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Regional bank stocks have had an epic run over the past eight months. From September until May, the SPDR S&P Regional Banking ETF (“KRE”) returned 101%. After such a large move, we believe regional banks have shifted from extremely undervalued to fairly valued. However, we think there is still opportunity in small banks due to their low valuations.
Here is a table showing the median Price-to-Tangible Book Value (“P/TBV”) of banks grouped by market capitalization. As you can see, the median P/TBV declines as the market capitalization declines.
Not only are the median values higher for larger banks, but we can see the range of values is wider and higher.
The current distribution of bank valuations has important implications for bank mergers and acquisitions. With larger banks trading for higher valuations, they can use their stocks as currency in mergers and acquisitions, and the “merger math” will be attractive to investors. Here is a table comparing the distribution of bank valuations in 2021 to valuations in 2018.
As shown in the table, in 2018, valuations were more consistent across different-sized banks. The similar valuations made mergers more difficult because the financial benefits of mergers were less compelling.
We see two main reasons for the current distribution of bank stock valuations. In recent months, the stock market has been driven by the pandemic reopening trade. Ever since Pfizer announced positive news about their COVID-19 vaccine in November, stocks of companies that would benefit from the end of the pandemic, such as banks, have rallied. We believe non-traditional bank investors have moved into banks by purchasing exchange-traded funds and stocks of the largest, most liquid banks. This has led to the largest banks having higher valuations.
A likely reason for the lower valuation of banks with market capitalizations below $250 million is the annual reconstitution of the Russell indices. Each June, the Russell indices are remade as stocks are shuffled in and out of the Russell 1000 and Russell 2000. This year is unusual because of the strong stock market rally and because of the large number of initial public offerings, so the minimum market capitalization for companies in the Russell 2000 is close to $250 million compared to $90 million in 2020. This means about 79 small-cap banks are leaving the Russell 2000 index on June 25th. We think this is widely known by small bank investors, so small-cap bank stocks are trading at lower valuations.
Currently, we believe the best opportunity in bank stocks is among small banks because they trade at lower valuations.