Insights

Many financials have ripped higher in October vs a flat market, off the back of 90% of reporting companies beating estimates; most of them by wide margins. However financials also rallied in June before giving back almost all their gains, and post election waters may be choppy.

Over the coming months, the rally will hold for two reasons – operating leverage and sustainable money flows. In specific, we just saw the beginnings of operating improvements, and can now expect some level of multiple expansion from accompanying money flows.

How rallies hold: We can track how stocks move over time by combining

1) cash flow / earnings growth with

2) multiple expansion / compression on that earnings and finally

3) Share dilution

To use a popular example, below is Apple over the past year. Almost all of the stock’s upside has been from holders willing to accept a lower future return from a higher multiple:

Banks show the opposite story, often generating earnings growth but suffering multiple contraction. Ameris Bancorp (ABCB) is a typical example:

So, where would the cash flow and multiple expansion come from to support recent bank gains?

Part I: The earnings have returned… Most smaller banks are earning what they earned a year ago (below). Some of this is from mortgage, but banks have other levers to pull, including investing current substantial excess cash into mergers, buybacks, and loans to bolster earnings. See arrows below pointing to happier times in 2019, vs recently reported 3Q20 earnings:

…However, the market has given the sector no multiple expansion as yet – most small banks have few estimates, so when using dividends and price / tangible book, the median valuation for small banks remains near March fall-out zone levels, back when we were tracking northern Italy hospitalizations.

Part II: Multiple expansion comes from money flows, which are on deck: Money flows will change in coming months and quarters, for a few reasons:

1. Money will flow in from the sector itself This includes buybacks and mergers. 45 banks reinstated share repurchases in the last quarter or so. Another approximately 100 – including the largest banks – should join them in the coming 3 months. On the merger front, industry consensus is the spring is coiled, with reversion to norm dependent on a credit backdrop. Third quarter results, including zero and negative provisions from some lenders, suggest the spring can now release.

2. Money returning from “hideouts”

Between mid March and Third Quarter earnings, no pension fund, endowment or other large allocator lost his or her job by being underweight financials. Those allocators now have a decision to make given recent results. Continue with Nasdaq 100 at 2-3% earnings yield or get 3x that with banks? Own treasuries paying 80bp or get 3% bank dividends on 30% payout?

How much risk is involved? One bank raised defensive common equity between March and today. Only a handful among 800 public banks even cut dividends. This stability has value over time.

You can buy a “cyclical” like Great Southern Bank (GSBC) at 9x rising estimates, 3.3% yield, repurchasing shares, reporting steady results through 2020, or you can buy the market at 21x and half the yield, getting a share of Apple’s 60% multiple expansion off the back of 12% cash flow growth. Further growth is not guaranteed – picking on AAPL, the company accepts ~$10bn a year from Google to protect a search monopoly while charging app store fees that may not hold up well in a blue wave. Can you name a recent Apple product innovation?

The money will flow to where it’s treated best, and banks have a good argument.

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

1. Margins:

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

2) Expenses:

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

3) Capitalization:

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.

Centerstate Bank’s correspondent group recently published a recommendation that banks who wanted to confirm their independence should be running 50% efficiency ratios with a goal to reach 40% in the years to come, in part by cutting branches: https://csbcorrespondent.com/blog/5-things-your-bank-should-be-doing-now-not-get-acquired-later.

Taking this to heart, and joining the list of banks closing in aggregate 50-100 branches a month across the US, Northwest Bank in Pennsylvania last Friday announced a reduction of 20% (!) of its branch network: https://finance.yahoo.com/news/northwest-bancshares-inc-announces-branch-200100961.html. As you can see below they are joining a party that’s been going on for some time:

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: