Saturday, August 11, 2012

Do Banks Deserve a Place in a Dividend Portfolio?

Earlier this week, we learned that Standard Chartered bank (a stock that I own) was accused by the New York Department of Financial Services (DFS) of engaging in illegal financial transactions with Iran. A worst-case scenario for the bank would be a loss of its New York banking license -- a possibly crippling action since so much money flows through the state of NY, and specifically New York City. The best-case scenario (save a complete dismissal of the allegations) would be a one-time fine and a temporarily tarnished reputation.

Pick your poison

From a dividend investor's perspective, the first case would be far worse as it could impair long-term profitability (indeed, StanChart keeps its accounts in USD) and increase the risk of a dividend cut or perhaps a rights issue. Assuming StanChart did, in fact, do something illegal a hefty a one-time fine should be relatively good news for dividend investors as the company's payout ratio is about 40%, so there's some margin of safety there to absorb a one-time shock. Plus, StanChart has excellent liquidity metrics and an industry-leading capital position. It would have to be a very severe punishment, in my opinion, to put the dividend at risk.

Just a few weeks ago StanChart increased its dividend by 10%, so if the firm knew about the DFS investigation it clearly felt comfortable raising the payout. If management didn't know about the DFS investigation then it either thought it was doing legitimate business in Iran or it was delusional enough to think they would get away with it. If management knowingly conspired or concealed transactions while at the same time heralding its reputation to investors in the recent conference call, that would be enough for me to consider selling my position.

However this plays out, this week's news has raised a number of questions and resurfaced concerns about bank stocks. If this can happen to Standard Chartered -- a self-proclaimed "boring" bank that successfully navigated its way through the financial crisis and had avoided all the scandals that plagued other banks (LIBOR, mis-selling products, etc.) in recent years -- what global bank couldn't this happen to? And more importantly: Do modern banks deserve a place in a dividend portfolio?

Times have changed

Dividend investors have been understandably apprehensive about bank stocks following the financial crisis, as the events clearly put into perspective the reality that modern banks are not the 3-6-3 banks that used to anchor many dividend portfolios. Today's global banks, by contrast, have opaque balance sheets and are more exposed to fat-tail risks (rogue traders, money laundering, etc.) that can quickly impair results.

As a result, today's banks are very difficult to value and you're thus putting a lot of faith in management's ability to make the right decisions. This is exactly why recent events at JP Morgan (the London Whale) and this week's story about Standard Chartered are so disappointing. Both banks have been held up as models for global banking post-financial crisis and the reputations of both firms have been questioned, leaving investors with fewer straws to grasp. If you don't trust the bank's management, it's hard to feel confident about the bank's future.

Worth the trouble?

So why bother with banks when there are plenty of good dividend-paying shares in "less risky" sectors?

I think it's completely understandable for a dividend investor to walk away from bank stocks given events in the last five years, but it's important to keep the following things in mind before making that decision:

1.) If most investors are walking away from bank stocks, that could be an opportunity for contrarian investors to make money in the long-run.

2.) By managing your own portfolio, you get to determine how much exposure you want to certain companies and sectors. If you're cautious about banks but think there's opportunity, make them a small percentage of your portfolio so they can't do permanent damage if things go south.

3.) Sufficiently capitalized banks with good liquidity should be better able to deal with periodic shocks to their business without cutting the dividend.

4.) After the carnage of the financial crisis, banks have a vested interest in building dividend momentum as a sign of improving health.

I should note that this was part of my thesis for Standard Chartered, so time will tell if it holds water.

Look before you leap

StanChart will remain a small part of my portfolio for now, but I don't anticipate adding any other bank stocks to my dividend portfolio in the near-future. Some stocks are just simply not worth the trouble, even if they're potentially undervalued, and I think most global bank stocks fit that bill today. There are plenty of alternative investments out there with more transparent balance sheets, higher dividends, and better cash flows and are easier to value, as well.

Whatever you feel about big bank stocks, be sure to approach them with eyes wide open. Times have changed and today's banks aren't the banks of old -- their dividends are riskier and you should demand a meaningful margin of safety given the heightened uncertainty.