Goal for this Post and this Series
The goal for this post and future posts is to identify banks with the best prospects for superior shareholder performance over the next 3-5 years.
As background, the data used in this analysis and ones to follow in this series are derived from three sources: FDIC, Ycharts, and Bankregdata. Ycharts data reflect 12/31/2018 year-end numbers for 663 publicly traded U.S. banks. Data from the FDIC as well as Bankregdata capture FDIC call report numbers as of 3Q 2018. Unless otherwise noted, all data reflect median performance of the population of banks in any given chart.
The approach taken for this series builds on the findings and analysis from my 2016 book, Investing in Banks (2016, RMA). The publisher plans to release a second edition in 2019 analyzing industry performance since the book's release. Seeking Alpha readers are getting an early look at some of the key analysis which will be reviewed in the updated book.
The data used for this post considers over 100 performance criteria as well as total shareholder returns (dividends plus stock price change) of banks over the past 1, 3, 5, 7, 10, and 15 years.
"The Good": Bank Profitability and Earnings Momentum in 2018
Let's begin with a level set about bank performance in 2018.
Bank earnings are expected to be 40% greater in 2018 than any year in history. Chart 1 shows my 2018 estimate of industry net profits of $240 billion.
As a sidebar, it's worth reminding bank investors that banks earned only $25 billion in Q4 of 2017 after earning nearly double that in the prior quarter (Q3 2017 earnings of $48 billion). The steep decline was the result of non-cash accounting treatment for changes in tax law. When banks report 4Q 2018 earnings this month, expect to see P/E ratios based on 12 trailing months to decline meaningfully for many banks. When this happens, which is certainly not new news, investors will realize that a number of banks look downright cheap from a P/E perspective. The challenge will be sifting those that are cheap for good reason from those that are truly priced attractively.
While tax reform is a boon to bank profits, 2018 would be a year of record bank profitability even in the absence of changes in tax law.
Chart 2 shows industry Return on Equity by quarter since 1984. During this past quarter (Q3 2018) the industry registered its best ROE since 2006. For the first time in more than a decade, banks as a group are now comfortably producing returns exceeding the industry's cost of capital that I calculate to be 8-10% for any given bank.
Chart 3 addresses the single most important factor bank investors must monitor: Credit Quality. My favorite credit quality metric is quarterly Loan Loss Provision as a percentage of Assets.
As chart 3 reflects, industry credit quality is excellent. The rolling four quarters of Provision expense as a percentage of Assets is running roughly at half the 34 year average. At some point in time, the Provision will revert closer to the average, but the industry is not there today.
Clearly, some investors appear certain of two facts. First, they are sure a recession is on the way, and second, they are sure bank profits will plummet when the recession hits.
Here's what we know: The U.S. economy is not in a recession. Also, to my knowledge, no U.S. bank has issued an earnings warning to investors in recent weeks advising of a pending material hit to earnings as a result of deteriorating credit quality. Without question, earnings calls this month will drill deep into credit quality trends.
The last industry chart to examine before we get to the bad news of bank stock performance is chart 4. While this chart shows the simple Equity/Asset ratio, all the myriad ways to measure Capital adequacy show a similar trend and message: Banks are over-capitalized. It is this fact that explains why the Federal Reserve has not objected to massive returns of capital to bank investors in recent years.
"The Bad": Bank Stock Prices in 2018
You might think that record bank profits would translate into a nice upward trend in bank stock prices. Clearly, that was not the case last year. In the second half of 2018, bank stock prices retreated at a much faster rate of decline than the overall market. Of the 663 publicly traded banks I track, the median bank had a total return (stock price change and dividends) of -8.2% compared to -5.6% for the S&P 500.
If your personal bank holdings declined far greater than -8.2%, likely you owned only big banks. Chart 5 shows size mattered in 2018 as bank stock price performance aligned closely to bank size. As the chart shows, total return for bigger banks fell nearly -20% compared to roughly -2.5% for banks with assets less than $.5 billion. I do not recall another year when bank stock prices aligned so closely to size.
