Pet Banks

• The Bottom Line: Historically, “pet banks” were state banks favored by the US government; for modern investors, the term is a powerful metaphor for a dangerous and often overlooked risk: a company overly dependent on a single, powerful customer or political favor.
• Key Takeaways:
• What it is: A business that derives a dangerously high percentage of its revenue from one client, creating a fragile dependency.
• Why it matters: This extreme concentration_risk can destroy shareholder value overnight if the key relationship sours, erasing any perceived margin_of_safety.
• How to use it: Use the “pet bank” concept as a mental model to scrutinize a company's customer base for signs of unhealthy dependency before you invest.

Imagine a small, charming town whose entire economy revolves around a single, massive factory. The factory employs most of the townspeople, supports all the local shops, and funds the schools. For a time, the town thrives. But what happens if the factory closes, moves overseas, or simply decides to use a different supplier? The town's prosperity vanishes in an instant. This is the essence of the “pet bank” problem in investing. The term itself comes from a fascinating and fierce chapter in American history. In the 1830s, President Andrew Jackson waged a political “war” against the Second Bank of the United States, a powerful national institution he viewed as corrupt and elitist. To dismantle it, Jackson ordered the withdrawal of all federal funds from the national bank and redirected them into dozens of smaller, state-chartered banks. His opponents mockingly called these chosen institutions “pet banks.” The nickname implied they weren't selected for their financial soundness or merit, but for their political loyalty to Jackson's administration. They were the president's “pets.” The result was chaotic. Many of these banks, flush with government cash, engaged in reckless speculation, contributing to the financial Panic of 1837. Today, while the original pet banks are long gone, the term lives on among savvy investors as a shorthand for any company that is dangerously beholden to a single customer. This customer could be a corporate behemoth like Apple or Walmart, or a government entity like the Department of Defense. Like the town with one factory, these companies may look incredibly successful on the surface. They might boast of soaring revenues and impressive growth, all thanks to their massive contract. But a value investor, trained to look for durable, resilient businesses, sees the hidden fragility. Their success is built not on a wide and stable foundation, but on a single, precarious pillar that could crumble at any moment.

“The chains of habit are too weak to be felt until they are too strong to be broken.” - Samuel Johnson. This is true for individuals and for companies that become habitually dependent on a single source of revenue.

This dependency fundamentally alters the power dynamic. The company becomes less of a partner and more of a servant, forced to accept shrinking profit margins, unfavorable terms, and constant demands from its all-important client. Its fate is no longer in its own hands, making it a speculative bet rather than a sound investment.

The “pet bank” concept cuts to the very heart of value investing because it directly challenges two of its most sacred principles: the economic_moat and the margin_of_safety. A value investor seeks to buy wonderful businesses at fair prices, and a business with a “pet bank” problem is, by its very nature, not a wonderful business.

• It Annihilates the Economic Moat: A true economic_moat protects a company from competition, allowing it to earn sustainable profits. This protection might come from a powerful brand (like Coca-Cola), a network effect (like Facebook), or low-cost production (like GEICO). A company dependent on one customer has no real moat. Its success is a privilege granted by its client, not a right earned through competitive advantage. The moment that client finds a cheaper, better, or more convenient alternative, the “moat” proves to have been a mirage.
• It Creates Unquantifiable Risk: Value investors are obsessed with risk management. We analyze balance sheets, calculate debt levels, and study cash flows to understand what could go wrong. The risk of a single customer leaving is catastrophic, yet it's almost impossible to quantify. It won't appear as a liability on the balance sheet. It's a hidden, binary risk: one day the contract exists, the next it might not. This uncertainty makes it impossible to confidently calculate a company's intrinsic_value.
• It Demolishes the Margin of Safety: The margin_of_safety is the bedrock of value investing. It means buying a security for significantly less than its underlying value to protect against errors in judgment or bad luck. With a “pet bank” company, the intrinsic value itself is incredibly fragile. Even if you buy the stock at what seems like a cheap price (e.g., a low P/E ratio), your margin of safety is illusory. The “E” (Earnings) in the P/E ratio could be slashed by 50-80% in a single quarter if the main client walks away. The risk is not that you overpaid for the earnings, but that the earnings themselves could evaporate.
• It Misaligns Management Incentives: When one customer is the entire game, management's focus shifts from long-term value creation for all shareholders to short-term appeasement of the key client. Resources are poured into satisfying that one relationship, while innovation, diversification, and exploring new markets are neglected. The company stops running to win the race and starts running just to stay on the treadmill set by its master.

For a value investor, a “pet bank” situation is a flashing red light. It signals a lack of durability, an absence of a true competitive advantage, and a level of risk that is fundamentally at odds with the goal of preserving and growing capital over the long term.

Identifying “pet bank” risk isn't about a complex formula; it's about investigative work and applying a critical, value-oriented mindset. It's a qualitative analysis that begins with reading a company's annual report.

A disciplined investor should make this a non-negotiable step in their research process for any potential investment.

