How growth kills economy of scale: A case study

A newspaper article describing the losing sheen of tablets is on ET today. The premise is simple:

“The India tablet story is losing steam. After a 56% surge in 2013, tablet shipment fell nearly 28% sequentially in the first three months of 2014. 

As many as four million units were sold last year, compared with 2.66 million in 2012. But in the January-March quarter of 2014, only 0.78 million tablets were shipped, down more than 17% from a year earlier “

The growth of tablets industry has been phenomenal in the last few years. In 2012, a Hindu BusinessLine article showed a year on year growth of 673%. The growth this year has slowed down to 76%.
A 76% growth in any sector will draw deep cheers but so much has been the historical growth for this sector that a high two digit growth rate is a dampener.

But deep inside this development is a conundrum. The only difference between two manufacturers of electronic hardware is economics of production (or economy of scale). A smaller entity can’t make as much profit as a bigger manufacturer makes purely because the fixed cost per unit is lower.

In absence of any switching costs for the end consumer, price becomes the only difference. For laptops, mobile phones and tablets it is evident. There is just no switching cost for the end consumer. As a result, price or rather features per unit of price become the driving idea behind any transaction.

But with Google’s Android push in the last 5-6 years, almost entire onus of features have moved from hardware to software. There is just no difference between two devices! As a result, there is no differentiation and there is no switching cost for the consumer.

In absence of such demand side advantages, economics of scale becomes harder to protect. But harder still when there is growth involved.

As mentioned elsewhere in this blog, growth expands the pie and everyone becomes a competitor and no one the incumbent. This cocktail effectively makes the least efficient competitors quit the game. ET corroborates this:

“From a peak of 68 players competing in the market in the second quarter of 2013, the number has fallen to 30 now.”

A 50% reduction in the players implies a huge churn. This lack of stability is another indicator that there is no moat really.
However a small silver lining adopted is the new focus adopted by the companies. The manufacturers are going niche rather than going global. Increasingly making their tablets industry centric, they are re focussing on software. As a result they have a chance of creating durable moats, as professionals will (or should be made to ) spend considerable training time to master the different features of a software.
Reminds me of Bloomberg terminals.


Retail is Detail-II

This is the second in series of Retail is Detail. The first post can be found here

If it takes 5 machines 5 minutes to make 5 widgets
How long would it take
100 machines to makes 100 widgets? 100 minutes or 5 minutes

In a lake, there is a patch of lily pads. Every day, the patch doubles in size.
If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?
24 days or 47 days

A group of 40 Princeton students were given this test. Half of them saw the questions in clear and legible fonts. And the rest half saw it in small fonts, washed out gray print.

90% of the students who saw the questions in clear prints made atleast 1 mistake.
ONLY 37% of the students who saw the questions in faded unreadable fonts made a mistake.

Whats happening here?

Kahnemann explains it by describing how bad ineligible fonts are inducing cognitive strain on our brain. We are taking extra effort to read it. We are furrowing our brows and making intelligent guesses about what a font can really mean. So what it does, is accidentally triggers our System 2- the more rational, intelligent, calculative part of our psyche on.

“accidentally triggers”– note the phrase ladies and gentlemen. Our rational, calculative brain is a slow guy. He doesn’t like to work unnecessarily.It can either be consciously prodded into working or accidentally triggered into it.

When fonts were difficult to understand, our System 2 swung into action and we got better answers.

The answers of the previous two questions are 5 minutes and 47 days respectively. I played a trick on you by bolding out the wrong ones.

What has it got to do with COSTCO?

COSTCO doesn’t give its customers too many choices. While others thrive on offerring 10-15 choices for one particular item, COSTCO limits itself to 5-6.

This lack of choice lowers people’s tendency to judge and think deep. This leads to its customers doing more impulsive shopping. And inflates the individual billing rate.

Costco goes one step ahead and does one better on WALMART. If you have read my thesis report on retailing ,I mentioned at one place:

A retailer is a dispenser of shopping experience. However a retailer can’t charge for that experience. She has to pass on the costs to the products and should reflect in its profit margins

Not WMT,not Target, not JC Penney or anyone else, no one can charge money for that experience. But COSTCO does. And COSTCO does it so well, that people pay to shop at COSTCO. This generates a tremendous amount of float for COSTCO.

From their 10-K:

Membership Policy
Our membership format is designed to reinforce member loyalty and provide a continuing source of membership fee revenue. Members can utilize their membership at any Costco warehouse location in any country. We have two primary types of members: Business and Gold Star (individual). Our member renewal rate was approximately 89.7% in the U.S. and Canada, and approximately 86.4% on a worldwide basis in 2012, consistent with recent years. The renewal rate is a trailing calculation that captures renewals during the period seven to eighteen months prior to the reporting date. Businesses, including individuals with a business license, retail sales license or other evidence of business existence, may become Business members. Business members generally pay an annual membership fee of approximately $55 for the primary card-holder, with add-on membership cards available for an annual fee of approximately $55 each. Many of our business members also shop at Costco for their personal needs. Gold Star memberships are also available for an annual fee of approximately $55 to individuals who may not qualify for a Business membership. All paid memberships include a free household card.

