Earnings Are High but Bank Stock Prices Are Low

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Banks are doing very well, if you look at credit quality and profitability. But tell that to investors.

Last week, the Federal Open Market Committee raised the target federal funds rate by 75 basis points, the third hike of that magnitude in a row, to combat inflation.

The market has punished equities lately in response, but even more so, bank stocks, probably in anticipation of a recession that may have arrived. The S&P 500 fell 21.61% in 2022 as of Friday, Sept. 23, but the S&P U.S. large cap bank index was down 25.19% in that same time frame, according to Mercer Capital using S&P Global Market Intelligence data. By asset size, large banks have seen the biggest declines so far this year.

Going back further in time, the cumulative return for U.S. bank stocks in general, as measured by the S&P U.S. BMI Banks index, was down 5.30% as of Sept. 22 from the start of 2020, compared to a gain of 21.55% for the S&P 500.

Investors’ dim view of bank stocks belies the underlying strengths of many of these banks. Bank net income of $64.4 billion in the second quarter was higher than it had been in the same quarter of 2018 and 2019, according to the Federal Deposit Insurance Corp. Since 2019, in fact, bank profitability has been going gangbusters. Rising interest rates improved net interest margins, a key profitability statistic for many banks. Plus, loan growth has been good.

And credit quality remains high, as measured by the noncurrent loan and quarterly net charge-off rates at banks, important bank metrics tracked by the FDIC. Despite weaknesses in mortgage and wealth management, this combination of variables has made many banks more profitable than they were in 2018 or 2019.

“Earnings are excellent right now, and they’re going to be even better in the third and fourth quarter as these margins expand,” says Jeff Davis, managing director of Mercer Capital’s financial institutions group.

Investors don’t seem to care. “It’s been a real frustration and a real incongruity between stock prices and what’s going on with fundamentals,” says R. Scott Siefers, managing director and senior research analyst at Piper Sandler & Co. “You’ve had a year of really great revenue growth, and really great profitability, and at least for the time being, that should continue. So that’s the good news. The bad news is, of course, that investors aren’t really as concerned with what’s going on today.”

Worries about a possible recession are sending investors away from bank stocks, even as analysts join Davis in his prediction of a pretty good third and fourth quarter for earnings this year. The reason is that investors view banks as sensitive to the broader economy, Siefers says, and think asset quality will deteriorate and the costs of deposits will rise eventually.

The place to see this play out is in two ratios: price to earnings and price to tangible book value. Interestingly, price to tangible book value ratios have remained strong — probably a function of deteriorating bond values in bank securities’ portfolios, which is bringing down tangible book values in line with falling stock prices. As a result, the average price to tangible book value as of Sept. 23 was 1.86x for large regional bank stocks and 1.7x for banks in the $10 billion to $50 billion asset range, according to Mercer Capital.

Meanwhile, price to earnings ratios are falling. The average price to earnings ratio for the last four quarters was 10.3x for large regional banks, and 11.4x for mid-sized bank stocks. (By way of comparison, the 10-year average for large cap bank stocks was 13.4x and 14.6x for mid cap bank stocks, respectively.)

For bank management teams and the boards that oversee them, the industry is entering a difficult time when decisions about capital management will be crucial. Banks still are seeing loan growth, and for the most part, higher earnings are generating a fair amount of capital, says Rick Childs, a partner at the tax and consulting firm Crowe LLP. But what to do with that capital?

This might be the perfect time to buy back stock, when prices are low, but that depletes capital that might be needed in a recession and such action might be viewed poorly by markets, Childs says. Davis agrees. A lot of companies can’t or won’t buy back their own stock when it’s gotten cheap, he says. “If we don’t have a nasty recession next year, a lot of these stocks are probably pretty good or very good purchases,” he says. “If we have a nasty recession, you’ll wish you had the capital.”

