Saturday, August 25, 2018

The Real Reason for Bank Scale: Trading Multiples

"Get big or get out." "You must be twice the size that you are to succeed." These are bromides that some industry talking heads might be telling you. I hear it and read it frequently. And in today's social media, non fact-based opinion society, if you say it enough, people may start to believe it.

I moderated a strategic planning retreat with a bank that achieved top quartile financial performance. Their growth was solid too. Their asset size was less than $500 million. A director challenged me: Does our size matter so long as we continue to perform the way we have performed? My answer: Not really, with one exception.

Trading multiples. I referenced this phenomenon in a 2013 blog post, Too Small to Succeed in Banking. In that post I opined, "As we migrate towards greater institutional ownership, stock liquidity is becoming increasingly important." What I said then likely remains true today. Institutional owners (funds, etc.) now own two-thirds of shares outstanding in publicly traded US banks. 

But why does this matter to my sub $500 million in assets bank client?

So I ran some charts for you (courtesy of S&P Global Market Intelligence).

The bottom table was a bonus so readers can see that at the end of 2017 bank p/e's relative to the S&P 500 p/e surpassed their 10-year median in every asset category. Significantly so for banks $500 million to $5 billion in assets. So, on a relative basis, valuations are higher. 2008 was an anomaly because the S&P 500 companies traded at stratospheric p/e's because they had no "e".

Back to my main point. Over the past 10 years, banks that have less than $500 million in total assets have traded at lower price-to-tangible book multiples. In every year. And the differences in multiples match up nicely by asset size. The price-to-earnings chart is a little murkier based on the choppiness of earnings. However, investors tend to value smaller financial institutions more on book value than earnings. A good earner, like my client, tend to trade at relatively low p/e's because they have great earnings. 

Does that sound right? Earn better, and get rewarded with a lower p/e?

Fair is in the eye of the beholder. If you remove nearly 2/3 of the potential shareholder base because you have little daily trading volume, then you have less buyers seeking your shares. Supply and demand.

And that is where the economies of scale argument has merit. If you intend to remain independent, and continue to perform well and grow sufficiently, then you are likely delivering total returns acceptable to shareholders. Even without trading multiple expansion.

But if you would like to acquire a nearby financial institution, and you are trading at lower trading multiples than other would-be acquirers, you would be at a disadvantage. Your "currency" isn't worth as much as your larger competitors. Which may also make you vulnerable to an aggressive buyer's offer to buy you, if the buyer is large and has much better trading multiples than your bank.  

Fortunately, unsolicited offers are not common in our cordial industry. But we shouldn't rely on it.

~ Jeff

Sunday, August 12, 2018

Guest Post: FInancial Markets and Economic Update by Dorothy Jaworski

Economy and Momentum

At the end of June, 2018, the current economic expansion turned nine years old.  We have one year to go to match the longest expansion since World War II, which was the prosperous period engineered by Maestro Greenspan from March, 1991 to March, 2001.  He also ended that expansion by tightening and then keeping interest rates too high for too long.  After easing and keeping rates low

for three years, the Fed began tightening from June, 2004 to June, 2006.  By the time it was clear to all of us that the economy was being dragged down by the housing and mortgage crisis, the Fed finally lowered rates, but it was too late.  They were forced then to take rates to zero to deal with the financial crisis.  Rates that were too high did not cause the crisis, but certainly did contribute to it.  And here we are, all of these years later, looking to match the record length of GDP growth of ten years and watching a Fed that continues to raise interest rates.  We know that even the best of them raise rates too much, keep them too high for too long, and then are forced to lower them to try to save economic growth, usually too late.  There was a reason they had to lower rates to zero and keep them there for seven years.

Five more quarters to go and I believe in 2019 we will set a new record length for an expansion, albeit without hitting 3% GDP growth for any one of those ten years.  This is because the economy has been gaining momentum, however modest, from the tax cuts and deregulation.  The economy has grown 2.2% annually since 2009, while the record expansion of the 1990s saw growth of 3.6%.  The second quarter of 2018 saw growth of 4.1% (the highest quarterly growth since 2014) and the third quarter may be close.  Growth for the entire year of 2018 is expected at 2.8% and 2019 at 2.4% to 2.5%.

