March 15, 2023

Investing in Banks During Extreme Market Volatility

In the course of the last week, we saw two prominent, well-established and significant banks demise. The bank runs caught everyone by surprise because it’s not a credit crisis, like in ’07-’08. Unfortunately, it started with some bad public relations, that resulted in a panic with tens of billions of dollars withdrawn and lead to a liquidity issue.

On Wednesday, several analysts came out with updates reiterating their confidence in Silicon Valley Bank (SVB), home to nearly half of the venture-backed startups in the U.S. On Thursday, a record $42 billion was withdrawn by depositors in the largest bank run in U.S. history. A few days later, Signature Bank of New York (SBNY) was closed by regulators after a reported 20% of deposits were withdrawn. There was little time for the banks to react and access liquidity.

They were successful, profitable and viable banks, so how did this happen? SVB grew so much in the past few years going from 60 billion to over 200 billion in assets, that they had to do something with the money. Instead of conservatively investing into short-term securities, they decided to invest into longer term, low-risk government bonds. However, when interest rates rose substantially, the value of those securities dropped. SVB had no intention of selling these securities, they intended to hold them until maturity, so the paper losses were temporary, not permanent. However, when SVB decided to raise money to strengthen its balance sheet, the venture capital and startup community panicked and withdrew record amounts of money. There wasn’t a problem with SVB, until everyone thought there was a problem and ran to the bank to withdraw money. With SBNY, the bad press around cryptocurrency deposits resulted in fear and money withdrawals. It became self-fulfilling.

Now, how do we go forward? As of Sunday, the Federal Reserve created the Bank Term Funding Program (BTFP) providing additional funds for up to one year to eligible depository organizations. This will to help guarantee banks can meet the needs of their depositors, and is only specific to government bonds. Although the Fed did move quickly to help the economy, ultimately, had it been around a week before, both institutions would probably still be in business.

Unfortunately, the future is unpredictable and low probability events happen. The best thing we can do is see the present clearer than others and react accordingly. Fear and uncertainty can produce tremendous volatility—but occasionally there’s opportunity to purchase great businesses at steep discounts. Baron Rothschild of the famous Rothschild’s banking family in Europe once advised, “The time to buy is when there’s blood in the streets.” 

How can we take advantage of a situation that’s shaken the whole financial system and make it a learning experience? We should take the knowledge gained with a cautious, but opportunistic open mind. Not all banks are painted with the same brush.

This does also bring up serious questions on the government’s overall role in the banking system. Hopefully, the recent actions of the FDIC, Federal Reserve and Treasury ease concerns. Steve Forbes recently shared an eloquent overview of our current landscape: Watch 3- Minute Video

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Banking is one of the oldest and most established industries. Lending has been around since the beginning of trade, but the modern banking system can be traced to my Italian roots—in medieval and Renaissance Italy, particularly Florence, Venice and Genoa. However, interest rates went up so quickly that having a true understanding of what banks invest in; their portfolio market value and tangible book value are hard to ascertain. Some banks’ tangible book value could be inflated.

I have been investing in banks for over thirty years and other areas of investing during volatile times and taking advantage of fear, uncertainty and cyclicality, but have been cautious and get as much of an understanding as I can. I have invested in well over 125 banks over the decades and now know the factors contributing to some of my success. There were times where my bank investments went down, however, it seems that often of the time I more than made up for my losses. When I buy high-quality banks that have outstanding management, good growth at attractive valuations during moments of uncertainty, I have found that it has usually worked well over the long-term

Perhaps there are other areas of investing where one can get higher returns, but the risk-adjusted returns offered when investing in the banking sector has been attractive to me. The criteria that I use to invest in banks are:

  1. High-quality banks trading below intrinsic transactional value
  2. Attractive business models and
  3. Outstanding management team with a good culture.

Moreover, I look for banks with high-quality loan portfolios, low credit risk and very low charge-offs. They regularly have low cost of deposits or good deposit franchise, low price to tangible book value (PTB)/ low price-earnings (PE) ratios / low price/earnings-to growth (PEG) ratios, good net interest margins (NIM) and often they are in growth markets. I like to invest in banks where there is usually an alignment of interest with board, management, customers and shareholders, increased earnings to growth, growing book value, significant inside ownership, operating in very desirable markets which could make the bank an attractive acquisition target. All of the above creates a greater margin of safety.

There are three major reasons why banks buy other banks:

  1. There are significant cost synergies; a bank that has a platform that buys another bank can eliminate up to 50% of the redundant cost.
  2. A bank that has higher currency (higher multiple) can buy other banks (trading at lower prices) and is accretive to acquiring bank’s earnings.
  3. The acquiring bank is looking for a platform; a niche, a market or other strategic reasons.

I look at quantitative factors like good return in equity (ROE), high return on assets (ROA) and low efficiency ratios. The lower the efficiency ratio, inversely, the higher the ROA. I also like to see a large concentration and a number of successful bank investors that inherently put more pressure on the board and management to outperform. I like to be cautious, open-minded, flexible and opportunistic to take advantage of different segments within the banking space including private banks (there are over 5,000), small or thinly traded public (there are approx. 700), and regionals because different segments provide opportunities at different times. At one time, there were over 17,000 banks in America. Most countries only have a handful of banks.

I don’t like to invest in low-quality banks with poor management that are slow growers. I also don’t like turnaround situations unless they have already turned with perhaps new management and a new direction. I have found that most turnarounds take longer than one thinks and they’re usually more problems than one sees. So I am fine with, what I call, turnarounds that have already turned. One of my biggest historical mistakes over the years is buying value traps. Just because banks are cheap does not mean they’re good. At the end it comes down to three major areas: quality, value and growth.

Banks tend to drop before there is a downturn or recession, but they tend to bounce back before there is a recovery. And since banks are cyclical, it’s important to take advantage when opportunities arise. It’s crucial to be disciplined to buy the highest quality banks that are growing at very attractive valuations. Currently banks are at attractive valuations due to the concern of bad loans, increased interest rates and all the fear of liquidity, potential run of the banks, uncertainty and volatility that there is in the current environment. Banks are also below the valuation of the S&P and lower than their historical averages. The challenge today is not credit which historically has made investing in banks risky, but rather a challenge in liquidity and confidence. Today banks are well capitalized, they are underwriting loans carefully, and over all currently have good credit. And, although loan growth has slowed, they still have had growth.

There are aspects of banking that can be disrupted, but the banking industry is a relatively stable and an important part of our economy. On average 4-5% of banks sell each year. Often when banks are purchased, they are bought at a meaningful premium to where they are trading at.

When you have a disciplined investment process, a tremendous amount of experience, a good reputation, high integrity, proven track record, incredible contacts and the ability to find and evaluate many opportunities, it greatly improves your chances of success. Although the fear and uncertainty of liquidity is very elevated, I will continue to invest in high quality banks.

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