Can be found here


Effective November 1, 2011, for new members, and January 1, 2012, for renewing members, we increased our annual membership fee by $5 for U.S. Goldstar (individual), Business, Business Add-on and Canada Business members to $55. Our U.S. and Canada Executive Membership annual fee increased from $100 to $110 annually

From here

So how do they recognise it in accounting?

Membership fee revenue represents annual membership fees paid by substantially all of the Company’s members. The Company accounts for membership fee revenue, net of estimated refunds, on a deferred basis, whereby revenue is recognized ratably over the one-year membership period.

From here.

So how does it get reflected in their financials?






So much so that, their liabilities more than make up their inventories, allowing them to operate in a close to zero current account as possible.

This is how they are inverting.
Munger gives another aspect of how Jeremy Siegel James Sinegal went to use inverting the business model of COSTCO. He said Siegel Sinegal started by asking what kind of customers he wouldn’t want. The answer was easy. Those who park their vehicles for hours at end in the store’s parking lot, spend hours in the store and yet buy nothing. He wouldn’t want the penny pinching folks from whom he cant charge anything extra.

So he targets exclusively the upwardly mobile $100,000+ annual income population.

And boy, is he minting money!

WMT and COSTCO are different giants. They eat different food (read customers) and hence they are not straight away direct head to head customers. But their similarities are hard to ignore.

1. Both have fanatical management
2. Both have thrived by bringing people onto their “platform”- WMT by opening stores in a radius of 2 kms for an average JOE. COSTCO by bringing in membership cards to shop there.
3. Both have grown by laser sharp targeting. WMT grew on rural America, COSTCO growing on upwardly mobile America. WMT whenever it tried to move out of its base has paid. I am not aware of COSTCO making such mistakes. (Think: Sam’s Club)






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Retail is Detail

Watch the following video and try to spot the following ideas:

1. How Costco prevents the triggering of System 2 (remember Daniel Kahnemann’s idea) ?  Costco uses Munger’s (and original Jacobi’s idea) – “Invert, Always Invert”- can you give an example?

Also read this piece of understand Walmart’s success to contrast this with Costco’s strategy.

Are they head to head competitors? Can you think of their differences? Perhaps they are having lots of similarities. Can you spot them?


Then read this piece by Tren Griffin (A Dozen things I learned from James Sinegel) and understand more about Costco.

As Griffin said

If you are the big picture guy, then you are out of picture. Retail is Detail

Competition Sutra #5: Localization- The secret to WMT’s success


This is the fifth part ‘Competition Sutra’ series. This series is an attempt to distill the core learnings of Bruce Greenwald’s seminal book “Competition Demystified”


Walmart had no patent, no product, no intellectual R&D pipeline and no government license, yet it has thrived in such a competitive sector as retailing- it is worth taking a look.

Walmart’s success hinged on three manifestations of the advantages a localisation strategy offers.

1. Supply Chain Efficiencies:

Walmart’s supply chain even back in 1970s was a work of art. Due to close concentration of stores, a truck plying on a single route could serve multiple stores. This reduced WMT’s overheads and led it to innovate on a very early variant of just in time supply chain.

2. Lower Ad-Spends:

The policy of localisation and concentration also led to higher efficiency in its ad programs. Since a TV station charges on the basis of per 1000 customers served, for WMT this meant efficiency if it opened more stores. This led to lower ad spends per dollar of sales made. Walmart could penetrate deeper into a community by building more stores and lowering its ad costs . In fact point #1,2 led to an overhead reduction by almost half while compared to K-Mart or Seers. Resulting in operating margins about double to that of its larger peers.

3. Executive Supervision:

To be fair to WMT, the management has always been a top class affair in the organisation. The operations were divided under different area managers, who spent 4 days of the week starting from Monday in their respective stores and held meetings with Mr. Walton in the last two days of the week. The dense concentration of the stores made it possible for the managers to spend more time in the stores than travelling between them. This in turn led to better managerial oversight and improved strategic performance.

Banking on Trust-III

This is the third and final post on the Banking on Trust series. While the previous post winded down to an extraordinary length I recognise it lacked the practical treatment. I hope to set it out right this time. For the first part see here and the second part take a peek here

The last post, Banking on Trust-2 can be summarised in four words- “Management maketh, Management breaketh.”

Due to the highly discretionary job of risk management and a fragile business model (need plenty of other people’s money to even work) a good management can be the invisible asset for a bank.

And I argued, though admittedly without much proof, that Wells Fargo Corp’s management has been extraordinary in its handling of the business.

Let us attack the issues one by one.

Competitive Advantage 101

What separates a big 4 bank (Wells Fargo, JP Morgan Chase, Citigroup and Bank of America) from community banks?