In a future post I will address big bank stock performance, and specifically, my theory as to why big bank investors suffered so much greater in 2018 than owners of small banks.
Moving on, Chart 6 takes a different angle on bank earnings by examining several bank metrics/characteristics that are often viewed by analysts as critical determinants of bank profitability and performance. The data reflects the median 2018 total return of the top (or bottom) 5% of the 663 publicly traded banks for each metric. For example, the top 5% of banks in 3Q 2018 Return on Assets ("ROA") had a median total return of -10% in 2018.
There are three metrics in chart 6 which should stand out for bank investors.
Note that the three metrics/characteristics -- high Return on Equity, high Net Income compared to Compensation (my favorite productivity metric), and the best (lowest) Efficiency Ratios -- were associated with banks that saw the worst returns in 2018. Long-time bank investors should be surprised by the underperformance of banks with these characteristics because each has historically been associated with superior total return. This tells us something really strange occurred in 2018.
Before speculating why banks with superior operating metrics underperformed for shareholders in 2018, let's consider chart 7 which shows the median 2018 total return for banks with the highest 3Q 2018 concentration in the eight most common loan categories.
This chart tells us that the best performance was associated with Farm lenders and Commercial Real Estate lenders. Students of banking know that smaller banks tend to concentrate lending activity in these loan categories. Consequently, investors should not be surprised by the relatively strong performance from Farm and CRE lenders in 2018.
The three worst performing loan categories are multifamily lending, commercial and industrial (C&I) lending, and credit card lending. Large banks tend to have disproportionately high concentrations in these lending categories. Historically, banks with heavy C&I concentrations have produced consistently attractive long-term returns as I documented in my 2016 book. Once again, investors are reminded by chart 7 that something odd was going on in 2018.
Expanding the Lens to 1, 3, 5, 7, 10, and 15 Year Total Return Performance
The next chart is very important for bank investors to understand moving into 2019. As noted, I have analyzed bank stock price performance over time based on a review of 100+ performance metrics/criteria. Banks were divided into deciles (10 groups of banks with 66 banks per group) from highest to lowest for each of the metrics/criteria. The top (1st decile) and bottom (10th decile) banks were then analyzed for total returns for 1, 3, 5, 7, 10, and 14 years.
From this analysis 12 metrics/criteria have been identified as being associated with above average total return for six different timeframes: 1, 3, 5, 7, 10, and 15 years. Chart 8 identifies the 12 metrics/criteria that are consistently associated with banks that achieved above average total returns over each of the six timeframes studied.
Banks with some or all these 12 metrics/criteria consistently outperformed peer banks over six different timeframes since year-end 2004. As chart 8 indicates, banks in the top decile of 3Q 2018 ROE, Net Interest Margin, and Funding Costs (cost of deposits), have consistently generated total returns superior to the industry over the six timeframes studied.
If you examined charts 7 and 8 carefully, you might be perplexed as to how high ROE could be associated with low stock price performance in 2018 (chart 7), but consistently high stock price performance over all six timeframes which includes 2018.
Here's what's going on. Chart 7 covers just the top 5% of all banks whereas chart 8 includes the top 10%. This tells us that the median total return in 2018 of the top 34 banks in ROE was significantly worse than the median total return of the top decile which includes twice as many banks. In other words, many of the top 5% of ROE banks underperformed in 2018 Total Return compared to banks in the next 5% of high ROEs.
Why might this be happening? One possible explanation is that the highest ROE banks include the Card lending banks which traditionally have superior ROEs but also are especially vulnerable to a weakening economy which brings weak employment which results in consumers struggling to pay credit card bills.
Investors in 2018 appear to have unloaded banks thought to be the most cyclical. While selling certain bank stocks at this point in the business cycle may make sense, it is possible the selling has been overdone, creating opportunities for prudent bank investors.
This post is not the place to dig deep into each metric/characteristic, but I want to make a few more high level observations about the data in chart 8.
- First, profitability matters. My research shows that there is no more important determinant of superior long-term bank returns than consistently high profitability (as measured by ROE and ROA).
