Friday, April 11, 2014

Determining intrinsic value for a bank; why discounts to book shouldn't persist

My last post generated quite a response.  Between investors thanking me for the idea and others accusing me of pumping and dumping the stock the most interesting response was an article posted on Seeking Alpha.  The author goes to great lengths to explain why at 40% of TBV M&F Bancorp is fairly valued.

I don't have any interest in getting involved in online debates, if I did I would have posted a comment.  Instead I want to further explain my thinking on banks and show that even an unprofitable or marginal bank has a lot of value.  I don't expect everyone to agree with me, that's what makes a market.  I'm also happy that there are investors who will pass over what I consider obviously cheap stocks, if there weren't I might not have an opportunity to buy them.

In Security Analysis the concept of intrinsic value is defined as the value a well informed private market buyer might pay for a business.  A company's intrinsic value is the amount that both the buyer and the seller would consider fair after extensive due diligence were performed.

Public market and private market transactions differ greatly with the private market being much more efficient.  Private companies are often sold at or near their intrinsic value.  This is because both the buyer and the seller come together and determine a mutually agreeable price.  Outside of unusual circumstances prices paid are reasonable for all parties.  The dynamics of a private market purchase are different than a public market purchase.  In the private market an acquirer sees a company that they believe they have the operational wherewithal to improve.  The acquirer doesn't mind paying a fair value because they believe their expertise, or existing systems will allow them to generate better returns with the company they purchase.  Explained another way private transactions are operationally focused whereas public transactions are financially focused.

The intrinsic value of a bank is no different than the intrinsic value of an industrial, or insurance company.  A bank's intrinsic value is what a well informed buyer and well informed seller would mutually agree on as a fair price.  The question is then, how do we get that value?

One of the reasons I love banks and banking is because they're very easy to compare.  Consider two banks in the same town across the street from each other.  Their business is the same, they both take in deposits and make loans.  If the banks aren't making the same returns it's interesting to consider why.  Why are two companies located across the street from each other generating different returns from the exact same business model?  Maybe it's marketing, or the culture of the employees, or the color of the toasters they're giving away.  It isn't as if one bank can make better loans than the other, often their rates are the exact same.

In this scenario what's even more fascinating is that when the outperforming bank purchases the underperforming bank the underperforming bank becomes outperforming.  This suggests that performance has nothing to do with the location or the product, but the culture and how the bank is managed.  This is true across banking and other industries as well.  A friend related a story recently about how their company purchased an underperforming location and after instituted some of their cultural practices saw a remarkable change in profitability at the new location.  The new location contained the same employees doing the same job as before, but with different motivation and new management they were able to execute at a higher level.

I met for coffee with a local former bank executive back in the fall and he walked me through how a banker views a bank acquisition.  I made a reference to the methodology in my Versailles Financial post.  Incidentally PL Capital, a well regarded bank financial-focused hedge fund walked through a similar valuation methodology during their recent Value Investing Conference presentation.

The idea is that the value in a bank lies in the ability to remove costs post transaction and better utilize the assets.  A perfect example of this might be some of the small banks that are making $10-15k in net income a year.  Most if not all investors look at banks like that and throw up their hands claiming that anything a 2-3% ROE is worthless and should trade at 50% of book value, or at the very least passed over.  Fortunately that's not how bank acquirers see a bank like this.  They see a bank where if the CEO were gone ($250k salary), the CFO were gone ($150k salary), and the CLO were gone ($150k salary) salary that $550k in operating income would almost magically appear on the income statement.  This doesn't even begin to factor in the integration of a better core system, or branch efficiencies, or culture changes that can lead to growth.

The problem with small banks is they don't have the scale to outrun their costs.  But larger banks, or the combination of two or three smaller banks do have that scale.  Once those cost hurdles are removed the acquiring bank can reap near-instant profits by simply removing top executives and putting into place simple cost saving measures.

I put together a small table from CompleteBankData.com showing the average efficiency ratio of all banks broken out into different asset ranges.  All of the ranges are in thousands, so for banks from $0 in assets to $100m in assets the average efficiency ratio is 153%.  An efficiency ratio this high means that the bank's expenses are 153% of their revenue.  You can see that as banks attract more assets their efficiency ratio drops dramatically.  Simply moving from below $100m in assets to above brings enough efficiencies that most banks in that category have the chance of being profitable.


When I invest in banks my goal is to find banks where I can look past their current situation and see something more valuable.  I try to see valuable deposits, or an under utilized assets that can be re-allocated to a higher purpose under a different management team.

The major criticism I'll receive on this post is that my line of thinking relies on a bank merger or catalyst to unlock value.  Many investors don't want to invest in a company that needs a merger or dramatic corporate action to unlock value.  My response to them is that there are many companies earning 10-15% returns on equity that are trading at fair prices worth purchasing.  I prefer to purchase undervalued companies without knowing how or when value might be unlocked, but I am confident that it will eventually.

I remember in 2010 a few investors were talking about idea of permanent net-nets; companies that seemed like they'd been in the results of net-net screens forever.  I'll point out that none of those companies are net-nets anymore, they have all appreciated significantly.  I am proposing the same thing for undervalued banks.  With a terrible crisis in our rearview mirror some investors are making the claim that 40% of TBV is a fair value and that many banks are so terribly run they will never be worth book value.  That's crisis thinking, a bank like M&F Bancorp has a lot of value to an acquirer, and ultimately the fair value that I base my investment decisions on is what I think a private acquirer might pay.

My investment philosophy doesn't rest on the theory that every company I own needs to be acquired. Rather I believe that if something is fundamentally cheap eventually an acquirer, or other investors will take notice and the price will rise accordingly.