Short Answer: Scale
Long Answer: Economies of Scale.

Being larger in size Wells Fargo and Company (WFC) is able to keep  its fixed costs per unit of loan disbursed far lower than its local competitors.

With lower fixed costs, it is able to charge lesser interest on loans disbursed thus winning the first battle in a commodity business.

Another question.

What prevents the community banks from growing into a big 4 bank?

Short Answerr & Long Answer: Search costs for customers

 The incumbent banks have been able to offer full services at a lower cost (due to scale) than community banks. As a result for a customer it is difficult to find a substitute of such a bank which offers all those services at lowest prices. And hence community banks stay ever small.

The management of WFC understands these ideas very well. Yet they have taken their execution to a completely different level. By being one of the first banks to repeatedly  innovate its financial offering (keeping in view changing regulations as well as customer needs) it has performed extremely well.

Peruse this:

A history of success of WFC

1967: WFC introduces a Mastercharge card as a new form of credit card.

1968: Under high inflation, FED restricts overseas spending. But outbound customers and expats need a solution to this new regulatory development. WFC recently opened London subsidiary WESTERN AMERICAN BANK swings into action- servicing the clients and turning in better than expected performance.

Converts to a federal bank charter (Community Banks- 0, WFC-1)

Mastercharge credit cards which turn out to be a success. Adopted in 37 States and used by 13million cardholders. These numbers generate substantial benefits for WFC. Accepted by virtually every major oil company.

1970: WFC organised as a bank holding company to broaden their services. New branches opened in Sydney, Hong Kong, Luxembourg, Mexico City, Managua etc.

1975:  Its market share of the retail savings trade increased more than two points, a substantial increase in California’s competitive banking climate. With its increased deposits, Wells Fargo was able to reduce its borrowings from the Federal Reserve, and the 0.5% premium it paid for deposits was more than made up for by the savings in interest payments.[from wiki]

1978: Fed allowed banks and thrifts to offer savings intruments with interest rate linked to T bills (savings rate deregulation). Wells Fargo quickly              deregulates its own savings rate. Launches two new plans in response to this. Automatically allows savings account interests to be moved into checking accounts.

1978-80: Wells Fargo’s investment services becomes a leader. More accounts garnered than any other money manager. Wells Fargo’s early success, particularly with indexing—weighting investments to match the weightings of the S&P500—brought many new clients aboard.

In short,with a rise in offerrings WFC is constantly increasing the search costs for customer. But the management of WFC has one more ace up its sleeve.

A mental model to analyse Mastercharge

But wait a second here!

Are we missing something?

Yes surely we are! We missed an important development.

In 1967, WFC launched a system of transaction where customers can take credit from their banks for purchasing items. It was named Mastercharge.

Lets first explore, the success (if any) of Mastercharge as of 1969.

37 states out of 51 adopted it.
13mn customers use it.
Almost every major oil company supports it.

Can we make a reasonable guess on the future of Mastercharge? Its benefit to WFC?

Surely we can. Mastercharge is nothing but the first credit card offering in the world. It is essentially making its customers dependent on itself!

Thats the classic case of moat. Think about it! Marlboro, Coke, See’s Candies. All are businesses which will be sorely missed by its customers.

Lets attack it from another perspective. Lets check if it can be lodged off from its perch (13mn cardholders, acceptance by major oil co.) by a new competitor.

Have you heard of Replicator Dynamics? It is an interesting mental model.

Its in essence a system which says- folks adopt those behaviours more readily which has the more payoff (the material aspects) AND is copied by more number of people. So we can see- people switching and adopting new behaviours. Something like people coming from different cultures quickly adopt the cultures of their new country.

I will be talking about this mental model in another post (Stay tuned!)

Lets apply it here.

Assume that Mastercharge gets a new competitor called Surcharge. It is the new kid on the block. Zero people use this and no states have adopted it, yet.

Now Alex wants to enroll in one of the two credit card companies- Mastercharge or Surcharge. 

What does Alex see? Alex sees around him 13mn customers already using Mastercharge. 

13mn cardholders of Mastercharge! 

It effectively means wherever Alex looks, he sees every card holder as a Mastercharge holder. He is surely going to adopt that behaviour which is being followed by others [Replicator Dynamics].

But when 37 States and all the major oil companies have adopted Mastercharge, what does it imply?

A large number of vendors are already using it. So for Alex, Mastercharge has clearly become significantly beneficial.Its the classic Network Effect at play. 
Each new vendor when joins the network makes the network more valuable to its individuals (Think Facebook in 2006 and 2014).

So for Alex, not only does it make more sense for him to adopt Mastercharge than Surcharge, it also makes it more profitable to him (i.e. gives him disproportionately large material benefits than Surcharge).

Thus we see, Mastercharge owning the market, like a boss!

Mastercharge finally became -> this

The ace up Wells Fargo’s sleeve

The management perhaps thought, if I am indeed locking away the community banks in services why not go the entire way!