- Second, banks with low funding costs (deposits are a vital "raw material" for banks) are a clear-cut competitive advantage that is most pronounced in a rising interest rate environment.
- Third, credit quality matters. When, not if, the economic cycle turns, investors will discover just how much credit quality matters. Undisciplined lenders will be punished.
- Fourth, lending concentrations matter. Some lending categories provide better returns over time than other kinds of lending. A perennial underperforming loan category is 1-4 family lending (mortgage lending). Mortgage loans are increasingly viewed by borrowers as a commodity. Consequently, banks with a preponderance of home mortgage lending struggle to achieve returns above their cost of capital.
- Fifth, as a rule of thumb, banks with less capital as a percentage of assets provide superior returns to banks with more capital. (Capital ratios are not well understood by academics, bank investors, and even bank boards and bank regulators. Capital ratios are an arcane topic subject to gross over-simplification. In recent years, the biggest challenge has been the over-politicization of capital ratios. Fortunately, the Federal Reserve has acted with independence and integrity and recognized that U.S. banks have adequate, if not excess, capital.)
The Opportunities: High-Quality Banks On Sale
Let's try to distill the headlines from the prior charts and determine possible implications to bank investors in 2019.
We know bank profitability (ROE and ROA) and shareholder returns are highly related over time. We also know that some of the banks with the best ROE numbers showed the worst industry returns in 2018. Is it possible that some banks with high profitability were hit so hard last year that they are now priced attractively for buy-and-hold investors to acquire?
To answer that question, I have created a scatterplot that shows the results of several screens of the 663 publicly traded banks. Here are the steps involved in identifying High-Quality banks that may be "on sale" at this time.
- Step 1: Stack rank the most current (9/30/2018) ROE for the entire population of 663 publicly traded banks. This identifies the 100 banks with the best current ROEs.
- Step 2: Calculate the average ROE for each bank over the past 15 years as well as the Standard Deviation (measure of volatility which many investors consider to be a key component of risk).
- Step 3: From Step 2, calculate the Risk-Adjusted Return on Equity ("RAROE") by subtracting the standard deviation of 60 quarters of ROE from the average ROE for the same 60 quarters. This step narrows our search to just those banks that have not only a high current ROE but a high average ROE with low volatility. The higher the RAROE, the better.
- Step 4: Compare current valuations to valuations over the past 60 quarters. To do this, calculate each bank's average Price to its Tangible Book Value ("P/TBV") as well as its standard deviation of the P/TBV.
- Step 5: From Step 4, calculate the "Z-Score" for each bank's P/TBV. (A Z-Score measures the statistical significance of the bank's 12/31/2018 P/TBV compared to its history. The greater the Z-Score, the more statistically significant is the difference between the current value and historic average.)
Chart 9 reveals the results of the screening process. Here's how to read chart 9. Each dot represents a publicly traded bank that had industry leading ROE in 3Q 2018. Banks on the left side of the vertical axis are banks with high current ROE but historically highly volatile ROEs. Banks on the lower half of the horizontal axis have a 12/31/2018 Price/TBV less than historic averages.
From a statistical view, the most attractive banks are those in the lower right-hand quadrant, especially those with RAROEs greater than 10% (very rare among U.S. banks) and with a Z-score of at least -1.0.
In my next post, I will highlight the 12 most intriguing banks identified from the lower right-hand quadrant of chart 9. A case will be made in this upcoming Seeking Alpha article for building a portfolio of these 12 High-Quality banks.
Risk-averse investors may not want to buy any bank stocks until the big banks start reporting earnings next week. Expect earnings calls to focus intensely on credit quality trends. Also, while I do not expect any of the big banks to report material weakness in credit quality, you can bet that if any do, they will see their stock prices get hammered. And if the hammers start swinging, do not be surprised if they swing indiscriminately and whack High-Quality banks, too. If and when that happens, buy-and-hold investors may have an opportunity to acquire shares of High-Quality banks at a reasonable price.
Investors with an appetite for more risk may want to take a position now in a few of the High-Quality banks in anticipation of solid numbers forthcoming from upcoming 4Q earnings reports.