In line with the principle of “don’t know, don’t do”, many investors like to buy consumer stocks, as long as they have a direct perception of whether the goods are selling or not, investors are not prone to make big mistakes; beyond consumer stocks, it is financial stocks that are popular, after all, everyone deals with financial institutions and can perceive the market competitiveness of financial institutions from the product experience.
However, in practice, consumer stocks have helped many investors on the road to wealth growth, while financial stocks have performed poorly. Leaving aside investors’ holding philosophies, financial stocks are far more complex than consumer stocks, and making good investments in financial stocks is much more difficult. The biggest difference lies in the importance of management. Compared to the consumer sector, the characteristics of the financial industry can magnify the influence of management to an incredible degree.
Second-rate business under product homogenization
While consumer products are differentiated by brand, financial products show a high degree of homogenization. Whether it is deposits, loans, insurance or securities, it is easy to fall into the quagmire of “price wars” due to product homogeneity, such as the battle for deposits in the banking industry, the rate wars in brokerage and investment banking, and the price wars in insurance products, which have to rely on regulatory agencies to intervene to maintain the normal order of industry competition.
Most of the industries plagued by homogenization are very bitter, such as low-end manufacturing, not to mention the hard work, but also by the upstream and downstream industry chain squeeze, can not make money, belonging to the typical asset-heavy, low-ROE third-rate business. The financial industry because of licensed operations and regulatory intervention to a certain extent to reduce the intensity of competition, although not reduced to third-rate business, but also destined to become a first-class business of light assets, high ROE.
How to be considered a first-class business? According to Warren Buffett, this type of business usually has two main characteristics: one is the price increase does not affect sales, the second is only a small amount of capital expenditure to support a significant increase in turnover. a shares, Maotai is a typical representative of first-class business, other high-end consumer goods, pharmaceuticals, Internet companies also have this quality.
On the contrary, the financial industry, due to product homogeneity, price adjustment affects sales, and the expansion of the scale of heavy reliance on capital, how to say it is not related to first-class business, can only be considered second-rate business.
But investors should not dislike the second-rate business, one of the real first-class business is rare, and most of the valuation is very expensive, may be a long time lack of good buy; the second relies on excellent management, some companies can make the second-rate business first-class performance, transformed into a dark horse of investment.
Berkshire is essentially an insurance-based business, so why is Warren Buffett willing to take a second-rate business as the foundation for development? In addition to his preference for insurance float, more importantly, it comes from the recognition of the management of its insurance companies. In Warren Buffett’s view, good management has the ability to turn the ordinary into the miraculous, and can make the ordinary business very great.
In terms of the insurance float that Warren Buffett enjoys, a poorly managed insurance company’s float costs can be higher than the yield on Treasury bonds for a long time, making it a burden to invest; while a well-managed insurance agency can reduce the float costs to negative values, helping Warren Buffett achieve a great investment legend.
In other words, it is not that second-rate business financial stocks cannot be invested in, it is just that investors must put management in a very important position when choosing stocks. We will also see the significance of management to financial institutions in several features that will be addressed below.
Highly leveraged operations squeeze valuation space
Another major characteristic of the financial sector is the high leverage operation, the general corporate gearing ratio of more than 60% is considered high, while financial institutions are generally around 90%. Leverage has an amplifying effect, which can amplify both profits and losses, and can amplify both good and bad.
The characteristics of highly leveraged operations give the financial industry two major characteristics.
The first is the obvious cyclicality. The financial industry serves the real economy and inherently follows the real economy for cyclical fluctuations, but the highly leveraged nature of the financial industry further amplifies this cyclicality, making the financial industry far more volatile than the real economy.
Cyclical properties usually increase the difficulty of investment, unless the long-term holdings across the cycle on an annual basis, or buy at the wrong point in time, even if held for three to five years may not be able to return capital. From the perspective of the broad cycle of financial industry development, the golden period of the banking industry has become a thing of the past, the insurance industry is still in a period of rapid development, while the golden period of securities companies has just opened.
However, the major cycle is nested within the minor cycle, and from a three-to-five-year perspective, the banking industry bottomed out in 2020 with good share price trends; the insurance industry has entered the low growth of the transition period since 2018 with sluggish share price performance; and securities firms are subject to the bull-bear atmosphere of the stock market with sharp fluctuations. This nesting of cycles has once again increased the difficulty of investment.