If you're interested in seeing how CompleteBankData.com can simplify your bank research, or help you find profitable bank investments sign up for a trial and see for yourself.

Disclosure: Long M&F Bancorp.  I receive a small commission for items purchased through the Amazon link above.  Prices through the link are the same as if you went to Amazon.com directly.

9 comments:

  1. Nate,

    Imagine you were a PE investor or a search fund guy looking for a scalable business. Why wouldn't you use your CBD tool to go find a bunch of undervalued banks and roll them up into your own bank holding co.?

    Or would you?

    It seems like a very simple and scalable model with current undervalued acquisition opportunities. Now, granted, if you're acquiring you'll probably pay closer to full value than the current bargains but it just got me wondering...

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    1. Taylor,

      This is a great idea, a bank acquirer could easily use the tool to find potential acquisitions. It isn't much different than how any investor would use the tool to find banks to invest in.

      I think the problem with a rollup model is you need the bank regulator's approval to buy above a certain threshold of a bank. For someone who has these qualifications a rollup makes a lot of sense.

      Nate

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  2. Banks are the ultimate commodity business. What separates one bank from another is obtaining revenue outside of the net interest margin side. JP Morgan, Wells Fargo, US Bank, NY Bank Mellon are great examples of this. Small community banks are just a play on how steep the yield curve is going to get in the future. Sure some of these banks got niche businesses, but with internet banking gaining steam these businesses won't have the capital to spend on technological innovation to keep up.

    Consolidation is the end game for this industry so why not just stick with the inevitable winners? On a depressed earnings basis the major banks are still solid values. Plus you got the back stop of the Federal Reserve to keep you sleeping well at night!

    -DL

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    1. Yes, it's the side business that adds value for sure. A lot of community banks have specific niches like auto lending, or certain types of construction lending etc. Some have valuable financial advisories too.

      If I understand you correctly you'd say just buy the largest banks and wait for them to acquire others? I think the problem with that is the larger banks have reached their limits and regulators are preventing them from growing via acquisitions. Look at Capital One's purchase of ING Direct as an example.

      Maybe another way to play it is by identifying acquisitive regionals that will be the winners. In your view who are the winners going to be?

      I'm terrible at identifying winners ahead of time, but I seem to do alright identifying cheap things. I'm going to stick with what I'm good at.

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  3. Nate,

    It’s a fantastic thing that regulators are preventing the big banks from making any more stupid acquisitions. They will be forced to innovate by investing in technology and returning capital back to shareholders (utility model). The big banks don’t have to do a damn thing, but watch themselves get larger and larger over time.

    Look at the FDIC data on deposit market share in the US and go back 20 years. I believe the top 10 banks controlled 20% of the deposits and today it is more like 55%. See the trend? You don’t need to have a high IQ to figure out what’s the end game. The banking system in Canada shows you what the end result will be.

    Here’s something to think about. Right now all the banks are enjoying low costs on their deposits and many of them have more deposits than they can lend. How many of these deposits are gonna shift to other institutions when short term rates begin to rise? Old granny is gonna move her money to CD’s offering higher yields from her community bank in an instant since she needs income to live off. On the other hand when you look at the major banks they have engineered clever ways of keeping their deposits “sticky”. What, you don’t have the minimum $5,000 in your checking account? You have to pay $10 per month or whatever they charge. Throw in all the other services the major banks can offer online and the constantly improving technology it’s gonna be a hassle with deal with a smaller community bank unless they are willing to give back some of their earnings to the customer.

    Yes there’s value in the smaller community and regional banks, but when you compare the expected long term returns to the larger US banks… the discrepancy isn’t that large. May as well buy once and collect dividends till the end and avoid paying capital gains or margin your gains and purchase other cheaper companies down the road.

    -DL

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  4. It was a much bigger deal back in 2010/2011 than it is today, but my biggest worry would be that book doesn't reflect reality. Some community bankers don't want to or just can't (to maintain the illusion of sufficient capital ratios) mark their books. You saw (and still see to a lesser extent) a number of marks to the loan portfolio when an acquirer's loan team comes in and does DD. My favorite metric on some of those M&A presentations was Price / Adj. Tang. Book.

    But I believe you are thinking about it the right way through an acquirers eyes. C-suite headcount/public company expense are easy culls for a larger institution. That's not even considering eliminating some of the branch footprint.

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  5. Your valuation method is essentially the same which we used to value small businesses when I was doing a student project for one small consulting office. That is also the common sense method that all businessmen understand regardless of their educational background (no need for CFA).

    (Just for side note we didn't use the model because we were thought to do the valuation that way in school, but because the boss said it was simple and it works and it gives the right answer.)

    Like the SA article shows, one can find justification for any price prevailing in the stock market from "higher mathematics" (as Ben Graham put it). In this case low ROE -> sell your stock significantly below liquidation value.

    -Epa

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    1. I don't think that low RoE/low PBV is higher math as Graham put it, but very straight forward valuation. If capital is stuck in an investment earning returns on invested capital lower than the cost of capital, that investment is destroying value hence the discount to book. It could be invested in the broad market and then it would be worth 1x book. It is true that those same assets of a low RoE bank would be worth more in the hands of another owner. And that's the crux, it is only worth more in those hands, so this approach still seems to me a big gamble on M&A. Seeing beyond the current situation I absolutely agree with but this is purely betting on an acquisition. That might work with a basket of such stocks but not with a single one. In Japan you have numbers of banks that continue to run on a stand-alone basis and trading below book for a decade now.

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  6. Nate,
    Do you consider a bank's underwriting/profitability history when selecting banks below 1x book?
    Thanks

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