Saturday, November 18, 2017

Bank Dividends: Go Ahead and Drink The Kool Aid

Dividends are no longer sexy. So says Rob Isbitts, a Forbes contributor in a recent article that he penned. Not sure they ever were sexy, but he has a point. Read the article, make your own judgement.

Or read on. Today I had another debate with my colleagues about discount rates. You know, those rates you learned in Finance class, CAP-M, or Ibbotson Build-up? Yeah, text book stuff. Don't hear much about either on CNBC these days.

I view things simplistically. If you are going to project out into the future, say in strategic plan projections, then you should discount back to present day to determine if your strategy is adding or eroding value. A key component to the calculation is the discount rate.

So here is my simple definition of what your discount rate should be: The annual capital appreciation rate expected by your investors. That differs based on business model, in my opinion. If you are executing a fast-growth strategy in a slow-growth market, you may be taking larger risks. Therefore, your investors should expect greater capital appreciation, and therefore a greater discount rate.

If you grow more slowly, and closer to your market growth, you would likely be executing a less risky strategy, and you should consider a smaller discount rate. But your investors would still expect equity-like returns. Common stock remains the lowest rung on the capital hierarchy, regardless of strategy employed. 

Absent a change in your market multiples, your stock's capital appreciation should move in tandem with your earnings growth, or possibly your book value growth, or some combination of the two. That is typically how banks are valued. So what if in executing your strategy, you're projecting 6% earnings compound annual growth? I doubt your investors would be happy with 6% annual returns. How do you deliver the returns they are expecting?

How about the dividend?

Let's look at Territorial Bancorp in Honolulu, the holding company for Territorial Savings Bank. Why Territorial? Aside from my affinity for Hawaii because I lived, worked, and went to college there, they are a highly capitalized thrift that converted from mutual to stock form in 2009. Their capital ratios are not an issue.

Territorial had an inconvenient truth in their 2016 10k, or annual report for those that don't speak in SEC forms. See the below chart.

They have under-performed bank stocks and the wider market over the past five years. They are not a poor performer though, having a year-to-date ROA of 0.89% and Efficiency Ratio of 56.5%. The challenge may be their balance sheet growth, only 4.1% per year, on average, since 2011 (see table). The Hawaii population is projected to grow 3.46% over the next five years.

One way Territorial is trying to improve shareholder returns is through dividends. Their dividend has grown at a CAGR of 22% since 2011, even though their EPS has grown at a CAGR of 8.5% over the same period. In 2016, that resulted in a dividend payout ratio of 52.3%, up from 29.1% in 2011. Quite a commitment to the dividend. An 8.5% annual EPS growth, combined with a 2.8% dividend yield, should result in a total annual return of 11.3%. That assumes no change in Territorial's price/earnings multiple. Not too shabby. 

So why don't others deliver higher dividends to stoke shareholder returns, especially if their balance sheet is growing slowly, and their EPS growth is not enough to meet shareholder expectations? Why maximize profitability only to accumulate capital?

Territorial is working their capital position down from a very lofty perch post-conversion. Clearly dividends are one part of their strategy, as well as share buybacks. The buybacks are typical for a converted thrift. Although don't get me started on the logic of issuing shares at $10 only to immediately start buying them back at a higher price.

What if, as Territorial "normalizes" their capital position as per their capital plan, they have to cut the dividend? This is a common objection I hear from bankers for not increasing their dividend and payout ratio. They don't want to cut it. And suffer the consequences. Like GE recently did.

The Board and executive management of Territorial have this covered, in my opinion, in the form of a special dividend. In 2016, their regular quarterly dividend was $0.18/share. In December, they declared a special dividend of $0.20/share, in addition to their regular dividend. They recently declared a special dividend this year of $0.30/share, payable in December. Once their capital levels return to "normal", if the special dividend reduces capital ratios, they can reduce it or eliminate it altogether, without impacting the regular dividend.

But no, bankers object because their shareholders will grow to "expect" the special dividend. As if active shareholder relations programs can't mitigate this risk. 

As a result, many keep banging the growth drum to stoke EPS and therefore shareholder returns. As if growing faster than the bank's markets can continue ad infinitum. If it doesn't pan out, we turn first to cost cutting (largely within our control). Then to buy-side M&A (less within our control). And if we fail to deliver shareholder returns by these methods... then sell-side M&A (within our control). 

