Earnings Are High but Bank Stock Prices Are Low

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.

Why Elections Are Good For Bank Stocks

election.jpgKeefe, Bruyette & Woods’ [research] team is out with the note: “The Election Edge: Elections Have Historically Benefited Financials,” which reviews the impact of recent U.S. presidential elections on the equity market and financial stocks.

While performance trends from the ’08 election are undeniably impacted by the financial crisis, we still found several overarching trends. For a longer performance history, we used the NASDAQ Bank Index to measure trends in bank stocks around elections back to 1984, the first year the exchanges were open on Election Day. We are unable to replicate such long-dated analyses for the other financial industry groups due to lack of industry index data prior to 1995 and in some instances, the lack of an investable public equity universe historically (e.g., REITs).

  • Financial stocks rallied and outperformed the market going into three of the last four presidential Election Days. Financials outperformed the market and posted gains in the YTD period up to Election Day in ’04, ’00 and ’96. This outperformance did not hold true in ’08, when financials were impacted by the financial crisis. However, similar trends are playing out in ’12 through 9/21 as financials increased 21.8 percent while the S&P 500 index (SPX) rose 16.1 percent.
  • Among financials, banks consistently outperformed the market going into the last four elections. Both large and small to mid-cap banks (SMID) outperformed the SPX in the ’08, ’04, ’00 and ’96 elections. As with the financials, similar trends are playing out in ’12, with the large-cap banks rising 27.5 percent and SMID-cap banks increasing 17.6 percent, both outperforming the SPX’s 16.1 percent gain.
  • Longer-term analysis back to the 1984 election shows similar outperformance trends for banks. Banks as represented by the NASDAQ Bank Index outperformed the SPX during the year-to-date period up to Election Day in all seven presidential elections going back to 1984.
  • Similar performance trends hold true for the four-week period leading up to Election Day. Financials outperformed in the ’08, ’00 and ’96 elections over the four weeks prior to Election Day while banks (large- and SMID-cap) outperformed during this period in all four last elections. Banks, as represented by the NASDAQ Bank Index, also outperformed in this four-week period prior to Election Day in every election since ’92.
  • Election Day is not historically a market-moving event. With the exception of 2008, the SPX rose between 0 to 1 percent on Election Day. Financials exhibited similar performance, ranging from a decline of 0.4 percent to a gain of 1.6 percent in the ’96-’04 elections.
  • Financial stocks underperformed post-Election Day through year-end in three of the last four presidential elections. Financials lost their steam once the election was over, underperforming the market in the post-election period in ’08, ’04 and ’96.
  • Despite the underperformance of financials, life insurers and diversified financials outperformed post-Election Day through year-end in three of the last four elections. Life insurers and diversified financials underperformed the market and posted losses after only the ’08 election, when performance was significantly impacted by the financial crisis. Long-term post-Election Day results are mixed for the banks, with the NASDAQ Bank Index underperforming the SPX in three of the last seven elections (’08, ’04, ’88).
  • Election Day is rapidly nearing and will occur on Tuesday, November 6.

How to Raise Capital in a Difficult Market: What Investors are Looking For

raising-capital-session.jpgIt goes without saying that community banks have had a tough time raising capital in this environment.

One exception is Oritani Financial Corp., a $2.6-billion asset holding company for Oritani Bank in New Jersey, which has raised a total of $413.6 million since 2010.

Kevin Lynch, the company’s chairman, president and CEO, said at Bank Director’s Acquire or Be Acquired conference in Phoenix, Arizona, last month that raising money was an intense marketing effort that required lots of preparation and a good business plan.

Lynch and the bank’s chief financial officer met with 30 institutional investors in four cities over the course of a week.

“The questions come at you like bullets and you’ve got to let them know you’re running the bank and you know what you’re doing,’’ he said. “Your potential investors are going to say ‘does this guy know what he’s talking about?’ You should be prepared to say who your customers are and what your delinquents are and what you’re going to do about them.”

He said investors are interested in knowing whether you can grow organically and how you will deploy the capital.  Get to know the investors you are about to meet and learn what their goals are: is it a long term or short term investment for them?

Not all banks have had as good experience raising money as Oritani.

“Access to capital is critical,” said Stifel Nicolaus Weisel Executive Vice President and Vice Chairman Ben Plotkin, whose firm advised Oritani. “For banks trading well below book value, raising capital is a challenge.”

The problem is, a lot of banks are trading below book value. Banks with fewer than $1 billion in assets were trading on average at 72 percent to tangible book value as of mid-January, Plotkin said. That compared to about 120 percent price to tangible book value for banks with more than $1 billion in assets.

On average, larger banks have fewer balance sheet problems, and have had an easier time getting rid of problem loans.

Plotkin said investors are interested in banks with more than $1 billion in assets, with no looming balance sheet hole to plug, attractive demographics and ability to generate loan growth. They want a low level of non-performing assets, a loyal and low cost deposit base, and qualified management with a proven track record, he said.

Lynch also offered some other tips for raising money in the equity markets:

  • Have detailed knowledge of your portfolio and plans to build it
  • Know your largest loans and customers
  • Know all delinquent loans and how you are collecting on them
  • Know your asset quality levels, current market conditions and competition
  • Provide examples of lending and credit review practices
  • Know your loan pipeline and sources
  • Know how you will maintain credit quality while ramping up portfolio size