Have you considered banks for your investment portfolio? If not, you may want to reconsider. You see, banks become an attractive sector for finding investment ideas when the yield curve steepens, making banks more profitable. That’s the scenario we’ll likely be facing if the Federal Reserve begins to taper and lets longer-term rates rise. In this article, you’ll learn more about the fundamentals of investing in banks so you can decide for yourself.
Fundamentals to Consider When Investing in Banks
5 Categories of Investable Banks
The banking universe can be broken down into several financial institution categories:
1. Money Center Banks
Money center banks are very large global/national banks such as JP Morgan, Bank of America, Citibank, and others.
2. Super Regional Banks
Super regional banks are banks with large market shares in certain parts of the country. For example, Regions Financial operates in Birmingham, Alabama. Others include Fifth Third Bank out of Cincinnati, Ohio, and Truist based in Charlotte, North Carolina.
3. Community Banks
Community banks are local neighborhood banks. You’ll find thousands of them that are publicly traded. An example is Lake Shore Bancorp, Inc. (the link will take you to an interview with Lake Shore Bancorp CEO and CFO).
4. Consumer Banks
Consumer banks or retail banks provide financial services to individuals; these include credit card companies and auto lenders). Here are a few examples:
- Capital One
5. Fin Tech
FinTech or financial technology represents new technologies for delivering financial services to clients. Think of PayPal, Apple Pay, and SoFi.
What About Credit Unions?
Credit unions aren’t publicly traded so aren’t part of the five categories of investable banks. Interestingly, credit unions are actively buying community banks. This is a newer phenomenon and will be around for a while.
3 Drivers of Bank Valuation
Broadly, banks have three drivers in their valuation for investment:
- Loan generation business
- Deposit franchise
- Non-interest income
According to the Corporate Finance Institute,
“In the United States, banks are required to retain 10% of the customer deposits as reserves, while using the other 90% to provide loans.”
As you might imagine, interest rates – and more specifically the interest spread between deposits and loans – directly affect the loan generation business. Banks use depositor money to make loans at a higher interest rate than they pay on deposits thus capturing a spread. If the interest rate yield curve gets steeper, that spread is wider and the bank makes more money. The slope of the yield curve has been a significant headwind for banks since the Fed began extraordinary measures to deal with the 2008 financial crisis.
Deposit franchises and related locations give a bank market share and become attractive to acquirers based on the geography of locations that can enhance the current position in that location.
Non-interest income includes income from insurance or securities brokerage, mortgage sales, and investment services, and trust management. Non-interest income seems to be growing for banks and at present is not much of a concern.
Bank Trading Multiples
Currently, banks trade at much lower multiples than the overall market. The market currently trades at 25 times estimated earnings while banks in the universe we follow typically trade at 15x or less. With improving profitability, this may represent a bargain.
Price to Tangible Book Value
In addition to Price to Earnings when looking at banks, one should consider price to tangible book.
Tangible book value is the assets minus any intangibles minus liabilities. It gives a very rough estimate of a bank’s liquidation value. If you can buy bank stocks close to tangible book value, you are getting some form of a margin of safety.
Banks and Credit Quality
For an investor, the biggest Achilles heel for banks is credit quality. In times of economic stress, borrowers default on their loans. This usually results in a big hit to a bank’s tangible book. Credit is the greatest risk of buying a bank’s stock.
Credit runs in cycles. During an economic expansion, borrowers borrow more whereas, in a recession or other economic downturn, they default. It’s critical to know where you are in the economic cycle. At this point in the cycle coming out of COVID with incredible amounts of government support, loan losses are low and are likely to stay there for a while making credit quality less of a risk.
How Have Banks Weathered COVID-19?
The COVID-19 pandemic created a great deal of concern for banks. However, the continuing economic recovery and the tailwinds created by government economic support raised bank share prices.
As a result, banks are now able to reverse the hefty loan-loss reserves they were forced to create when the pandemic began. With the help of the Federal Reserve and fiscal policy, actual loan losses during the pandemic were relatively small. Banks’ balance sheets were historically strong going into the pandemic and were well-preserved coming out.
What is the State of Bank Merger Activity?
Merger activity continues in the banking industry with larger organizations acquiring smaller ones, regional banks expanding to neighboring regions, and, as mentioned above, credit unions purchasing community banks. For example, Pioneer Bancshares operates in east-central Texas with a presence in the attractive Austin market. It is being acquired by Sunflower Bank/First Sun Capital, a privately held company.
The Case for Investing in Banks
1. Bank stocks trade cheaper than the market.
2. Bank profitability is improving with the yield curve steepening.
3. Consumer credit is likely to be good in the short to mid-term.
Community banks trading at discounts to their tangible book or discounts to where peers are trading or to their estimated take-out valuations are worth considering.
Are You Thinking of Investing in Banks?
Are you ready to look for investment opportunities within the banking sector? Pendragon Capital can help you.
Banks that we monitor and consider for inclusion in the Pendragon Capital Bank Investor Portfolio include the kind of banks that took part in the recent “Under the Radar” Virtual Bank Conference events.
Let us know if you have additional questions about bank investing and how banks can be a part of your portfolio.
Thanks for reading.
>> Learn about the Pendragon Bank Investor Portfolio <<
Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.
Photo credit: Irma and Paul Milstein Division of United States History, Local History and Genealogy, The New York Public Library. “U.S. Assay Office; U.S. Sub Treasury; Banker’s Trust Tower; Hanover Bank Building” The New York Public Library Digital Collections. 1914. https://digitalcollections.nypl.org/items/7cb73ce0-b55b-0132-33ca-58d385a7bbd0