Opportunity in Growth Banks

Not all research is for securities currently held. Any securities for which research is provided herein may be reduced, completely closed out, or not purchased at all without notice of any kind.

October 21, 2019

Regional bank stocks have had a challenging period over the last 16 months.  Since June 2018, the S&P Regional Banks Select Industry Index declined by 18% and trailed the S&P 500 Index by 27%.

During this time, the median bank in this index increased earnings by 10%. Banks are expected to continue to grow earnings going forward.  Using Regions Financial (or “RF”) as an example of a generic regional bank, RF’s forward price-to-earnings (“P/E”) multiple has declined from 13.6x to 9.5x.  On a price-to-tangible book (“P/TB”) basis, RF’s multiple has declined from 2.1x to 1.4x.  This type of decline in valuation is consistent across RF’s peers.

We believe there are three main drivers for the poor performance of regional banks:

1) Change in the outlook for future interest rates,

2) Negative sentiment regarding the economy leading to credit risk fears, and

3) Poor relative strength in a stock market driven increasingly by momentum.

While we see the merits of each of these issues, we also believe there are several positive factors that offset these negatives such as continued easing of regulatory environment, strong capital discipline within the industry, and a prolonged economic cycle due to the lack of imbalances in the banking industry.  Also, we believe market sentiment around regional bank stocks will change when the Fed signals it is done cutting rates.

We like sifting through industries that have gone through tough periods in the stock market, especially ones with which we are familiar.  We like to look at companies that had the worst stock price performance to see if there are fundamental reasons for the declines or whether the stock prices are down in sympathy with the rest of the group.

In this new era of the stock market being driven by exchange-traded funds (or “ETFs”) and momentum, we think stocks with individually good investment cases get driven to levels where they are mispriced when they are included in a sector or industry that is out-of-favor with stock market investors.  One area that we currently think is mispriced is a group of banks that had high levels of organic growth over the past 5 to 10 years.  We call this group of banks “Growth Banks”.

The 14 Growth Banks grouped together share some similar characteristics.  They have demonstrated the ability to grow organically.  They have all grown deposits per share by at least 9% over the past 5 years.  Their stock market valuations have declined dramatically since June 2018.  The banks in this group trade at 25% to 50% discount to their historical median valuations.  These banks range in market capitalization value (or “market cap(s)”) between $1 billion and $10 billion.  We prefer smaller banks like the members of this group because they can grow faster.

How to Identify Growth Banks

We believe the most valuable banks are the ones with high profitability that can generate loan growth and deposit growth organically.  We believe the banking industry can grow loans and deposits at a rate equal to nominal GDP.  So, if economic growth averages 2.0% and inflation is 2.0%, then nominal GDP should average around 4.0%.  If the banking industry matches this, then 4.0% is our baseline for an average bank.  Since banks generate returns on equity (“ROE”) between 10% and 20%, they only need to retain a portion of their earnings to acheive average growth.  In the last few years, banks have been disciplined in returning their excess capital to shareholders through dividends and share repurchases.  However, we believe a better use of capital would be to grow their core businesses faster.  We try to identify banks that have some specialty that allows them to achieve above average industry growth through loan and deposit generation.

We identify Growth Banks by looking at the increase in the loans per share and deposits per share over an extended period of time.  By looking at these metrics on a per share basis, we are adjusting for capital actions by banks.  We are not phased by banks who grow loans and deposits by issuing shares to buy other banks.  On the other hand, if a bank is able to buy other banks at attractive prices, their per share metrics may improve.  Looking at these metrics on a per share basis also gives banks who repurchase shares regularly a benefit in their numbers.

Over the last five years, of banks with market caps above $300 million, the median bank has grown deposits per share at 6.2% per year.  If we restrict this bank universe to banks with market caps above $10 billion, the median is 7.2% per year.  We suspect most readers are surprised by these growth rates.  We are too especially when you consider the extremely high multiples investors are paying consumer packaged good (or “CPG”) companies with low single digit growth rates.  Put simply, this group of banks grow at 6% and have 10x P/Es, but CPG companies grow 2% and trade at 25x P/Es.