It’s tricky to raise dividends for the same reason. Most banks shy away from cutting dividends, because that would hurt investors, and try to manage to keep the dividend rate consistent, Childs says.

And in terms of lending, banks most certainly will want to continue lending to borrowers with good credit, but may exercise caution when it comes to riskier categories, Davis says. Capital management going forward won’t be easy. “If next year’s nasty, there’s nothing they can do because they’re stuck with what’s on the balance sheet,” he says. The next year or two may prove which bank management teams made the right decisions.

Evaluating Executives’ 2020 Performance

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Bank boards know that the world has shifted dramatically since January, when they drafted  individual executives’ performance expectations. Using those outdated evaluations now may be a fruitless exercise.

As the impact of the pandemic and the social justice movements continue to unfold across the United States, boards may not feel that they have much more clarity on performance expectations currently than they did back in March. At many banks, credit quality has replaced loan volume as the key operating priority. Unprecedented interest rate cuts have further deteriorated earnings power.

Many boards of directors are revisiting how to evaluate the executive team’s individual performance for fiscal year 2020, considering these new realities for their businesses. Individual performance evaluations are a tool for evaluating leadership behaviors and abilities; as such, it sends a clear indication of what the board values from their leaders. After a year like this, all stakeholders will be interested to know what the board prioritized for their bank’s leadership. 

Considerations for Updated Individual Performance Evaluations
This year has been defined by unprecedented developments that broadly and deeply impact all stakeholders. More than any other industry, banks have been called on to support the country using every tool in their toolkit. Reflecting this broad impact, bank boards may find it useful to establish a revised framework for evaluating leadership performance using six “Critical Cs” for 2020:

  • Continuity of Business: How quickly and effectively was the bank able to transition to a new operating model (including remote work arrangements, staffing essential workers in office or branch, etc.) and minimize business disruption?
  • Customer Satisfaction: How were customers impacted by the change in the operating model? If measured, how did the scores vary from a normal year?
  • Credit Quality: Where are the trends moving and how are executives responding? Did the institution face legacy issues that took some time to address and may be compounding current issues?
  • Capital Management: What balance sheet actions did executives take to strengthen the bank’s position for the future?
  • Coworker Wellbeing: What was the “tone at the top”? How did executives respond to the needs of employees? If measured, how did the bank’s engagement scores vary from other years?
  • Community Support: What did the bank do to lead in our communities? How effective was the bank in delivering government stimulus programs like the Small Business Administration’s Paycheck Protection Program?

For publicly-traded banks, the compensation discussion and analysis section of the proxy statement should provide a thorough description of the rationale and process used for realigning these criteria and the evaluation approach used to assess performance. Operating results are likely to be well below early-year expectations for most banks; as a result, shareholders will be keenly interested in how leadership responded to the current environment and how that informed pay decisions by the board.

This year has created an unprecedented opportunity to test the leadership abilities of the executive team. Using the six “Critical Cs” will help boards assess the performance of their leadership teams in crises, craft a descriptive rationale for compensation decisions for fiscal year 2020, as well as evaluate leadership abilities for the future.

Creating the Correct Dividend Policy

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dividend-7-17-19.png“I believe non-dividend stocks aren’t much more than baseball cards. They are worth what you can convince someone to pay for it.” – Mark Cuban, investor and owner of the NBA’s Dallas Mavericks

Directors can use dividends to convey confidence and attract yield-hungry investors, but they must strike a balance between payouts and future growth.

Dividends are an important part of the capital management strategy at many banks, and the operating environment has made yield more important to analysts and investors. A bank’s dividend policy is a highly visible signal of management’s confidence to deliver consistent results. The board of directors is responsible for determining a bank’s cash dividend; it is paramount they strike the right payout.

After carefully considering regulatory capital requirements, a board still has a fair amount of discretion when establishing the dividend policy while retaining sufficient funds for growth. Boards often weigh dividends against share repurchases to manage capital. However, trading multiples and capital levels heavily influence stock repurchases, which tend to be more discretionary than regular dividend payments. A lower tax rate on dividends and ordinary income is another factor that favors dividends over share repurchases.

