Why own bank stocks now?
A decade removed from crisis, bank stocks are only now regaining the confidence of investors. A series of satisfactory regulatory stress tests are evidence that most necessary repairs have been made, and many banks are now rewarding shareholders with increased dividends and buybacks.
Yet a number of banks are trading at a discount to historical valuation ranges (such as book value), which appears to be at odds with the restored health of their balance sheets, improving profitability and satisfactory growth prospects. Many investors are concerned about the current market environment despite (or perhaps because of) 2017’s surprising performance. While bank stocks have performed well of late, we believe many still offer a favorable combination of risk and reward. Bank valuations should respond favorably should one or more of the following tailwinds gain strength:
- The new administration has signaled that the push for financial regulation has run its course. Easing capital requirements should pave the way for larger dividends, increased share buybacks and faster balance sheet growth, particularly at the large cap banks that are sitting on an estimated $120 billion of excess capital. Banks may also get the green light to edge back into some of their former investment activities.
- A lower corporate tax rate is another potential boost as most banks are presently paying close to the full corporate rate. However, this benefit might be tempered by other tax code changes. A reduction in interest deductibility could be expected to dampen demand for loans, for example.
- Banks and bank stocks are generally thought to be key beneficiaries of rising interest rates. Those zero-interest checking account balances are worth far more to banks when they are put to use funding loans with higher yields. A rate hike in December is widely expected – what follows in 2018 is less clear.
- Bank profits are leveraged to economic cycles. An accelerating economy would signal stronger demand for loans, more transactions on which to earn fees, and healthier borrowers.
On the basics of banking:
Most of us can explain how a manufacturing company earns money. It’s pretty much how many widgets are sold, times the price, less the costs of production. The business of banking is different, and so is bank accounting.
Banking is balance sheet-driven. The asset side of the balance sheet is comprised almost entirely of loans while the liability side is mostly deposits, along with a considerably lesser amount of shareholders’ equity. Banks earn money by charging more interest on loans than they pay on deposits. Beyond earning this spread, banks offer services that generate fees while incurring expenses, mostly in the form of salaries, and ultimately pay over a share of their profits to the tax collector.
Credit losses are a natural part of banking. The cardinal rules are to lend prudently, collect effectively, and to price sufficiently to cover those loans that prove uncollectable.
Banks play an essential intermediary role – maintaining confidence in banks’ individual and collective safety and soundness is paramount. Banks are thus given special protection through deposit insurance and stand-by funding arrangements. The price for these benefits comes in the form of rules and oversight.
The financial crisis led regulators to require more capital and greater liquidity (the ability to easily convert assets to cash). The result has been a safer banking sector, but one with lower profitability.
On the valuation of bank stocks:
A different business model necessitates different valuation approaches. We believe in considering multiple valuation methodologies, because each has its strengths and weaknesses. We gain greater confidence when several approaches are telling us a stock is under- or over-valued. In the case of banks, we have two preferred tools.
One is an adaptation of the multi-stage discounted cash flow (DCF) exercise that underpins much of our general analysis. We like a DCF approach because it does not merely capture a snapshot in time but rather holistically considers a company’s capital structure and cost of capital, expectations regarding future returns, and its tax burden. DCF leads us to a price target and suggests a range of outcomes if our central assumptions play out differently.
For examining relative value among a group of banks, we like to assess the relationship between profitability and price by running a regression between return on equity ratios and price-to-book ratios. The idea is that those institutions below the line are trading too cheaply relative to the returns being generated while those above are expensive.
As always, our valuation work sets the stage for us to ask the critical questions, “What is the market missing?” and “What catalysts are going to change the market’s view?” (Each bank merits a specific response – we hold a favorable view of overall sector dynamics, as mentioned previously.)
A Teaching Moment
Rock Point Advisors is assisting with the second annual Chartered Financial Analyst (CFA) Institute Research Challenge, a global competition that tests equity research and valuation, investment report writing, and presentation skills. Teams from schools such as UVM, St. Michaels, Champlain College and Northern Vermont University are among the estimated 4,000 college students who are participating in the event.
The local students are researching Community Bank System, an upstate NY-based regional bank that recently acquired Merchants Bank of South Burlington, the last remaining statewide Vermont bank.
Todd Wulfson, who is on the board of the Vermont CFA chapter, recently arranged for our Director of Research, Jean Sievert, to conduct a two-hour tutorial, drawing on her 30+ years of experience researching financial companies. Mike Huffman was on hand at the event to help field the students’ questions. Research analyst Jackson Bargiello is once again serving as an industry mentor for the team from his alma mater, UVM.