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

Bankers: Don't Hate the Dividend

Me to Bank CEO: Have you considered, instead of a growth strategy, maximizing profits and paying out most of it in dividends? CEO: *crickets*

And so it goes with my suggestion that slow growth, superior profits and high dividends is a viable strategy. Particularly for financial institutions in slow growth markets. This strategy could also manifest itself in mutuals and credit unions, as they can pay a bonus dividend to core depositors out of their robust profits.

But as I told one banker yesterday, not many are drinking my Kool Aid. 

Growth is sexy. With growth comes accolades. Management gurus spew bromides such as "grow or die". And so our industry has been cut in half in the past twenty years, because so many of us chose the latter.

I think it may have been a business professor that told me growth above and beyond market growth would only last for a short time. The bank CEO, mentioned above, was asking for my opinion on his growth and acquisition strategy. His market grew at 3.6% the prior year. The market leader, of the "too big to fail" variety, actually grew market share from the prior year while the CEO's bank declined in market share. So they weren't succeeding taking business from the 800 pound gorilla to sustain growth. Nor was their market growing at a pace that would fuel book value and EPS. Hence my suggestion.

When I suggested it he sought examples. I didn't have the answer off the top of my head but he motivated me to look at the strategy from a total return perspective. I have an affinity for total return because it focuses on what you deliver to your shareholders, regardless of how you deliver it. Capital appreciation plus dividends, no matter the proportion. My suggestion to the CEO was 4% EPS growth combined with a 5% dividend yield delivering a 9% total return.

Getting back to my research, I reviewed all publicly traded banks and thrifts with between $1 billion and $5 billion in total assets. I eliminated any bank with greater than a 2% non-performing asset/total asset ratio to control for credit quality challenges that impacts profits and trading multiples. The results are in the below table.

I admit that the lower dividend paying banks delivered a better three-year total return than the higher dividend banks. But not materially so. Certainly not a slam dunk that motivates the vast majority of bankers to opt for a lower dividend, higher growth strategy.

The remaining ratios are very similar: ROAA, price/book, and price/earnings. Shareholders don't appear to penalize the higher dividend strategy by ascribing lower trading multiples to those banks' stock valuations. In fact, by growing slowly, maximizing profits, and paying the majority of profits in shareholder dividends (or depositor dividends for mutuals and CUs), one could argue that this is a lower risk strategy and avoids the roller coaster "high-highs" and "low-lows" that banking's high fliers tend to experience during economic cycles. Lower risk shareholders should expect slightly lower returns. So it is intuitive, right?

But no. Instead, those in slow growth markets set sail hoping to perpetually grow faster than their markets will allow, and rely on acquisitions to stoke their growth. Grow or die. Are we going to get a different result than we have gotten?

~ Jeff

The Law of Large Numbers for Banks and Credit Unions

While a colleague and I sat patiently waiting for our flight, we were discussing an upcoming strategic planning session with a client. He asked what I thought were their chances of success. I thought their future was bright, but pointed to a couple of headwinds working against them. One of them was the law of large numbers.

The law of large numbers in banking requires ever more asset generation as the bank becomes larger to sustain growth. If a bank is publicly held and management tells their investors they shoot for 10% growth, the number gets harder to achieve as the bank grows larger.

This was true of our client, where I estimated they needed between $1.5 billion and $2.0 billion of new loan production to grow their balance sheet 10%. We have many clients that haven’t achieved that total loan size in their 100 year history.

Some banks have done it. One such bank that consistently stunned competitors and analysts with hefty growth was the former Commerce Bank of Cherry Hill, NJ. They did it through rapid branching, buying business in new markets particularly from municipalities, and their reputation (self-proclaimed) as America’s Most Convenient Bank. Their CEO was not as much concerned with top tier financial performance, quarter over quarter, so long as the bank was investing in the growth engine.

Many of us do not have that luxury. So how do we get 10% growth, or deliver double-digit total return to shareholders, as we get larger? Some do it through acquisition. Acquisition criteria gets looser as the bank gets larger and the need to “feed the beast” grows.

But could there be another way? It may be difficult because while the bank was growing, the CEO was touting the growth strategy to constituencies. So changing strategic course calls for strategic leadership.

As it gets more difficult to grow, and as potential acquisition targets decline, could it be time to turn this growth engine into a cash cow? It’s the natural evolution of business. If you’re management team is ideal for your current size and not much larger, and your markets are not yielding sufficient growth, why not maximize profits and reward shareholders, not in the form of robust capital appreciation, but in dividends? Mutuals and credit unions could reward depositors in the form of a special dividend. What a great benefit to bank with you!

The accompanying table shows banks that are growing slowly, yet have superior financial performance and a strong total return to shareholders, delivered in great part by a greater than 4% dividend yield.

Perhaps the bottom two are restrained more by their markets than the law of large numbers. I particularly wanted to throw in the sub $200 million in asset bank to show bankers that it can and is being done at this size. But I ask you, what is wrong with this strategy? If the answer relates to taxes, I’m not sure you’re getting my point.

And my point is this: staking your success to a growth strategy that your management team cannot deliver and your markets cannot support requires you to make acquisitions to deliver the total return demanded by your shareholders. Following this strategy will result in poorer acquisitions, diminished ability to manage a sprawling franchise, and ultimate erosion of franchise value.

Think Sovereign Bank. Do you want to join them?

What’s your number?

~ Jeff


Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.