S&P periodically publishes a popular article highlighting banks ranked by lowest price to tangible book value. Below is a recent sample of the banks on the list:
Value investors like to sort through these banks because in theory they can shoot up in price with more adept management or in the event of sale, as recently occurred at Standard Bank of Pittsburgh or Security Federal of Tennessee:
There is an issue however – for every one Standard, there are multiple value traps, run by managements indifferent to their ownership base. Banks are particularly susceptible to this because activists are uncommon across much of the country and it can be expensive and draining to run against entrenched managements – much easier to simply sell shares.
As a result we see 20-year charts like this at Glen Burnie (GLBZ) of Maryland:
Peoples Financial of Biloxi (PFBX) is grooming a successor for its CEO. That successor is the CEO’s son.
Even owners of SFBK, had they bought any other time than the last 18 months, would have to explain performance:
How to sort trash from treasure? There are 800 publicly-traded banks so folks following the sector become adept at developing a criteria for un-investables. Some screens might include:
Not located in a demographic / fiscal hazard zone area (NJ, IL, CT, among others).
Not so small they are trapped either needing to raise capital at deep discounts to book or hoping to sell for book value given the bank is essentially a branch with too much management (about 10 banks on this list)
Not a transactional bank (USMT, FIEB, HAFC have transactional elements).
Not a corporate governance exception. Customers Bank (CUBI) CEO Sidhu was removed in a shareholder revolt at Sovereign Bank in 2006. If CUBI’s 3x P/E and ~ negative 50% 3 year return are an indication, he has not yet been granted benefit of the doubt 14 years later. The executive pay packages at CUBI are…unusual.
Plenty of CEOs are working overtime in solid and sustainable business models, with heavy fee components, to earn shareholders money. The compounding from these positions can generate well more over time than a merger premium. It would actually be a disappointment of sorts if a bank like Truxton or Communities First (both below) were to sell – chances are good the buyer would replace a predictable, high margin return stream with one that is more volatile and lower margin…
Today’s market allows us to have higher quality bank management teams, often at discounts to book. We should take advantage.
Earlier this week I published a column on five ways US banks outperformed their European and Japanese counterparts. Those included capitalization, efficiency, return of capital, governance and regulation / government interference.
But as we see the EuroStoxx bank index reach an all-time low this week, many in the market persistently suggest US banks are headed in the same direction as the hapless foreigners, so much so that it’s nearly conventional wisdom.
So the US is in better shape now, but is Pal right?
Today’s sequel answers that question by showing why US banks are the way they are, and why they will continue to run circles around Europe and Japan. We know that US banks return capital and Europeans don’t, but why? Why does JP Morgan spend hundreds of millions to lobby while Paribas does what they are told to do? Why do we see bad decisions cascading to the point the EU banks are trapped, trading at 20% of tangible book and with no choice but to merge, shrink, and deflate their host economies?
The answer is greed.
These problems develop when the 9-member Management Board of $1.5trn asset Deutsche Bank owns less stock cumulatively than the Chief Risk Officer of $17bn Independent Bank of Texas owns by himself. I’m confident that risk officer is one of thousands of officers in the US banking system checking their stock price daily.
Small banks in the US brag about how much insiders own. Management at Deutsche own 0.03% of a stock with a $13 billion market cap. Speaking of $13 billion, that’s the amount of dividends JP Morgan will pay this year, an amount CEO Dimon referred to as a “drop in the bucket”.
Gekko said “greed works” referring to corporate takeovers, but it also seems to work for banking systems.
A look at whether the US banks are headed the way of Europe and Japan…
One of the reasons most US bank stocks have struggled to regain their levels of February is the belief that the US economy is following the path of the Europe and Japan, and the US banking sector is in turn following those countries’ “basket case” banks. This belief in our secular decline, popular with macro pundits and the pensions and endowments that follow them, is a sad prospect. Below we dig in on the details and risks.
Why are the overseas banks so bad? Year after year these banks capture more risk than reward – making ~6% ROEs with 30-40x leverage from laughable sub 2% net interest margins. They are too stubborn to free up capital by running off subpar assets to repurchase shares at 50% of tangible book or below. Some, like Deutsche Bank, compete with the profit-optional Landesbanken. Unreformed Spanish and Italian banks entertain zombie corporations in markets with 10%+ unemployment. These banks are pinatas for their clients and governments, with management teams passively absorbing blows instead of finding better uses of capital. You might compare them to coal companies – capital intensive with low margins – except they are systemic, so are difficult to kill and reorganize.
The issues are margins, expenses, governance, capital management, and government meddling. US banks are imperfect but the foreign banks are worse across the board, now and into the future.
Let’s briefly break down the differences
This is the primary reason the foreign banks have fallen apart. Margins overseas are 1-2%, and unless they operate all digital, banks simply have to take too much leverage to hit their 10% ROE targets safely. The US does have a few banks with margins dipping close to European territory, notably Wells Fargo at 2.2% despite not having a sizable securities arm, and JP Morgan and Bank of America at ~2% with large securities books. These margins are actually artificially low given recent jump in cash balances. In the US most regional banks run 3.0%, and expect stabilization or slight growth, while community banks are 3.25% – 3.75%. Putting that in perspective, US regionals run approximately double the spread of Europeans and 3x Japan. Below is an exhibit from Mitsubishi UFG’s September 10 deck. Embarrassing. USA 1, Japan and Europe, 0
In the US the new trend is to close branches. Not a few, but multiple banks have each announced 20% branch closures in recent weeks. PNC is closing 160 branches and Wells is looking to cut $10 billion in costs.
The Europeans are making an effort for second place:
Mitsubishi, among the biggest Japanese banks, is closing a few branches but still working on the 2010 playbook of branch revitalization, shown below:
In a narrower victory USA 2, Rest of Developed World 0
4.2% leverage ratio is what Societe Generale considers “strong”:
4.2% is the level of the dumbest US banks in 2007. Citi ran 5.2% leverage in 2006 and hit 4.03% for the bailout win in 2007. Even Deutsche Bank, with its own 4.2% ratio today, admits this level is unacceptable:
Sumitomo as an example in Japan sports 5.57%
Today the one US bank of the big 4 that had to cut its dividend – Wells Fargo, carries a 7.9% leverage ratio.
USA 3, Rest of developed world: disqualified for hitting linesman with a tennis ball to the throat.
4)Governance / Return of Capital
Governance and capital go together because once a government or central bank tries to push its banking system around, that bank has the option of punishing shareholders, or managing around restrictions. JP Morgan is notable for navigating crises intact and returning tens of billions in capital on the other side. Even Wells Fargo, punished in part by an excel error in the Federal Reserve model, still pays a 1.7% dividend yield. Conversely the major Europeans are currently not even allowed to pay a dividend. They have only themselves to thank, for running ridiculously low core capital ratios. US bank share buybacks could reach $100 billion in 2021. Buybacks are not even a consideration in the other markets.
USA 4, Rest of Developed world – PAC 12 football (self disqualification).
5) Government meddling:
More and more ECB members have begun to understand that negative rates work in theory but not in practice. Like covid lockdown advocates, they persist based on theory instead of the reality around them. The Federal Reserve, even resident harlequin Kashkari, has repeatedly and wisely resisted this policy “unanimously.” Negative rates disincentivize lending, zombify borrowers and many believe reduce velocity of money.
Stay tuned for a Biden administration, but US banks outperformed Europe massively during Obama despite 0% rates and a tarnished reputation that has since been partially repaired.
USA 5, Uninvestables: 0
The US has a major debt overhang and low rates will be with us for years but our banking system is far ahead of the overseas banks in all important cultural aspects.
Branch closures are generally boring to investors because they are incremental – the stock of Northwest’s parent rose about 3% post event and the cost saves should run $13 million on a bank earning a bit over $100 million annually. They are boring but they are essential, because low cost wins over time if doing the commodity banking that so many banks do. It’s also a waste of money to run a $30-$40 million deposit branch when wholesale funding may be 25bp or less for the next 2-3 years. Finally, branch traffic tends to decline 1-3%+ each year (per FMSI and S&P) with that number accelerating dramatically now that Covid lockdowns forced millions to figure out how to work online technology.
The issue is some banks can close branches more easily and profitably than others. Beyond standard roadblocks such as lease terms, location and local demographics, the biggest variable is technology. While banks like PNC spend heavily to develop solutions in house, most smaller banks are dependent on the core processor oligopoly. (FIS, Jack Henry and Fiserv). These processors know they have the banks under contract and a 30% EBITDA margin to uphold so with this unfortunate incentive set, banks are notoriously frustrated with their responsiveness to technology initiatives. This podcast: https://podcasts.apple.com/us/podcast/core-providers-open-banking-apis-what-should-you-know/id1077822235?i=1000445744820 provides more detail.
So how to get to 40% efficiency with a legacy network? Increasingly, providers will move to startup cloud-based processors or other means to get to “open API”, meaning the ability to easily bolt on software solutions to offset the “inconvenience” of a closed branch.
For example, Live Oak Bank likes to point out that they ran 1/3 more PPP loans than they would have otherwise because of the flexibility of a cloud platform. Live Oak only has one branch, but increasingly other banks are making the same conclusion. This is why we tend to focus on technology right behind credit and capital management when speaking to banks to determine long-term return potential.
Perhaps this is also why Live Oak, part owner of one such cloud processor, has outperformed its peer group by 50% this year:
One topic that typically comes up in recent bank management discussions is capital plans. A proactive and well thought out capital plan is among the best determinants of “management quality.”
Some banks have been increasing dividends. Some just hope to maintain dividends; some are issuing subordinated debt and some are repurchasing common stock.
Very few are issuing common stock, because common equity levels in US banks are the highest in the developed world, and should remain so after 3Q and 4Q increases in charge-offs at hospitality and retail etc.
But how do management teams optimize their capital in a changing backdrop? Many are lost. They need a helping hand, and here it is: if you are not issuing subordinated debt or preferred at 4-6% to get regulatory support, and using it to buy in stock at 9-15% earnings yield on forward estimates, you need to revisit your math.
It is very likely your bank has enough common equity. Regulators approve of sub debt as capital too, so use the system to your advantage. Sell the 5% capital and buy the 10% capital. Regulators will know their bases are covered assuming your risk exposure is at or better than industry average.
One other note – if you want to pay a 3-5%+ dividend, trade well under tangible book, and are not repurchasing, you are sending a message that the market has it right, you are worth under tangible book, and the company should, by extension, be liquidated. That’s what trading under tangible book value means – you are worth more being wound down than you are as a going concern. If you disagree on liquidation, you can buy the stock in, grow your tangible book per share, and engender shareholder goodwill assuming credit metrics are in check.