aconfusing thing, because for most people, a loan is not an asset. But it is for banks. Which is why,when you take leverage and assetsall together,it gives you a more complete picture of a bank than justlooking at return on equity would.

Magyer: And there areother things you can do if you want to double click a little bit and here. You can look at the makeup of,digging into the assets, what kind of loans are made. If they'rebusiness loans, that's going to be higher risk,traditionally, than residentialmortgages.

Lapera: Andeven with residential mortgages, there's a bunch of different types.New York Community Bankspecializes in multifamilyresidences, which is apartment buildings, basically, inNew York City, which is a very safe real estate market,versus maybe someone who is sellingsingle-family homes near an oil fieldin Texas.

Magyer: That's a great point. To flash anAustralian example, the requirements have changed recently, but up until recently, a bank couldmake a loan on a residential mortgage. Historically, properties have done very well as an investment class in Australia. The bank would only holdas little as 3%of capital against that loan. So, they would be levered 33:1 on thatmortgage. The logic is the same that U.S. banks had before they got their face crushed, which was, "Well,people always pay their mortgages, and there's collateral in the assets, so we're backed up there. There's mortgageinsurance, so you don't have to worryabout that. And just becauseone person's mortgage goes south, someone across the country,that doesn't mean that could happen to them."I think we all learned that that's not necessarily the case. Australian banks have notlearned that lesson. They will, eventually. I don't know when.

Lapera: Let'sactually talked about that. We were chatting a little bit before the show, and you said that Australian banks arereally expensive. This is not a spacethat I'm normally in.

Magyer: You don't dabble inAustralian banking?

Lapera: (laughs)I did once because I studied abroadat James Cook University inNorthern Queenslandin a town called Cairns. So,I needed to open an Australian bank account. But other than that, no,I have not actually interacted with Australian banks at all.

Magyer: Cool. So,up until recently, Australian bankswhere the most expensive banks in the world. They're still very expensive. Why are they so expensive? Well, default rates have been incredibly lowin Australia. The country hasn't had arecession in 25 years. Just think about that. To an American, you're like, "What?! 25 years? That's crazy!" It'salmost the longest streak ever. Australians havea lot of confidence as a result of this. Just imaginehow different your life perspective would beif you had not seen a recession. You have professional investorswho are in their early 40s who have not seen a recession. It's a very different worldview.

Lapera: That's so wild.

Magyer: Yeah. So,I think the banks tend to make loanswith a little bit more of an optimistic view than American banksdo, andinvestors tend to value thema little bit more optimistically. So,I'm actually rather bearishon the Australian banks. It's not because I'm expecting some cataclysmic event. But there are a few things. One,net interest margins are getting squeezed --to get back to that thing I was saying you shouldn't pay too much attention to before. Default rates are near record lows. They won't stay that way. I don't know when exactly they'll pop, but they won't stay that way. The banks are also paying up around 75% of their income as dividends, which does not leave...

Lapera: 75%?

Magyer: Yeah. The yields are huge, andeverybody loves that and gets excited about it. But that doesn't leave much room for error, when you're levered 15:1. All you need is a slight down-tipin your profit. When you magnify that,there won't be a lot of gravy left over for dividends.

Lapera: Yeah. If they're smart, they'll cut their dividend instead of trying to hold on. Is the real estate marketsubstantially different than it is here? I realize, at the center of the country...

Magyer: No one is there.

Lapera: No one super duper lives there. Like some kangaroos. But is it a lot tighter as a result? Is housing super expensive? Is it D.C. levels or Iowa levels? Or is it somewhere in between?

Magyer: It's regional, but overall, it's very expensive. There was some work done by Jonathan Tepper and John Hempton in the past year, a couple of hedge fund managers. They went around and basically pretended to be interested in buying homes, and went to dozens ofdifferent banks to see what they could get lent. One bank was willing to lend them -- they were posing as a couple -- 10 times their income to buy a home. That's lofty.I personally don't think I could afforda mortgage that's 10 times my income, or buy a property that's 10 times my income.I just think, overall, it's not as extreme as the U.S. was in terms of loose lending standards, overall. No doc loans, or NINJA loans -- no income, no job -- those aren't really existing in Australia.

