Banks, Future of Banking

A Key Factor Separating Bank Compounders vs. Laggards…

  • Owning a basket of the most efficient banks is a consistently outperforming strategy
  • Upcoming forced selling brings a few opportunities.

Sort for efficiency among the forced selling We are currently entering an unusual season, when up to 80 banks are added, but mostly deleted, from the Russell 2000 index. This creates a wave of trading, and mostly selling this year, that can reach 80x a typical day’s trading volume in these shares. You can sell if a bank is a candidate to be sold if Vanguard is a holder and the market capitalization is below $260 million.

In that context, let’s look at those with a chance to reward dip buyers vs. those that stand to remain out of favor.

Below we see some bank efficiency champions, those banks with ratios 30% or below. In other words, their “operating margins” are 100%-30% = 70%.

Efficiency Champions

The print is small, but the worst 5-year return is 114%.

Now let’s look at the largest of the “inefficient” banks, those with an efficiency ratio over 80%, or operating margins below 20%. The best 5-year return is 59%.

Laggards

Every January 1 the efficient banks have a head start, with better multiple for acquisitions, more capital generation to support growth. Still, The market does a clumsy job in the short term differentiating between these efficiency winners and losers.

First index funds tend to push these shares up and down.

Another reason is some holders expect inefficient banks to sell, but the banks are usually inefficient because boards and management earn too much, and who wants to stop that?

A third reason is that these inefficient banks are usually oriented toward consumers, not businesses, and are slow to realize their branch networks are a drag.

This doesn’t have to be so hard.

Every conference I attend, some 70% efficiency bank CEO will explain how his or her bank is on the cusp of something great. Any day, customers will run into his branches due to a new checking feature or key hire made from Wells Fargo.

These plans rarely work. If you own an inefficient bank, you need to know whether legacy management is incented to sell. If you don’t have a feel, why not hop on the efficient competitor?

We don’t have a position in PKBK, one of the champions of the graph at top, but given it is among many efficient banks being removed from the Russell 2000, and consistently keeps 70 cents on the dollar, it merits closer study.

Buy “high margin” banks – let the others waste someone else’s money!

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