And, alas, we have fewer than 6,000 banks.

Are you drinking my dividend Kool Aid?

~ Jeff

Saturday, November 04, 2017

Schmidlap Bank, A Division of Community Bank

"We want to keep our charter because the OCC is a more distinguished regulator." Seriously, that is what a bank chairman told me when arguing to keep his bank's charter during merger negotiations.

But I try not to judge. Perhaps, if I thought the argument weak, which I did, there was something else behind it. Something like "we've spent 100 years building the reputation of this bank and 'poof', it's gone at the stroke of a pen." Or, "my grandparents, parents, and now me served on the board of this bank and I owe it to their legacy..."

Why not just say that? Perhaps there is little evidence of the benefit of your 100-year brand, so it's a difficult argument to make. But more difficult than claiming the OCC is a better regulator? 

In more recent merger discussions, however, I have heard more refreshing arguments that it is not necessary to re-brand every nook and cranny of your bank into one. Because one key argument to combine brands is the efficiency of advertising into one or more media markets. Does this make sense today?

I think not. Take the accompanying picture, all from my Twitter, Facebook, and LindedIn streams. Three different "promoted" posts. All specific to me. Based on all the intel gathered on me. My neighbor, or even my wife, see different ads. So combining names so you can realize synergies in your billboard strategy doesn't make sense like it did 20 years ago.

More success stories of the divisional approach are cropping up in our industry. One of my favorites is the affinity brand Red Neck Bank, a division of All America Bank. All America Bank is a traditional community bank located near Oklahoma City, and has been around since the 1960's. And yes, they recently switched names from Bank of the Witchitas. But did they have to? For the traditional bank, I'm not so sure.

Aside from the traditional bank, they thought out of the box, and established a digital-only division to appeal to a specific niche. And it has done well. Marvelously well. Even though it has not reached the "critical mass" that your investment bankers insists that you need. See the accompanying table.

On a more traditional front, I point to UNSY Bank in upstate New York. This bank, unlike All America Bank, is relatively new, having been formed in 2007. It's strategy, however, is to build brands that resonate closer to the communities where they operate. For example, the $349 million bank has only four branch locations, each USNY Bank. But they operate as Bank of the Finger Lakes, or Bank of Cooperstown, divisions of USNY. Their financial performance doesn't seem to be hampered by bifurcated branding.

The divisional approach is becoming more important as relatively small financial institutions worry about keeping up with customer preference, technology, and regulatory changes. Although I mock the investment banker that always seems to think your institution needs to be twice the size you are now, regardless of the size you are now, there is merit to achieving a certain size.

Merits that include: increased stock trading multiples, greater employee development opportunities, the ability to absorb regulatory costs, and greater resources to invest in technologies to afford you a long-term future.

But you need not give up your name to get a merger of like-sized institutions done. Nor dump your local brand for a homogeneous one that spans geographies.

~ Jeff

Wednesday, November 01, 2017

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

Quarterly Financial Markets & Economic Update- October, 2017

I love this time of year.  The leaves are changing colors and soon fall will give way to winter.  I cannot say I love the cold, bitter winter, especially when the roads are bad from snow and ice.  The markets have not given way to anything, with long term bonds still trading in a tight range and short term rates having risen from Fed action.  The economy moves along at its own pace.  We saw a strong second quarter, with GDP growth at 3.1%, and we know from the recent past that the third quarter should stay strong but weakness comes again in the fourth quarter.  This year, we may see a weaker third quarter due to the effects of Hurricanes Harvey, Irma, and Maria and the destruction left in their wake.  The overall forecast for GDP in 2017 is 2%.  Actually, the forecast for 2018 to 2020 is also 2%.  What else is new?

Fed Tightening
The Federal Reserve continues its tightening campaign.  They are expected to raise the Fed Funds rate for a third time in 2017 by another 25 basis points in December, 2017.  Why?  I suppose it is because they said they would raise rates three times this year and they are stubbornly sticking to what they said.

