Weekend thoughts: banks and aggression in a panic
I’ve been spending a lot of times on banks recently. If you’ve talked to me recently, it’s almost invariable banks have come up in the discussion. And even if you haven’t talked to me, I did a long post on the banks a few weeks ago, as well as a podcast right when the banks started blowing up, so it’s not hard to see where my focus is at!
I doubt that focus changes anytime soon; I’m hoping to do several more posts and podcasts on the banking sector in the near future.
Why that focus? There are lots of good banks trading at or below tangible book value right now, and historically that’s been a very good time to buy banks. I don’t think it’s crazy to think a good bank can do low teens ROEs over a full cycle; I also don’t think it’s crazy to think a bank doing a low teens ROE should trade for ~1.5x book (assuming low teens ROE means 13%, 1.5x book would equate to <12x P/E). If you assume it takes five years to get to that 1.5x book value and the bank pays out half their earnings as dividends (a lower dividend rate actually improves returns here as it allows for more book value compound, but most banks do something like 50% of earnings as dividends), buying a bank at tangible book today would get you a five year IRR of >21%… and that math would get even better if the bank bought back stock along the way (or if the multiple proved conservative!). And, even if the stock doesn’t rerate to 1.5x book, the key thing to get right here is really the ROE; if the bank can do low teens ROE, then your IRR will match that ROE even if the bank always trades around tangible book.
I’m not alone in thinking there could be opportunity in banks right now; I’ve never seen an industry with insider buying like I’ve seen across the board in banks recently. Bloomberg ran an article just yesterday highlighting the insider buys, and my friend Kuppy’s KEDM ran a full list of banks with insider buying a few weeks ago that is absolutely fertile hunting grounds for looking for value.
So you could probably just buy a basket of banks trading below tangible book value and do well right now….. but I think one of the interesting things in bank investing right now is that, in the wake of SIVB and FRC failing, the market seems to have decided that all but the most systemically important banks (like JPM) have no franchise. Just about every bank is trading in line with each other. So you’ve got the opportunity to buy banks with good “franchises” for below tangible book value and around the same price as banks that have lesser franchises (worse deposit quality, lower capital bases, riskier lending books, etc.).
I think that’s where the real opportunity is: if you’re willing to do work, you can find banks with unique franchises and pay the same price as banks without those franchises. If it turn out the market is wrong and those banks go back to earning returns better than their more commoditized peers, than you’ll generate some extra alpha. If the market is wrong and all banks are just commodities now…. well, you’re paying the same price as the commoditized banks, so you’ll get the same returns as the general banking sector (which I suspect will do pretty well given the current valuations!). That “bank with a franchise with no premium baked in” situation is the type of bank I’ve been trying to find / invest in; I’ve written up one such bank (on the premium side) and have found ~5 more I’m interested in on a similar “good franchise sold off to the point where you pay nothing for the franchise” and may discuss in the future (assuming I get a full position; Friday’s rally was painful given I’m not as big as I want to be yet!).
Anyway, I’ll likely have a longer post (or three) on banks in the near-ish future, and my DMs are always open if you’re looking at banks and want to swap thoughts, but there’s one question that’s been floating around my head that I wanted to throw out / discuss.
The question? Would you rather a CEO be aggressive or conservative in the current “crisis”?
I’ve been thinking about the question for a while, but it really came to mind when I read this quote from PNC’s CEO at a conference a few days ago. He was asked if there were any lending verticals he thought was particularly attractive to lend to right now, and he said that he thought office was really attractive given no one wanted to touch the sector currently so spreads were insane…. but he wouldn’t take advantage of those spreads because the “unfortunate truth” is shareholders would see PNC’s office exposure numbers going up and freak out.
I think that same line of thinking applies more broadly to how I’m seeing banks respond to the current crisis. Plenty of banks were buying back stock aggressively in 2022 and are still way overcapitalized today. In general, the banks have paused buybacks in the current environment out of “an abundance of caution”…. but there are a few banks that are overcapitalized that have suggested they’re ready to lean into their buybacks to take advantage of what they think is a quite undervalued stock.