Lets lock them out of physical proximity to customers as well!

Take a look:

Dotting the California: New Branches opened or pending in 1968

Its opening new branches so close to each other that it is effectively crowding out community branches.
In the same year it merged with Bank of Pasadena (a 10mn $ deposit bank), Azusa Valley Savings Bank and First National Bank of Azusa (combined 11mn$ deposits).

It acquired Sonoma Mortgage Corp.
In 1969, Wells Fargo has 19 offices in Southern California, the deposits exceeded 165mn$ and loans topped $230mn.

Offices in South California

In 1970, the conquest of Los Angeles and Orange counties(right) is shown. And also take a look at the San Jose metropolitan area expansion

The Conquest of South-West America aka LA and California

The Conquest of South-West America aka LA and California

So we see an all out attack to disproportionately increase the search costs in every way possible.
The qualitative aspects are done, let us train our guns on perspectives.

Is the management really running a tight ship?
Is it keeping its costs down?

In contrast BofA had an overhead margin of 47% in 1998 inspite of 100 years+ of experience

The management- does it go bonkers in good times?

With the qualitative aspects out of the way, let us consider the quantitative aspects of management i.e. its ability to make conservative loans, predict their vulnerability and make the right amount of provisions so that, I repeat, so that the net operating profit after tax is smoothened.

Take a look at this:

The NOPAT barely nudged even in a downcycle

What I did was simple.
I took the Net Interest Income subtracted only the charged off loans so that I get the true picture of ‘damage’ in the current year and added back the loan provisions.

Remember loan provisions exist to smoothen out bad loan losses. So ideally management should have anticipated the loan provisioning properly so that charged off loans are fully accounted for.
But probability of loan going bad is a combination of expected and unexpected developments.

Hence how good a management is, can be checked by how good its predictions are.
In turn, how succesful it had been in making its NOPAT smooth.

Since provisioning is tax free, I adjusted the tax accordingly. Taxes paid in real is the second row, and the last but second row are the taxes applicable on our adjustments, given the same tax rate.

Take a look at NOPAT levels again.
Remember in the period from 1970-72 US entered a recession.
With each economic downturn banks are the first to suffer losses.
And yet, Wells Fargo’s NOPAT has barely nudged.

What do we conclude?

We do conclude that Wells Fargo’s management has been extraordinary capable of cushioning the bank’s fortunes from macro economic shocks. WFC- 1 , Competitors – 0

So now it comes down to valuations. Lets take a look!

Valuations- Valuing the Wells Fargo!

It went public in 1972, and its average market cap for that year was around $1.5bn.
What growth expectations are we attaching to Wells Fargo?
Lets first try to establish a way to value this company.

We adopt the Economic Value Added (EVA) methodology to analyse this bank.

EVA = NOPAT – Shareholder Equity * Cost of Capital

Market Value of Enterprise = Shareholder Equity + Future Value of all EVAs

Using this framework, lets try to find out the EVA from 1967-1971. The cost of capital for a shareholder is merely the opportunity cost.The second best idea is investing in index, assuming a blank portfolio.Consider it to be the historical growth in index DJIA from 1940-1970. Thus the cost of capital equals 8%.

Hence plugging it in and assuming a 20% growth rate for the next 30 year, we arrive at its 1972 valuations of $1.5bn.

20% growth rate in EVA, discounted at 8% for the next 30 years.

Is it too costly?
Well it is if you see the time duration involved. Growing at the rate of 20% for the next thirty years is not a mean feat!

However if you consider that this is a good business, with  a responsible management at helm, with very interesting offerings like Mastercard and a deepening moat, then you might like to reconsider your position.

But I will be fair. Had I been in 1972, I wouldnt have dared to buy it. But given the mental model working in my head now, I would have surely stalked this company very closely.

Three Years ahead- August 1974

Let us consider three years ahead.

Has the position worsened?
Lets see.

In 1974, Wells Fargo NOPAT was $66mn.
Equity stood at approx 450mn$.
At a cost of capital at the same 8%, we have EVA of Wells Fargo in 1974 at $30mn.

If we assume the growth rate in EVA to be about 8% for the next 30 years, the future value of all EVAs come to $0.9bn. With the shareholder equity standing at $450mn, the market value of the enterprise comes to $1.35bn.

In 1974 for about 4-5 months (from August-December) it traded at a marketcap of $860mn.

Fours more years ahead-  1978

Let us go four more years ahead. How well would we have fared in our assumptions?

Constantly increasing Earnings and Dividend per share

It clocked an average of 18% growth in the last 5 years. Topline growth has clocked an average of 17%.

And has the moat deepened?

Everincreasing return on shareholder equity! What else is it other than deepening moat. And this has come at the cost of dumb competition.

Remember Walmart? Walmart did the same with mom and pop shops.

But ladies and genetlemen, I will completely understand if you are hungry for some more.

Take a look at this:

Increasing return on assets for WFC. Almost a vertical line!

