Insights

Twitter can be time sink or it can provide valuable insight on what the market is thinking. Some insight came recently when a well-followed newsletter writer (Long Short Value @lsvalue) posted that “Traditional Banks are a terminal short – prove me wrong,” followed by a list of “headwinds,” which included:

• Fintech competition
• Central Bank digital currencies
• Credit card alternatives, like buy-now-pay-later
• Low interest rates

First, let’s cheat over to the answer key. A big subset of the bank sector – large commoditized banks – are unquestionably long-term losers.

To wit, BBVA paid $13 billion to gather together assets in California and Texas over a decade ago, made little effort in marketing, technology, or strategy, and sold it all recently to PNC for $9 billion. HSBC, another bad operator, is planning a similar exit. CIT, which never bothered to compete with much other than price, gave up and sold for less than 50% of net assets. These lenders are still widespread, from Wells Fargo to Regions to KeyBanc. They are typically quick to jump into multi-family construction 5 years into a trend while firing the entire energy department with crude at its lows. Where is the world headed? They have no idea.

Before we look at the winners – the ones investing in technology, seeking out the best customers in the area, and building fee income streams, let’s look at the shortseller’s points in detail:

• Fintechs like Square, Stripe, and Revolut will take small business lending from banks.

Not really, but they would if the fintechs had any interest in banking. Square hasn’t gotten to a 200x multiple on its erratic cash flows by tying itself to a big balance sheet, and CEO Jack Dorsey doesn’t want to be regulated by the capricious FDIC . These fintechs are using bank or capital markets’ balance sheets and introducing customers onto those balance sheets. There is value to this outsourced customer acquisition, and banks or capital markets are paying an implied fee. It remains to be seen how large this fee will ultimately be, given there is no monopoly on using digital ads or platforms to originate loans. You could compare it to the Netflix vs Disney distribution vs content trade-off. In this case smart banks know they want to expand into distribution, but fintech is not sure it wants to expand into banking.

Further, these fintech customers tend to come from borrowers banks pass over for a reason, like restaurants or small shops. It’s great that these customers are getting capital beyond their credit card. Wholesale banks like Regions or Goldman, can do better buying these loans in place of shared national credits or bonds. The rest of the banks will stick to real estate borrowers and complex businesses.

• Central Bank Digital Currencies will take savings from banks.

Digital currencies are coming. Whether they become “money under a mattress” is a separate question. In theory, the Federal Reserve can set up a website, and let everyone track digital dollars just as if they were tracking their Bitcoin on Coinbase. This is an efficient way to get money in the hands of the poor, many of whom don’t qualify for a checking account. It’s also deflationary, because it takes money out of loan circulation, which would be strike one. It’s problematic at scale, because it puts a government bureau or its representatives in charge of running a business. Selling treasuries is one thing, administering another social-security style program is another, a possible strike two. Last, what’s the right deposit rate? Why is the Fed competing with banks again? Why can’t banks simple custody digital currency themselves, so the customer earns something. They likely could and would. Strike three for this argument. People want their bitcoin to earn interest, and they will want digital currencies to do the same. Bank investors will be keen to figure out which management teams are embracing this opportunity.

To that end, banks are already helping to do the Fed’s work. It’s not a surprise then that Citi CEO Corbat just shared that Citi has “been working with governments around the world in terms of the creation and commercialization” of digital currencies.

• Credit cards are being disintermediated from buy-now-pay-later among others.

This is the same situation as fintech above, but generally speaking the 7 major banks involved in cards are used to competition in this segment and if anything would advise caution given the narrow band of profitability in the segment. Further, these banks are not fools and while they appreciate the card business, they can see they receive an 8x multiple for it, vs a 20x+ multiple for fee streams like payments. The point being, don’t hold your breath for silicon valley to flood money into ways to lend money at high rates.

• Low Interest Rates

Guessing rates is a fool’s game but I’d suggest a glance at the yield curve, which is the steepest it has been since 2017. This means the market is not worried about low rates. The difference in yield between 10 year government bonds and 2 year is shown below. A rising line means higher rates are expected in future.