In a normal company / industry, I’d obviously be leaning towards the later companies. It’s the absolute height of mismanagement to see companies that were eagerly and aggressively repurchasing their shares in 2021 / 2022 who are now sitting on their hands when their stock has been cut in half (or more). And whenever I’ve heard a CEO talking about not doing something that made sense to do because doing so would create some accounting noise or cause them to miss a quarter or something…. well, I’ve had several management teams tell me something along those lines, and I can’t think of a single one that went on to create shareholder value.
But banking is different than normal business. Banking is very much a confidence game. If the whole market losses confidence in, say, a cable company and investors panic and sell the stock down 90%, the cable company isn’t going anywhere. The assets are still in the ground. The cash flows are still rolling in, and the company can use those cash flows to buy their shares back even cheaper. Yes, if they’ve mismanaged their debt structure they might have trouble rolling over the debt so if their CFO is just terribly incompetent a temporary freak-out could lead to a restructuring, but one way or the other the cable company will be operating tomorrow regardless of
That is simply not the case for a bank; as we saw in March, if the whole market losses confidence in a bank, your depositors flee and you have to firesale your assets. You effectively get margin called, the FDIC seizes you over the weekend, and Jamie Dimon gets to buy you for a song. A panic for a “normal” company does not impact the operating business; a freakout at a bank sends it to banking heaven.
It’s a tough balancing act for banking management. Sure, you want to be aggressive when you think you can create long term value…. but you have to get to the long term to realize that value, and it’s a tricky thing to weigh “making these loans will improve our ROE by 1% but also increase the risk of a bank run by some small but nonzero number.”
Consider PNC’s office dilemma. Right now, investors are looking at banks that have significant exposure to office loans and freaking out regardless of how those loans were structured. There’s a difference between having 10% of your loan book made to dental offices with personal guarantees from a dentist and 10% of your loan book made to vacant office towers in downtown San Francisco, but the market doesn’t seem to care. Imagine a scenario where PNC made a bunch of office loans this quarter on unbelievable terms: great spreads, done at insanely low LTVs (on an up to date valuation), and with the offices having great tenants on long term contracts. Sure, PNC would likely have created a lot of value…. but if investors saw PNC’s exposure to office increase significantly during the quarter, there’s a good chance they’d freak out anyway, and no matter how many times PNC promised investors “hey, these are great loans; look at the stats on them!”, investors would wonder what would happen if all of those loans turned out to be zeroes. Several investors I’ve talked to have looked at banks and run tests for what happens if their whole office loan book turns out to be worth nothing; I think that’s crazy, but that’s how scared people are of office. PNC had ~3% of their loan book in offices at the end of Q1’23; let’s say the took it to 10% during a quarter because they were seeing incredible deals that they knew they couldn’t lose money on unless a true act of God happened (the earth opened up and swallowed a city whole and the insurer went bankrupt). That’s great…. but if an investor ran that “0 the office building loans out” math on PNC and they had gone from 3% office loans to 10% office loans, the investor would think PNC would be roughly bankrupt in a disaster scenario. So PNC would be risking a confidence crisis if the “office CRE” fears really started to spread, even though their loans would be money good or better!
You can run a similar “bank gets crusted despite creating value” scenario for reducing capital to buyback stock, going more aggressive into loans in general, etc.
I don’t know the answer. I generally want to be aggressive when others are fearful…. but it’s just a tough, tough game and balancing act to play as a bank. I think it’s Warren Buffett who said any number times zero is zero to show that any risk is not worth taking if it increases your chance of zero’ing out because eventually you will zero out; if you’re a bank CEO, how do you assess the chance of a move that creates a lot of value in the long term but slightly increases the chance of a zero if things got really crazy (and, again, not because it was a bad decision, but just because the market shoots first on a strange headline number and asks questions later)?