• Step 1: Go Straight to the Source (The 10-K). Every publicly traded company in the U.S. must file an annual report called a Form 10-K. In this document, under a section typically called “Risk Factors” or “Business,” the company is legally required to disclose any single customer that accounts for 10% or more of its total revenue. This is your starting point. Don't take a blogger's or analyst's word for it—read it yourself.
• Step 2: Quantify the Concentration. Once you find the disclosure, note the exact percentage. This number is the most direct measure of dependency. You can categorize the risk level mentally:
  • < 10% of Revenue: Low Risk. No single customer has significant leverage. This is a sign of a healthy, diversified business.
  • 10% - 25% of Revenue: Moderate Risk. This is a significant customer. You need to investigate the relationship further. Is it a long-term partnership? Are switching costs high?
  • 25% - 50% of Revenue: High Risk. The company's fortunes are now heavily tied to this single client. The “pet bank” alarm should be ringing loudly.
  • > 50% of Revenue: Extreme Risk. This is a classic “pet bank” scenario. The business is in a precarious position. The investment case requires an exceptionally compelling reason to proceed, and a massive margin_of_safety in the price.
• Step 3: Assess the Customer's Power. Who is the major customer? Is it a small, loyal partner or a ruthless global titan? A company supplying a niche part to a small industrial firm is in a very different position than a company supplying screens to Apple. Giants like Apple, Amazon, Walmart, or the U.S. Government have immense bargaining power. They can—and frequently do—squeeze their suppliers' profit margins and can change partners with little notice.
• Step 4: Analyze the Relationship's “Stickiness”. How hard would it be for the big customer to leave? This involves understanding switching_costs.
  • Low Stickiness: The company supplies a simple, commoditized part that could easily be sourced from a competitor. This is a very dangerous situation.
  • High Stickiness: The company's product is deeply integrated into the customer's operations (e.g., a unique software system or a highly customized, mission-critical engine component). Here, the risk is lower, but it is never zero.

Discovering a high level of customer concentration doesn't automatically mean you should discard the stock. However, it fundamentally changes how you should value it. A value investor facing a “pet bank” situation must demand a much, much larger discount to their estimate of intrinsic_value. The heightened risk must be compensated for with a significantly cheaper price. You are not buying a stable enterprise; you are making a calculated bet on the continuation of a single, crucial business relationship. You must ask yourself: “What price would I pay for this company if I assume they lose this major customer in three years?” The answer is often sobering and reveals the stock is not nearly as cheap as it seems.

Let's compare two fictional companies to see the “pet bank” principle in action.

• Steady Parts Co. (SPC): Manufactures high-quality fasteners (nuts, bolts, screws) for the automotive and aerospace industries.
• Giga Display Inc. (GDI): Manufactures cutting-edge OLED screens for smartphones.

Here is a look at their customer base:

An investor just looking at growth might be captivated by Giga Display Inc. Its revenues have skyrocketed because its primary customer, Pear Inc., has a hit new phone. The stock trades at a seemingly reasonable P/E ratio of 15 due to its massive earnings. The value investor, however, sees the extreme danger. They read the 10-K and immediately spot the 78% revenue concentration. They know that Pear Inc. is famously competitive and is known to be developing its own display technology in-house. The risk of Pear switching suppliers or insourcing production is massive. The seemingly cheap P/E of 15 offers no margin_of_safety against a potential 80% drop in earnings. Conversely, Steady Parts Co. is a “boring” business. It grows slowly, but its revenue is durable. If AutoMaker A has a bad year or switches suppliers, it's a small dent, not a fatal blow. The value investor recognizes that SPC's diversified customer base is a powerful, if hidden, asset. They can calculate SPC's intrinsic value with far more confidence and know that the business is highly likely to be earning similar, or greater, profits in ten years. The choice for the value investor is clear.

Applying the “pet bank” lens is a powerful tool, but it's important to understand its nuances.

• Focuses on Business Quality: It forces you to look past exciting narratives and surface-level metrics (like revenue growth) and analyze the underlying quality and durability of a company's business model.
• Highlights Hidden Risks: Customer concentration is a major risk that is often downplayed by management and overlooked by euphoric investors. This framework puts it front and center.
• Simple and Intuitive: The core idea is easy for any investor to grasp. The “don't put all your eggs in one basket” principle is a timeless piece of wisdom that applies perfectly here.

• Ignoring the “Validation” Phase: For a young, small company, landing a huge contract with a major corporation can be a sign of technological superiority and a powerful validation of its product. The pitfall is assuming this early success automatically translates into a durable, long-term business.
• Being Statis vs. Dynamic: A company might have high concentration today but have a clear and credible strategy to diversify its revenue streams. An investor should analyze the trend over several years. Is concentration increasing or decreasing?
• Misjudging “Stickiness”: Some customer relationships are incredibly strong and durable due to high switching costs or deep integration. An investor might prematurely dismiss a company like this without doing the hard work to understand just how essential it is to its main customer. The risk is still present, but it may be lower than it appears at first glance.

• concentration_risk
• economic_moat
• margin_of_safety
• supply_chain_risk
• customer_diversification
• political_risk
• intrinsic_value