Where does that leave us? It means a business in place since Mesopotamia is not going to disintegrate. Someone is going to be lending at nice spreads; the question is what horse to bet on? Who are the winners? The answer is:

• Efficient, discriminating lenders. Closing 20% of branches is the new trend in banking, and not a minute too soon. Further, maligned, but highly efficient banks like Bank OZK (OZK), and Bank7 (BSVN) have sailed through the pandemic, compounding book value 10-20% vs. last year. Branch-light business lenders from little Victory Bank (VTYB) to Servisfirst (SFBS) also have flexible models. Again, banking is asset management, and bankers willing to thoughtfully underwrite non-commodity loans will do well for years to come.

• Banks with a differentiated strategy. Silvergate Bank (SI) isn’t particularly worried about digital currencies – they are part of the backbone helping customers transition between crypto and dollars. It looks like the market has noticed:

The best bankers understand technology is essential for profitable growth. The ones that don’t, get consolidated. Look for major market share changes, and mergers, around this fact as slower banks are crowded out in payments,

As for banks doing what they’ve always done, and lending at skinny spreads, to quote Alec Baldwin in Glengarry Glen Ross, “a loser is a loser.” Get that multi-family loan from Wells or whoever for 3.25% fixed, or that 2.5% auto loan at Santander while you can – the bank may be downsizing the department in order to grow energy lending within a few years…

A rundown of banks that have earned holiday greetings

2020 has been a tricky year for bank managements. Managers are supposed to look out for owners, customers and employees, and while the best ones strike a balance, most can’t quite get there, and it’s the markets job to call them out of that. Today’s message helps us determine who gets the gift of cheap capital.

First, a reminder – we invest to get a return, but investors also make capital expensive for bad managements & businesses but cheap for those that are good. For example it took 5+ years since the first oil crash, but eventually the investment community has driven frackers out of business. In Europe, policymakers have ruined the banking sector and taxpayers in Spain and Italy may soon be forced to buy equity to keep this critical sector alive. This process of shunning bad concepts is great for prosperity long-term and differentiates us from China, Cuba etc.

In this vein, let’s look at a few bank management teams who respect investor capital and deserve thanks this holiday season, vs. a few burning the turkey.

Giving thanks for some banks that gift shareholders this holiday season:

Wayne Savings (WAYN): In recent years Wayne withstood not one but two proxy fights with Stilwell Value, known as a tough but fair bank activist firm. After the second, management proposed a deal – make peace by ramping ROE higher. Stilwell has relented and subsequently received a cornucopia of shareholder goodness:

For those new to bank language, ROTCE is return on tangible equity excluding preferred, and efficiency ratio is like the opposite of the operating margin. In other words, the lower the efficiency, the less fat on the bone. Some banks run efficiency as low as 30%. Below-average performers consistently run over 60%

Wayne CEO VanSickle, who joined in 2017, has created a sustainable high performing bank – controlling expenses, repurchasing shares, and growing loans. His competence has allowed the bank to maintain its independence, beaten his index by 40% since arrival, and saved numerous jobs. Spiked egg nog party – Everybody Wins.

Pacific Financial (PFLC): Common Sense Pudding from CEO Portmann. If you trade 75% of tangible, credit is under control and you are posting 10-15% ROTCEs, consider a share repurchase. It’s likely a better use of capital than supporting that 3.75% fixed shared credit in the latest me-too multi-family project. Her actions will be remembered in 2021.

Centric Financial (CFCX): Same as above. To be clear, there are 50+ other banks in this category but CFCX and PFLC come to mind as banks with a growth plan also competing for capital.

All the share tender banks: HTH, AMTB, MVLF

Special recognition for the public banks running sub 35% efficiency: Servisfirst (SFBS, has outperformed its benchmark by 34% the past year), Merchants (MBIN, outperformed by 70%) Parke (PKBK, underperformed by 8% – it’s in New Jersey), and the popular Hingham (HIFS), which has outperformed the banks by 37% the past year and by 320% the past decade. You can’t reach 35% without a cultural recognition for owners.

Southfirst (SZBI) finally recognized they were too small to scale, so sold for a 100% premium. Merry Christmas!