And take a look at its effect on leverage:

Falling leverage implies better asset utilisation and deepening moat.

It just shows one thing- Wells Fargo and Company will continue to make a heck lot of a money for its shareholders. In fact, from 1974, if you would have bought and held WFC it would have returned 29400% ; compounded yearly at the rate of 15% for the next 40 years.

Think about it.

Recommended Reading:

1. John Hubers excellent posts on Wells Fargo which has served as an inspiration to conduct this study. here, here and here

2. Annual reports of Wells Fargo from 1968-71,1978,1988,1998

3. The featured image is taken from John Huber’s wonderful blog Base Hit investing


Banking on Trust-II

In the last post Banking on Trust-1 we discussed Bruce Berkowitz ideas on bank as an earning machine, how it can be an earning machine (by turning into a franchise) and Wells Fargo’s success in the same. I ended the last post by promising we will be discussing Berkowitz’s idea of WFC’s management. But before I go forward I want to make a detour.  I am going to talk about banking business in general and then in the last few paras talk about Berkowitz’s observations. Financial sector is often the least understood sector. Investors and laymen alike find it increasingly difficult to make sense of banking as a business. When I first started this series, I wanted to build my circle of competency in this sector as well as keep a public record of my understanding for others to learn and correct. So without much ado, here it is.

In a business like banking it is important to understand the driving factors in its success.

To explore this idea let us try to understand the problems of its CEO. If we explore this idea, then lots of factors become clearer. Better yet, let us try to form a financial business from scratch. Each case will be taken up as a case study #.

Lets get started:

(Note: In all previous financial statements, the balance sheet preceded the income statement by 1 year)

Case Study #1: We have 1000$ invested in a bond portfolio, which yields 22% annually and matures in 10 years. The loan portfolio is completely riskless. 

In this case, the balance sheet and the income sheet looks like this:

A simple credit financing operation

But note, that we would like to enhance the Return on Equity. The RoE of the operation is not very high. As a result, we would like to employ DuPont methodology for analysing RoE.

It says:

ROE = Profit Margin X Asset Turnover X Leverage

So employing this we understand that, increasing profit margin will either require taking more risk on the loan book or procuring cheaper capital. Both of which is say for the sake of argument not possible. Since the portfolio churns once in 10 years, increasing the asset turnover is also not possible. So the only way is to take in more debt.

Case Study #2: Intaking a debt of $ 500 at the rate of 2% to the existing operation.

As a result the balance sheet and income statement will look like this:

The leverage is mere 1.5 and ROE has also jumped by a similar level. However in two aspects this scenario is divorced from reality.

Consider this, when a financing entity offers me loan at 2% which is risky asset, how can this credit financing operation find riskless assets at 22% yield?

So it will be prudent to recognise, understand and acknowledge that the bond portfolio cannot be riskless and definitely the interest spread cannot be this high.

Analogously, if risk and yield are correlated, then undertaking investments in riskless assets will lead to negative spread. That is cost of funds will exceed the yield from those funds. So let us still for the sake of argument  continue to believe that they are riskless, however reduce the spread from 20% (22%-2%) to 1%.

In other words, the yield on commercial loans we make here is 3%

Case Study #3: The yield on commercial loans is 3%


The ROE has fallen once more! And this reflects a more practical scenario. So is banking business doomed with rock bottom ROE?

No, not at all. Remember , we can pull the leverage couple of notches. Now its mere 1.5x leverage. Lets jack it up!

Lets make it 20:1, no 25:1 leverage.

Case Study#4: Effect of 25:1 leverage on ROE

Note, the increase on ROE. The ROE is now 19.60%.

By now quite a few ideas have started coming to your brain,  I am sure. But lets explore a bit more.

We need to consider the inherent riskiness of the loans as well. So lets do it.

Lets indeed treat the loans as risky assets. Which implies, there is a definitive probability of certain loans going bad. Now as we can foresee, if we leave the entity (financial entity) to run as it is, with no difference made to account for the riskiness of the loans, we can face these problems:

  •  The Net Interest Income(NII) will be extremely volatile.
  • In good times when cost of fund is cheap, the banks will how high profits and in bad times when the default rate rises the profits of banks plunge- making banks extremely coupled with the economy and more risky to own during the downtimes.
  • Excess leverage of the banks make their balance sheets “fragile”- a small amount of default can wipe their equity portion and may even hamper their debt part.

These reasons and more, make it evident that “business as usual” is not wise. We will have to protect ourselves against bad loans while making some kind of provisioning to account for the riskiness of the portfolio.

If we think a bit more deeply, we can say for a bank the level of interest it can charge can be gleaned from this relationship:
Here r_{l} is the interest charged from the debtors, r_{b} is the risk free rate, E(d) is the expected annual default rate, k is the risk premium and c is the operating cost per unit of loan disbursed.

Thus, if L is the loan disbursed on average, the cost of funding is r_{d} and \Delta BL is the bad loans charged off (i.e completely written off), then the NII for the bank in any given year will be:

NII = \tilde{L}*((r_{b}+E(d)+k)-r_{d}) - \Delta \tilde{BL}

Note: Here we are using \tilde{L} and \tilde{BL} to imply that these are not constants but are changing variables. Also we have not used the cost per unit loan in the above equation because we are considering Net Interest Income (i.e post overheads).

This is a situation which considers that there is no provisioning. As a result NII will keep on changing as per the whims of \Delta BL. In bad times when the bad loans increase Net Interest Income will plunge perhaps even going into losses, and in good times when bad loans are below the E(d) rates, Net Interest Income soars.

So remember we are the CEO of this investment operation. It is our duty to see that the health of the business is not adversely affected in any case. We have to thus protect ourselves from the bad loans coming to bite us. Especially in the bad times. Let us create a separate account, where part of the net interest income will be kept aside to cushion the fluctuations in \tilde{BL} (bad loans).

Hence let us keep aside a fixed proportion, \gamma annually of the value at risk.
What is the value at risk here?

Naturally it is expected rate of default E(d) times the loan disbursed L.
Hence, provisioning equals \gamma * E(d)\tilde{L}.
So for each year, we will set up the amount by which provisioning exceeds \Delta BL.

As a result the Net Interest Income will look like this:

NII = \tilde{L} \cdot ((r_{b}+E(d)+k)-r_{d})-\Delta \tilde{BL} - (\gamma \cdot E(d) \cdot \tilde{L} - \Delta \tilde{BL})

On manipulating, we can find something interesting. We find:

NII = \tilde{L} \cdot [r_{b} +k - r_{d}] + (1-\gamma)\cdot \tilde{L} \cdot E(d) if LLP > 0

Here LLP implies Loan Loss Provisions.

In case LLP=0 , the situation reverts back to the representation where there was no cushion.
So what do we see with all this?

We see, the cyclical fluctuations in \Delta BL , bad loans i.e. is completely removed.
We also see, that it is a pseudo-expense.

Just like a manufacturing company can eschew depreciation completely and every few years it can show an extraordinary expense to replace the machinery, similarly without LLP the bank will show extraordinary losses every few years.
By using provisioning (which can be thought of as banking equivalent of depreciation), the CEO are able to smoothen out the profits and cycles

Thus let us account for the riskiness of the assets. Let us consider that expected value of defaults is 10%, and loan amount as per the previous case study was $26,000. Thus the value at risk is $2600. We set aside a proportion of this value at risk say about 1% as provisioning.

Furthermore let us assume there is no charge off this year.

Case Study #5: With 1% provisioning of VaR

Now we are getting closer to our ideas here:

What do we observe here?

1. Prudency demands we should be good at predicting the quality of our loan book, and honest in reflecting the same in our provisioning calculations.

2. In bull runs, there are additional pressure from market, from shareholders to constantly  beat the expectations. And it is that crucial time when CEO has to shut out the noise and allocate provisioning capital liberally. Because when economy contracts the bad loans will have to be offset from this.

3. CEO should build moats around their operation, so that customers dont switch easily at the drop of a hat and some amount of premium pricing can be charged for the services. .

4.  CEOs should be extremely low cost operators, so that the margins can be increased.

In this light it is important to note that the management of Wells Fargo have been prudent in recognizing risks,honest in acknowledging them and cautious in  accounting for them.

So what do we see, when Wells Fargo is hit badly by California Real Estate shock of 1990.

The management errs on the side of caution by high provisioning for the loan losses. So much so that, the earnings power of WFC is completely disguised.  Secondly, a manager who over reserves is one who will understand the price of risk. In other words, it is an indication of cautious, responsible and able managers.

Banking is a business where there is no place for gung ho managers. Being a business so fragile a tiny amount of neglect towards risk can wipe out the bank.

Berkowitz at one point drives home  harder the fact that Wells Fargo has captured the markets so heavily, mark my words, he says if Wells Fargo is to close down tomorrow then there would be significant shortfalls.

That, my friend is the mark of a company which has locked out any competition on its turf. In short it has got a moat around it!

What does it imply?

One thing. Management is the best as they come.

Wells Fargo is also the most efficient bank out there and has an ROE of 20% (as of 1990). Bruce Berkowitz at this point introduces PTPP Earnings, that is core earnings for a bank. It is called pre tax pre provisioning earnings. He points out that PTPP earnings of WFC stands at an astonishing $33.

And their provisioning which is extremely conservative, and assumes a complete charge off is not so. In fact their non performing assets are earning  a modest amount of interest.

Buffett reflects Berkowitz idea toto. He echoes that management of a bank is the singlemost make or break factor. The next important factor is costs. Wells Fargo has an average cost of deposits at 0.36%.

Similarly its return on assets stand at 1.43%, return on equity at 13% and return on tangible equity stand at 18.3%. Compared to any cheap community banks Wells Fargo is far better in quality and far better in value.

This post has stretched far beyond usual ones. For now taking your leave. Adios.

In the next post of Banking on Trust series, I will be discussing the business aspects of Wells Fargo- its competitive advantages etc.



A Success Template

This is an annotation and commentary of the wonderful interview that Mr Tom Murphy did with Harvard Business School talking about his early childhood and career. The idea for this post was taken by Greg Speicher’s wonderful post

Thomas ‘Tom’ Murphy was the  CEO of Capital Cities till 1996. He joined a small broadcasting company in New York in 1954 and gradually went on to build the television broadcasting empire that Capital Cities eventually became. He engineered some cannily crafted deals, acquisitions and partnerships finally to emerge as one of the most successful and legendary broadcast executive in the then USA.  In 1985 he shocked the media world by announcing the acquisition of American Broadcast Company(ABC) for $3.5bn. Incidentally it was his long association with Warren Buffet that helped him to iron it out. Finally in 1996, he sold the Capital Cities/ABC for $19bn to Disney.

He did an interview with Harvard Business School here. Whichever way you look, Thomas ‘Tom’ Murphy had some brilliant success in his life and career. Its important thus to read, understand and internalise the qualities of the man- that Tom Murphy is; for he can show us what it takes to be successful.

“I would say that the most fortunate thing that happened to me, outside of being born an American, was that my father and mother were just magnificent. They were very happily married. I would say that the single most important thing in my life is the wonderful family I came from”.

Its surprising with the way he starts narrating his story. If there is one word which describes it is gratitude. Of course one can always argue that when a man has achieved so much gratitude is the least thing he should feel. But then gratitude doesnt arise in vacuum. It arises from an acknowledgement of life blessings, and for that optimism is important.

Success Template #1: Be optimist, have a positive outlook to life.
Success Template #2: Yearn to be the best husband and you will be the best parent.

 “The three of us were always trying to get the best possible education for ourselves. My father was insistent about it—almost a nut about it. He wanted us to work hard and play hard.”

The importance of education is perhaps widely recognised and yet millions of us still fail to point it out enough. Its very easy to confuse education with mere collegial degrees. That might be education in the way society defines it, but that is not education as successful people define it. Broad, extensive and deep reading , the internalisation of such knowledge and its application is what defines education. Remember what Einstein said- “Education is what remains after one has forgotten what one has learned in school”.

Success Template #3: Educate yourself.

“One of the interesting things I’ve learned in my life is that one of the most uncommon things in life is common sense. It’s very hard to notice whether people have great common sense.”

It is of course a given that we as a civilization are progressively losing our ability to think, reason and figure out. But then we often confuse common sense with acceptance of common myths. There is no set out ideas behind this except that common sense, curiosity and learning by questioning are all connected at hip. One related and fantastic post can be found here at [ How we get duped by Common Sense ]

The second thing Harvard Business School did was it gave me associations through my classmates. We had all just come out of the service, and my classmates have become my best friends in the last fifty years.

This is one of the finest learning of mine in the last 2-1/2 years. I have learned to understand and value the power of networks. I am a slightly shy and introvert person. And keeping networks going is difficult for me. However much of the success of a lot of people I know arise from their associations. Associations and Networks are hallmarks of robust,successful systems. Ecology thrives on networks, as do democracy [Tocqueville remarked famously- Americans of all ages, all conditions, all minds constantly unite.] Much of his success in making the deal with ABC was due to his association with Warren Buffet.

Success Template #4: Form networks, nurture them and harness them

From here starts some of the golden words on businesses, investing and money making. Listen carefully, my friends for it is the sage speaking:

“There are not many great businesses that come along in a lifetime”

“Because of the limited availability of licenses, there was limited competition, and so it exploded over the next thirty or forty years”

“The business is not capital intensive, nor is it labor intensive.”

“The costs are somewhat fixed so as you had greater and greater sales, the margins would just continue to grow.”

“So just by being sensible about our business, we continued to grow the company and buy businesses from other people who didn’t see the potential profitability that we saw.”

This is absolute gold. What we have in our hands, ladies and gentlemen is the very template of very successful business. The fact that great businesses are not common is iterated and reiterated time and again by Munger, Buffet and all of the focus investors. Great Businesses are great because they have rare characteristics in them. And what are they?

Success Template #5:

  • Barriers to Entry.
  • Asset Light
  • Priceability (ability to undertake pricing hikes)
  • Buy keeping the long term vision in mind.

In the following quotes he tells about how understanding his businesses made him money. Remember Buffet and Munger repeatedly point this out that understandability is the most important quality to look for in the business. And this can also be stretched to advantages and strengths of the business model.

“…as long as I could in the businesses we understood, which were television and radio.”

“When we got as big as the FCC would allow, I went into another business that I could understand, which was the newspaper business. In a sense, it’s a monopoly business like broadcasting and it is advertiser supported.”

