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.