Banks where we wonder if shareholders are the turkeys:

First, the names below are not necessarily “uninvestable” – in fact one of them may soon be an excellent investment and has rallied 40% in the last 2 months. However, recent performance or actions raises the question, “are employees ahead of shareholders?”

We have to start with the “100% efficiency club”, where more than 100% of revenue leaves via expenses. 14 of 770 public banks claim membership. Most are stuck due to small size but two are not – $670 million Carver (CARV) and $430 million Golden State (GSBX). Digging into the issues at Carver, a “special situation,” is itself a poor risk/reward in this forum and we will leave it that it is part of the 100% efficiency club.

Golden State has issues with its regulators and it’s not clear how quickly they can address them and certainly not clear one should pay 79% of tangible to see where things go.

BOL Bancshares (BOLB), Peoples of Biloxi (PFBX) and Glen Burnie (GLBZ) have an assigned seat on this list if judging by ROE or shareholder return over time. With that said, let’s see what unfolds at Peoples in the weeks ahead.

First United (FUNC): This is well documented by Driver Management, which is suing directors under the premise of rigging their own election. First United has not grown assets in a decade, in part due to restricted access to capital markets.

Republic Bank of Arizona (RBAZ) is using a lawyer to send letters to a major shareholder. Whenever a bank trades under tangible book, as Republic does, the market is judging the bank guilty of being worth less than going concern value until proven innocent. The shareholder-friendly solution is to fix quickly or merge.

Customers (CUBI) claims it is looking at launching a “massive” buyback soon, because it trades at 67% of tangible. I’m listening, however part of the discount may stem from a senior manager taking home ~$20 million in compensation per S&P over the past 5 years despite the bank not breaking 1% ROA.

Investors (ISBC): Another sub 1% ROA bank where the risk officer, as one example, receives $2mm in total annual compensation. The dollar doesn’t seem to go as far in the senior management labor pool as it used to. Investors runs a 53% efficiency over the past year. One wonders if it could have been closer to 40%.

Have a Happy Thanksgiving, and take care of your giving!

Cryto – the marketing construct that meets a need. Perhaps no theme is as popular among the many macro investor subscription services available than hating fiat money. What’s not to hate? Inflation takes 1-2% away annually according to fuzzy government statistics, or 5-8% if tracking the amount of liquidity growing each year in the system through M2. This seems like more than enough to handle population growth and maybe is instead a way to quietly keep 401K holders content while gradually stealing the value of their savings.

The preferred way to address this seems to be gold for Gen X and older, and crypto for anyone younger.

Also, if we hate money then perhaps we hate companies that are composed of money, which are the banks?

The beauty of banks is that there are smart banks and dumb banks. In its hurry to dislike banks, the macro newsletters are thinking of banks such as Bank of America and Wells Fargo. We can all agree that Wells in its current form is closer to a “dumb bank” and has fallen 50% in 2020 as the market came to grips with this.

Colarion tends to focus its efforts away from these stale ponds and thinks of the sector in the context of Servisfirst, Esquire Financial, Live Oak and others like them.

The folks at MVB Financial in West Virginia are an example of a “smart” bank. CEO Mazza was interviewed for a recent fintech survey and shared that banks are “at risk of becoming taxis in an Uber world” (https://seekingalpha.com/article/4358901-what-gen-z-thinks-banks). He has launched a business to gather deposits and related fees from each Draftkings and Kraken, among other crypto and fintech ventures, and the table below shows the company’s growth in gambling deposits. MVB’s crypto strategy, among other ventures, is an example why the bank is thoughtful about where the world is headed.

Who else is like MVB on crypto?

Silvergate Bank (SI) gets it. They have created an “exchange” for institutional investors to dollar settle crypto transactions, and the market has noticed:

A few others including BankProv (PVBC) and Metropolitan (MCB) are active in crypto as well.

One last company is worth mentioning:

Who knows, we may even see bitcoin on some banks’ balance sheets in the years ahead?

For those of us whose job is to find the smart banks, the understanding and adoption of crypto is one more tool in that kit…

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.