But raising the Fed Funds rate is not the only tightening going on.  Add to that the end of “QE,” or quantitative easing, which was the Fed’s bond buying binge that loaded up their balance sheet to over $4 trillion.  They have spent the last several years maintaining the current levels of bonds that they own.  They have seemed fairly nervous about their large balance sheet, so in September, 2017, they announced that they would allow bonds to mature or pay off in October- by $4 billion in Agency mortgage backed securities and $6 billion in Treasuries, for a total of $10 billion. But they won’t stop there.  The monthly amount will eventually rise to $50 billion.  Thus “QT,” or quantitative tightening, has begun, with uncertain consequences and disruptions to our markets, interest rates, the economy, liquidity, and the banking system.  All of this is happening while the markets widely expect the President to nominate a new Federal Reserve Chair to replace Janet Yellen, whose term as Chair ends in February, 2018.  Interestingly, her term on the FOMC does not end.

The tightening continues unabated, despite modest economic growth and stubbornly low inflation.  In fact, inflation has been less than 2%, the Fed’s presumed target, since 2009.  Neither GDP or inflation look to soar anytime soon, leaving us with Fed actions that will put upward pressure on short term and long term that will lead to lower GDP growth and lower inflation.  Something doesn’t seem right about this scenario, does it?

What Does the Economy Need?
Okay, I have been reading my economic textbooks, studying my data, thinking about the markets, and wondering about the Fed.  Why are they continuing to raise rates?  I theorize that they believe the unemployment rate is too low and will cause wage inflation.  They believe in the Phillips curve, which has an inverse relationship between unemployment and inflation.  They may also have seen an uptick in inflation earlier this year and thought they were right in raising rates.  Have they noticed that inflation was transitory and has now been falling?

The unemployment rate is low on the surface, at 4.2% in September, 2017.  The low unemployment rate in and of itself does not indicate that 7.6 million workers have multiple jobs to make ends meet, that the labor force participation rate of 63% is near a 40 year low, the pool of available workers is at 12.4 million persons, and that baby boomer retirees have given way to workers of less experience.  The Fed worries about wage growth soaring and driving higher inflation expectations.  I don’t think they have to worry too much; median household income in 2016 was $59,039, while in 1999 it was about the same at $58,655.  That is seventeen years!

I was fortunate to see a presentation this summer by Dr. Lacy Hunt.  He showed an enormous amount of historical economic and market data including real interest rates, debt levels, money supply, the velocity of money, GDP, inflation, productivity, and employment measures.  High debt levels compared to GDP, low velocity of money, low productivity, and low savings rates have conspired to keep GDP growth lower than historical averages, both on a real and nominal basis.  Downward pressure on inflation has been the result and Fed actions are only pushing inflation lower.  Tightening will bring higher short term rates, but may push GDP growth and inflation even lower.  We really don’t need either one to move lower right now.  Dr. Hunt demonstrated through his research that the extremely high debt levels are keeping GDP at low levels, keeping inflation at low levels, and keeping long term interest rates at low levels.  He believes we will remain in this situation for the foreseeable future.

Fiscal Policy
We are not seeing activity from Washington DC.  There have been several failed attempts to repeal and replace Obamacare.  Tax cut and tax reform proposals have been floated.  I really didn’t hear much about helping small business in them.  There isn’t much mention of infrastructure projects.  We are at a standstill when it comes to fiscal policy.  I believe that tax cuts will spur economic growth, but only if they do not increase government borrowing and the federal deficit.  As Dr. Hunt would indicate, increased government borrowing would only exacerbate the debt-to-GDP ratio, which has been greater than 100% for the past six years, and further weaken economic growth.   

Many other good ideas have been presented, including ones to improve education, job training, and worker skills to better match the job openings of today and the future.  We have seen the elimination of several regulations; the lifting of burdensome regulations will help everyone.

The Kilonova
Did you see the major announcement by astronomers on October 16th?  NASA captured pictures of an extremely huge collision of two neutron stars.  This occurred 130 million years ago, but the signal didn’t get to Earth until August 17th, which was only a few days before the solar eclipse in the US on August 21st.  (We managed to score some of the eclipse glasses and observe the 80% eclipse here in PA).  The collision is called a “kilonova,” and it led scientists to see bright blue debris and massive amounts of platinum, uranium, and gold being created.  In fact, there was an estimated $10 octillion in gold created!  That is $10 billion, billion, billion.  Now that would create some economic growth!

Thanks for reading!  DJ 10/17/17

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.