This is interesting enough because he is reflecting a theme which is so near and dear to Buffet’s franchise model. A monopoly business.

So we can add one more addendum to the template #5,

  • Monopolies and Oligopolies only!

One thing with Tom Murphy is, his sense of ethics and personal integrity stands out. His personal constitution becomes apparent- as one who values the old world principles. In India, decades of socialism has eroded personal principles; statism has eroded personal pride; And yet, I believe success mantras in India is not any different than it is in America.  As the legend said-

“I would also say, don’t give up on your ideas and certainly never give up on your ideals.”

The entire interview can be found here. Do give it a read.

Banking on Trust – I

This is the first part of a three part series on investing in banks. This is not a tip blog post, this is a discussion of different salient features which drive banking business. The method of analysis will be part inspiration and part plagiarism.  In 1992 Bruce Berkowitz gave an interview to Outstanding Investors Digest (OID) regarding Wells Fargo. These are some of the ideas presented by him and an exposition by me.

Wells Fargo is an American banking company with head quarter in South California. Its the second largest bank in US in terms of assets and the largest in terms of market capitalisation. It extensively takes home financing. In February 2014 it was ranked as the most valuable bank in the world for the second time in a row. Wells Fargo is owned by Berkshire Hathaway. At different points of time it was owned by some of the most stellar value investors of present era.Munger went to the extent of  calling Wells Fargo his investment filter. He implies that he constantly asks himself if he should put his money on a new investment when Wells Fargo is as a good and as cheap as it is.

But how do they think about a business as difficult as banking.

“Its a simple case of a bank with tremendous earning power”

Bruce very early in his interview makes it clear what is the Big Rock in his thought process. He underlines that Wells Fargo is a bank with a tremendous earning power. Wait a second!  What does it even mean?

How do we identify the earning prowess of a bank?
Or rather what are the driving gears of a bank?

At the very core of its operations a bank is at the end of the day a commodity business. The commodity is not some agricultural produce but it is an economic produce- MONEY!

People go to banks to deposit their money and avail loan services. So when banks take deposits they incur expenses . Similarly when they disburse loans the interest income is their revenue.
No significant differentiator with respect to any other competitor. Of course a bank can raise the interest offered on deposits to attract more customers but it will be akin to making higher payments to your supplier. So higher interests offered to deposits imply lesser profits.
Compare this with a coal miner- another commodity business:

1. He has no pricing power- that is his price is dependent on the lowest price offered in the market.
2. The fruits of innovation is never going to create a unique production process for his own firm.

3. As a result, margins are going to be just enough for producers to survive.

So a bank can attract loan availing customers by lowering interest rate. However this is not going to make him any profits. It will be a value destructive growth.

However there are times when a bank can move away from a commodity business to a franchise model. 

A related question here is- can we think about banking business in a different way?

And the answer is – Yes, we can think about banking business differently

So many people are dependent…

A Bank can also be thought of as a platform!.  This is an incredible insight. Think of it, two persons walk in to a bank to avail loans. One of them is already a client in the bank having his own deposit. The other doesnt. Guess which one of them will walk out of the bank first with a loan in his hand?

Banks started loaning out to people they know to control their risks, but it has now spawned into a lock-in system. If you do business with this bank, your working capital loans of your business is given by this bank then you can’t shift away your deposit savings account to another competitor providing competitive rates!

And vice versa. If you do have a deposit account then selling the loan services to you is going to be easier from your as well as bank’s  perspective.  This is a way of thinking. In developed and matured economies the difference in convenience is not going to be huge, however my common sense says it should be present.

Now lets try to think a bit more through it- what if a bank has a branch at every corner of the road? The stupendous distribution system itself is going to lock away other competitors from even trying to enter this business. And that is one excellent reason why community banks thrive in US.  And that is the reason why local moneylenders thrive in India.

So a bank with the biggest number of branches is going to win. However, branches imply growth and the margins of this business is low (why? because at its core its a commodity business). Hence it is imperative that the efficiency of the bank is as high as possible.


Thus for a bank to reinvent itself as a franchise- it has to have an excellent cost structure, low cost of funds, excellent footprint and the efficiency gains which come from scalability. 

In as many words, when OID asks Bruce Isnt that a contradiction in terms- a bank with a franchise?” He replies-” If I give you a billion bucks and let you pick your management team, how could you rationally hurt Wells?

Indeed how could you rationally hurt Wells Fargo when it has a 9000 branches spread all over US?

Footprint of Wells Fargo in US

Footprint of Wells Fargo in US

Its scale leads it to earn a ROE of 20% and a NIM of 5.5% (at that time) and a 3.5% (today).

Additionally, Bruce points out that the banking structure at the upper reaches of the pyramid (that is where WF resides) is completely oligopolistic. WF forms the one of the banks in the quartet- Bank of America, Citigroup and JP Morgan Chase being the other three.

In the next post we will discuss on how Bruce talks about management quality, Warren Buffett’s views and some other accounting techniques and ideas