Dividends can be a good measure of corporate governance. A dividend payout policy means that investors can worry less about unchecked growth or inefficient investments that do not maximize shareholder value.

Optimal Dividend Policy
The appropriate capital management policy can help a bank achieve an optimal trading multiple. The optimal dividend policy depends on a company’s earnings growth, capital requirements and ability to communicate its strategy to the investment community. Although cash dividends have been historically respected by bank investors, the prolonged low interest rate environment and the perception that banks are increasingly utility-like has elevated the importance of dividend payouts.

There is, however, an opportunity cost of using cash to pay out dividends rather than fuel growth initiatives. And an increased dividend can indicate that management expects higher future cash flows and possibly higher future valuations.

The Federal Reserve’s monetary policy encourages yield-hungry investors to favor stocks over fixed-income instruments. Given the current economic and interest rate environment, equity investors can achieve the safety of bonds through a combination of cash dividends and any upside from capital appreciation inherent in stocks. Dividend popularity has increased, due to respectable corporate cash flows, more favorable tax rates, and broad consumer confidence in the economy and stock market. Currently, the S&P 500 dividend yield is around 1.86 percent, compared to a 2.4 percent yield on 10-year Treasury notes.

In response to these considerations, management should determine the retention ratio, which lies in the earnings power above the dividend payment. Effectively measuring market, liquidity and credit risk—often done through stress testing—is vital to determining the margin of protection a bank needs to ensure the consistency of dividend payments. The DuPont formula, where return on equity equals return on assets times the equity multiplier, should underpin the financial perspective.

Industry-wide challenges like continued pressure on net interest margins and a diminishing ability to trim reserves will stretch the safety margin in the current environment. Banks with slower earnings growth need to carefully determine their dividend payout ratios. Increasing or stable dividends are generally positive signals to the market regarding the institution’s financial condition and prospects, while a dividend cut could paint a negative picture.

Changing Investor Views
The attitudes of analysts and the investment community regarding dividends have come full circle. This was not always the case, as investors preferred that banks retain capital for growth or to fund stock repurchases.

Retail investors, including executives and members of the board, are attracted to community bank stocks because of the sector’s predictable dividend payments. Directors would be well advised to focus on their bank’s dividend policy and the efficient use of capital as part of their fiduciary duties to shareholders.

Exclusive: The Inside Story of Colorado’s Leading Bank

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bank-4-25-19.pngGreat leaders are eager to learn from others, even their competitors. That’s why Bank Director is making available—exclusively to members of our Bank Services program—the unabridged transcripts of in-depth conversations our writers have with the executives of top-performing banks.

One such bank is FirstBank Holding Co.

With $18.5 billion in assets, FirstBank is the third-largest privately-held bank in the United States and the biggest bank based in Colorado, where its headquarters sits 10 miles west of downtown Denver. It’s among the most efficient institutions in the industry, with an efficiency ratio often dipping below 50 percent. It has an abundance of risk-based capital. And its return on equity has ranked in the top 10 percent of large bank holding companies in all but one of the past 12 years.

Bank Director’s executive editor, John J. Maxfield, interviewed FirstBank’s CEO Jim Reuter and Chief Operating Officer Emily Robinson for the second quarter 2019 issue of Bank Director magazine. (You can read that story, “How FirstBank Profits from Being Private,” by clicking here.)

In the interview, Reuter and Robinson shed light on:

  • The benefits of being a privately-held bank
  • How FirstBank became a leader in the digital evolution of banking
  • Strategies to stay disciplined at the top of the cycle
  • The advantage of having three former FirstBank CEOs serving on the board
  • Their philosophy on capital management and allocation

The interview has been edited for brevity, clarity and flow.

download.png Download transcript for the full exclusive interview