Still, prices are high,just like we saw with the dot-com bubble. Just because assets are freely traded,and there's nothing illegal going ondoesn't mean an asset can't get overvalued. I think there's probably risk in the Australian property market today. If you're buying Australian property with a five- to 10-year residential viewpoint, it'snot something I would stress about. But there's a lot of people -- something like one in seven Australians -- own an investment property. Which is a crazy concept in America.I certainly don't know one in seven people that own aninvestment property. And most of those are what's called negatively geared. Thatbasically means they're losing moneyon a cash flow basis month to monthin anticipation of getting it backin capital gains.(laughs)When I heard that, I was like, whoa! That's apretty foreign concept to Americanproperty investment as well.

Lapera: I mean,the things you're describing, while they're not quite as bad as they were during the financial crisis, are things that were happening during the pre-financial crisis.

Magyer: Yes.I remember, back then, it seemed likea surprising number of my friends were budding real estate moguls. And I was like, "Actually, no ... " It just seemed odd, at the time. Anyway. Overall,I think property is expensive,and there's some risk there to be mindful of. If you're thinking about buying the banks, which are super levered to that and don't have much wiggle room with their payouts, and rich valuations. So,overall, I'm not predicting a crash, I'm just saying thatI think the banks are basically priced as though everything will stay great. But there are many ways to lose. And I try to avoid situations like that.

Lapera: Fair enough.I think our listeners will haveone question after hearing all that. Not that they're going to go out and buy Australian banks, but, is there a way for U.S.investors to buy Australian stocks?

Magyer: Yes. You can do itdirectly. You can alsolook at Australian funds. It should be clear that I'm not actively touting our fund, whichdoesn't even exist yet. I'm just saying, broadly speaking,you can look at active management. You can also look at ETFs. The trouble with ETFs inAustralia, though, is that the market is super top-heavy. There's thebig banks, a couple big retailers, and commodity companies. Something like 10 companiesmake up almost half of the index. There's another 2,000 that make up the other half.

Among those,you've got companies that don't look anything like the big players. There're a lot of small, fast-growing software companies that aredeeply profitable, strong recurring revenue, great balance sheets. Those are the kinds of things I get into. So, you could look for active management,but to be honest,it's kind of difficult, straight up. You could go direct, but active management, you wouldwant to find a fund that's based here in the U.S. so you could make the investment. It's hard to invest in funds that are basedoutside of America, because then you run intowhat's called PFIC rules. That's a long story short.

Lapera: Fair enough. We talked about index funds yesterday. When I sayyesterday, I mean I taped ityesterday,so you would have listened to it onOctober 3rd.

Magyer: Time is a flat circle.

Lapera: So, our last show is the one we talked about index funds.I think we've covered everythingthat both of us wanted to cover,which is awesome. I did want to share this one fun fact about you, which is,according to your profile page, youbroke your high school's 400-meter track record.

Magyer: I did, yeah. That'sstarting to get a little long in the tooth and my profile, because it's been a while since I was in high school. But I did. I worked hard for that.

Lapera: Have you brokenany other records recently?

Magyer: (laughs) Not recently.

Lapera: Fair enough. Austin,have you broken any records that we should know about?

Austin Morgan: Definitely not for running.

Lapera: (laughs) Fair enough. That was Austin, our awesome producer, just in case you were wondering. Thank you so much for joining us. This has been super interesting. You are more than welcome to come on the showwhenever you want.

Magyer: Cool!I appreciate it.I'll take you up on that next time I'm back in the office.

Lapera: I was going to say, yeah, the time difference is kind of wild for you to Skype in.

Magyer: Yeah.

Lapera: But thank you again for joining us. I'll have to sharesome of my Australian stories with youat a later dateso we don't bore our listenerswith non-financial stuff.As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at or by tweeting us @MFIndustryFocus. Do you have a Twitter that people can tweet you at?

Magyer: @Magyer.

Lapera: Yeah, I had to write it. Thanks again to Austin for producing today's show. I hope everyone has a great week!

Gaby Lapera has no position in any stocks mentioned. Joe Magyer has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short October 2016 $50 calls on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.