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.
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 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%.
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.
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.
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.
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.