Second, polarization. Warren Buffett has commented that the banking industry is not our favorite because the nature of this industry is that the assets are about 20 times the equity (the specific leverage ratio is affected by changes in regulatory policy, readers need not care about the accuracy of this data), which represents the possibility of losing all the shareholders’ equity as soon as a little problem occurs with the assets. In other words, with the amplification effect of high leverage, both the strengths and weaknesses of management are magnified, and good management can quickly pull away from bad management, thus creating a polarizing effect.
Take listed banks as an example, there are only a few sought-after investment targets, and most of the listed banks, though cheaply valued, are in a long-term unattended state. If investors do not know the reason, they are bent on buying low-valued banks, they are afraid to be disappointed, in most cases, the stocks they bought will be in a long-term low-valued state.
In addition, the high leverage operation will also suppress the overall valuation level of the financial sector. Even good management makes mistakes, so the valuation premiums given to good management are usually outweighed by concerns about high leverage. In terms of valuation levels, one of the best targets in the financial sector is usually not as valued as an average player in the consumer sector.
In other words, valuations in the financial sector are suppressed by high leverage, and there is no ground to generate big bull stocks. If investors have a get-rich-quick mentality, then financial stocks are not a good choice.
Trapped in the cycle vs. outperforming the cycle
Many industries have cyclical properties, rooted in the cyclical imbalance in the supply and demand structure. That is, in a relatively stable environment of demand, product demand exceeds supply to enhance the profitability of the industry, attracting a large number of new capacity into the oversupply, the industry into losses; losses lead to a large number of capacity to exit, and the next round of oversupply to lay the foundation for a new cycle as expected.
In this process, the time lag effect of new capacity entry and exit is an important reason for the formation of the cycle. Take the pig breeding industry as an example, when pork supply exceeds demand and prices soar, it takes 1.5-2 years for pig breeding enterprises to expand capacity (about 6 months from breeding to mating, about 5 months from mating to piglet output, and about 6 months for commercial meat pig fattening), and at least 6 months to expand capacity even in the form of piglet purchase. The existence of the time lag effect leaves a full window for new players to enter, which in turn sets the stage for price wars and industry-wide losses after capacity expansion.
In the face of the above, it is difficult for the best companies to stay out of the way, so it is difficult for investors to pick out the best targets in cyclical industries that can cross the cycle. However, the financial industry is an exception.
Unlike the general manufacturing industry, the supply of financial products is not limited by existing capacity such as plants, and as long as the capital keeps up, it can quickly respond to market demand and achieve rapid replication of profitability. For example, when demand suddenly rises, both banks, insurance companies and securities companies can immediately expand the supply of products, without first spending six months to build plants.
Likewise, when the market is sluggish, in order to amortize fixed assets, heavy asset industries in general have to accept orders below cost, while financial institutions are not subject to this constraint and can fully and voluntarily shrink in size when profits are poor. For example, banks can refuse to issue medium to high risk loans, insurance companies can refuse medium to high risk policies, and securities companies can refuse to take on loss-making business.
Based on the above analysis, it is possible for financial institutions to leapfrog the cycle and even take advantage of it. However, in practice, only a few good financial institutions can do this, and most of them go with the flow.
For example, when the loan market is overheated, for better short-term performance and market share, banks may know that the risk increases and are reluctant to take the initiative to shrink the scale, and similarly, when the market is so frightened that it is profitable to expand lending, most banks do not dare to do the head of the bird, so as not to make a mistake in judgment affect short-term performance.
As Keynes said, the failure of conformity can bring more good reputation than the success of the deviant. Failure to follow the crowd will not affect the job, but if the maverick, once the failure to assume a higher career risk. That’s why the famous quote by Charles Prince, CEO of Citibank, “As long as the music keeps playing, we must get up and keep dancing.
The exception is good management that looks at long-term benefits, is not afraid of short-term fluctuations, and is able to lead financial institutions to out-cycle growth. After a few rounds of cyclical fluctuations, these financial institutions will be able to pull away from their peers and become a non-homogeneous presence in a homogeneous industry.
Excellent management is the most valuable asset of financial institutions
Warren Buffett has said that we are not interested in buying a bad bank at a “cheap” price, but rather we are only interested in buying a well-managed bank at a reasonable price. Buffett expressed a similar view about the insurance industry, saying that “a company’s management talent can be magnified to an incredible degree”.
The financial industry is both homogeneous, highly leveraged and cyclical, and management’s strengths will be slowly amplified over time until the gap is so wide that it is difficult to catch up.
For investors, when choosing financial stocks, you can’t just look at financial and valuation metrics, but management’s stamina and ability are the core variables that determine the long-term performance of the stock: either it becomes the most valuable asset or the worst burden.