Growth Banks are less dependent on near-term net interest margins

Growth banks are less dependent on changes in net interest margins for earnings growth over a 3-5 year timeframe than slow growing banks.  But, this is the opposite of what we have seen reflected in stock prices over the last 14 months.  We have seen the growth banks respond more negatively to the outlook for net interest margin compression than their slower growing peers.  Since early June 2018, the median stock price of this group of 14 Growth Banks has declined 28.8%, but the SPDR S&P Regional Banking ETF has only declined 19.8%.

Aren’t the Growth Banks Asset Sensitive?

We believe the main reason this group of Growth Banks has underperformed is because they tend to be asset sensitive.  They are asset sensitive because they grow their commercial and industrial (C&I) loan portolios and these loans tend to carry floating rates.  In addition, a few of these banks have a history of growing their more valuable non-interest bearing deposits.  Although non-interest bearing deposits are more valuable, banks with large amounts of non-interest bearing deposits are naturally more asset sensitive.

With the Growth Banks down because of interest rates, we have to ask whether we can own them despite declining rates?  Or, do we need to wait until we think interest rates have bottomed?  At what point do they get too inexpensive in the face of declining rates?  We may be at the point where the Fed is done cutting rates with the expected October rate cut and these Growth Banks may be too inexpensive at the same time.

Is Credit the Problem for Growth Banks? 

In addition to asset sensitivity, we believe some investors are avoiding these Growth Banks because they perceive these banks have higher than average credit risk.  The short story goes something like this, “We’ve had 10 years of economic expansion, so a downturn is around the corner.  The banks who are most likely to get hurt in the downturn are the ones who grew the fastest into the downturn and have the least seasoned loan portfolio.”

There’s a lot to unpack in this short thesis;

1) We are on the verge of an economic downturn,

2) Banks will be the ones who suffer the most during said downturn, and

3) Loan growth comes from the banks who have the weakest underwriting.

We are sympathetic to this argument.  We think loan portfolios are difficult to analyze as outside investors.  Also, credit issues are asymmetric against shareholders.  Our approach to combat this issue is to go slowly in entering new positions and to avoid the banks with the most obvious risks in their loan portfolios such as concentrations of construction and land loans.  We meet with management teams to gauge their appetite for credit risk.  We also study their history of credit results.  So, we view credit as the largest area of study for these Growth Banks.

Case Study: Western Alliance Bank

Western Alliance Bank (or “WAL”) is a fast-growing regional bank headquartered in Phoenix.  The bank also has significant presence in Las Vegas, San Diego, and San Jose.  WAL has grown tangible book value (“TBV”) at an annual rate of 22.8% since 2013.  The bank is able to grow TBV so quickly because it earns a higher than average net interest margin.  The bank also grows loans and deposits at a fast pace.