Why Worry?

You know me by now.  I worry about the economy and the Fed’s tightening campaign.  In my career, I’ve lived through many years of the Fed raising interest rates and it’s my experience that they usually tighten too much and keep rates high for too long, just like in 2001 and 2006-2007.  And does the following sound familiar?  They often cite unemployment they think is too low and inflation that could soar as their reason to keep raising rates.  They often fail to appreciate the message of the flattening, or inverting, yield curve.  Their reliance on the Phillips Curve continues to surprise me.  Unemployment is low, but there is considerable capacity in the higher pool of available workers and wage increases remain modest.  Inflation had risen earlier this year, but has been heading back down recently.

As well as the economy has been doing from the momentum of tax cuts and reduced regulation, there are always looming issues.   Consider the trade wars and tariffs.  There are some signs of slowing in the housing markets; both existing and new home sales in June fell amidst rising mortgage rates and fewer gains in home prices.  The flat yield curve is showing the pressure on short term rates to rise from both the Fed and unusually high issuance of T-Bills by the US Treasury, while longer term rates are sensing that inflation is falling back and growth may eventually slow.  Hedge funds are not happy with longer term rates as they keep shorting Treasuries and futures, expecting rates to rise and they do not.  The 10 year Treasury has touched 3.00% once in the past several months and is hovering just below that level at 2.95%.  The two year Treasury today is 2.66%, so one can see how flat the yield curve has become.  By the way, JP Morgan’s CEO, Jamie Dimon, recently said he thinks the 10 year Treasury should be at 5%...

Debt levels are still extremely high and economic growth will be restrained if debt service is not covered by income growth.  US Treasury debt now stands at 103.9% of GDP; levels above 90% have been demonstrated to slow economic growth.  Aha!  One of the causes of low growth since 2009 is uncovered!  Low productivity continues, just as it has since this recovery began in 2009, averaging only 1.3% since that time.  Low productivity is often associated with weak economic growth.  Another of the causes of low growth since 2009 is unveiled!  An obvious one is low inflation.  Gas prices pushed above $3.00 per gallon a few months ago and could lead to slower consumer spending.  And for all of the Fed watchers out there, money supply growth, as measured by M2, has continued to weaken on a year over year basis, from +7.1% for the year ending June, 2016, +5.6% for the year ending June, 2017, and +4.2% for the year ending June, 2018.   Milton Friedman, anyone?

In our local area, we are still seeing modest growth in Philadelphia and surrounding counties.  The Fed’s Beige Book remains fairly positive, citing “modest” growth.  Housing has done well, despite median sales price growth which is less than national averages and lower inventories of properties for sale, which may be propping up prices.  In 2Q18, Bucks County median prices rose year-over-year by 3.9%, compared to the national Case Shiller index at over 6.0%.  We have to live with national interest rates and the Fed and the yield curve affect us all.

Regardless of what I may worry about, we are faced with the reality that The Fed continues to indicate that they will raise interest rates- one or two times more in 2018- and several times in 2019.  Short term rates will rise along with them.  Long term rates may hold steady, unless stronger inflation makes a comeback, or may begin to fall back if economic growth slows.  Let’s hope we make it five more quarters to a record expansion before that happens. 

Globe Trotting

We were on vacation in Paris during July and got to experience France’s semifinal and final wins of the World Cup.  The streets of Paris looked just like South Philly after the Super Bowl win.  The fans there are as passionate as Eagles fans, but I will keep that a secret.  Philly has a chance to go wild again this year if the Phillies keep playing well; they are in first place for the first time since the end of 2011.  We also traveled to Metz and Normandy and accepted more honors for my Uncle Stephen by the great French people who live along the Moselle River.  We stood on Omaha Beach, with families enjoying vacation there, paid tribute to the fallen soldiers at the Normandy Cemetery, and climbed the 900 steps to the top of Le Mont Saint Michel.  Along the way, we witnessed building construction and renovation in Paris and in the small towns of France, showing an economy on the way to recovery.

Our economy here in the US is gaining momentum, too, especially on the concert circuit.  I got to see Rod Stewart again last week.  Life is good!

Thanks for reading!  DJ 08/09/18

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.