1. Fast-Growing Regional Bank
   1. National lending businesses – Western Alliance has developed several national lending businesses. These are Homeowners Associations, Mortgage Banking Warehouse Lines, Resort Finance, Public & Non-Profit Finance, and Hotel Franchise lending.
   2. Branch-light footprint – Western Alliance is built as a modern regional bank with only 47 branches. The average Western Alliance branch has $475 million in deposits.  This compares favorably to the average bank branch for the industry at just over $100 million.  We believe the banking industry is trending towards Western Alliance’s branch model.
   3. Technology banking – Similar to SVB Financial, which we wrote about in our April 2019 letter, Western Alliance has a thriving technology banking business. Through their 2015 acqusition of Bridge Capital, Western Alliance attracts deposits from start-up companies in the SF Bay Area.  Western Alliance also provides capital call loans to venture capital and private equity firms.  Capital call loans allow these firms to manage the timing of calling capital from their investors.  There have been few losses in this business.
2. Best-in-Class Operating Metrics – Western Alliance has best in class operating metrics. The following comparisons are with peer mid-cap banks headquartered in the western states.  Return on assets (“ROA”) of 2.08% compared to peers at 1.34%, ROE of 20.4% compared to peers of 14.8%, efficiency ratio of 42.9% compared to peers of 55.6%, and net interest margin of 4.66% compared to peers of 4.15%.  Other metrics are at peer levels such as loan-to-deposit ratio of 90% compared to peers at 92%, tangible common equity to tangible assets of 10.2% compared to peers at 10.3%, and non-performing assets at 0.53% compared to peers at 0.52%.
3. Low Valuation – Western Alliance’s current valuation is 9.8x 2019 earnings per share (“EPS”) and 9.3x 2020 EPS. This is inexpensive compared to peers and compared to Western Alliance’s own history.  Peers currently trade at 13.5x 2019 EPS and 12.8x 2020 EPS.  Between 2012 and 2018, Western Alliance traded in a range of 12x and 20x forward EPS.  We think Western Alliance should trade at valuations comparable to the best banks, which is 15x in the current environment and we believe will be higher when general bank valuations recover.
4. Strong Deposit Franchise – Western Alliance has a strong deposit franchise with 40% non-interest bearing deposits. Despite rapid loan growth, WAL has been able to keep its loan-to-deposit ratio below 90%.  Western Alliance is generating deposits through some of its niche businesses like Homeowners Association (or “HOA”) banking.
5. Diversified Loan Portfolio – Western Alliance has a diversified loan portfolio with 45% in commercial and industrial lending, 35% in commercial real estate, 11% in construction and land, and 9% in residential mortgage. The loan portfolio is also diversified geographically with 50% in National Business Lines, 20% in Arizona, 20% in California, and 10% in Nevada.
6. Low Expense Base – Western Alliance has a low efficiency ratio of 42.9%. Peers operate with a median 56% efficiency ratio.  Western Alliance has a low efficiency ratio due to its branch-light footprint, it higher than average loan rates, and a pay-for-perfomance culture.  In banking, the management teams and the investment community use efficiency ratio instead of operating margins.  The efficiency ratio is the inverse of the operating margin.
7. Potential Geographic Expansion – WAL has expanded geographically over the past ten years and we expect them to selectively expand their footprint in the coming year. When WAL expands geographically, they usually buy a smaller bank in the expansion city and use it as a platform to jump-start their growth.  They successfully executed this strategy with the Bridge Capital acquisition in the SF Bay Area in 2015 and Centiennial Bank in Orange County in 2013.  We would expect Western Alliance to expand its footprint to Seattle, Denver, and Dallas over the next 5 to 10 years.
8. Comfortable Capital Level – Western Alliance operates with a tangible common equity to tangible asset ratio of 10.2%. This is higher than its larger peers and gives the bank some cushion.  Western Alliance also generates capital at a high rate, so it is less constrained when considering growth opportunities.  Because the stock has underperformed over the last 18 months, Western Alliance has used some excess capital to repurchase shares.
9. Regional Bank Valuations – Regional bank valuations are attractive generally. Regional banks are trading at a larger than normal discount to the broader stock market.  Usually regional banks trade at 80% of the broad stock market’s price-to-earnings ratio, but banks currently trade at 55% of the broader market.  As the regional bank sector returns to a more historical relationship with the broader market valuation, we believe Western Alliance will regain its premium valuation.

Concerns: 

1. Credit was Weak in GFC – During the Great Financial Crisis (or “GFC”), Western Alliance struggled with credit issues. The bank was able to manage its way through the issues.  Heading into the GFC, Western Alliance had 70% of its loan portfolio concentrated in Nevada.   Some investors will wait to own Western Alliance until it successfully navigates a recession.
2. Asset Sensitivity – Western Alliance is asset sensitive, so it has benefited from rising interest rates. With interest rates declining and expectations for further declines, Western Alliance will see a decline in its net interest margin of about 5 bps for every 25 bps cut in the Fed Funds rate.
3. Hotel Franchise Portfolio – Western Alliance has a $1.2 billion loan portfolio to franchisees of major hotel brands. The average yield on this portfolio is 12%, they are taking some risk to earn this type of yield.  This is an additional risk factor for the bank.

We own a position in Western Alliance Bancorporation.  We think bank’s valuation will recover when the interest rate cycle turns.  In the mean time, the bank is posting double-digit organic loan and deposit growth.

We will continue to work on additional Growth Bank ideas.  We think the recent underperformance of this group of banks is unwarranted and more a reflection of declining interest rates than the business prospects of these fast growing banking organizations.

Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.