Video: Opportunities in Banking; My talk at the Fairfax Shareholder Dinner

I recently had the opportunity to attend and speak at the Fairfax Holdings annual shareholder dinner in Toronto.  What started as a small group of Fairfax shareholders meeting in the back of a restaurant to talk about value investing has grown into a large charity dinner that this year hosted 180 investors and investment professionals.

My talk focused on opportunities in bank investments and specifically highlighted two ideas worth further consideration, Eastern Virginia Bankshares (EVBS), and Fifth Third Bancorp (FITB).

The video is on YouTube and can be watched below.  The slides are a little hard to see in the video so I've included a link to the PDF version below.

Slides can be viewed and downloaded here.

Thoughts on risk

I was 12 and the hill looked enormous.  I'd done it in the past with success, so much success that I could almost taste the thrill.  The thrill of riding a bike down a steep hill on a rutty dirt path and then flying through the woods.  The sense of completion from doing something dangerous, and the sensation of my stomach in my throat.  I went first and my friends watched.  Everything started well until my front tire hit a root.  Suddenly I was going faster than my bike, except I forgot to let go of the handlebars.  My bike and I were flying through the air before we finally landed in a jumbled mess on the ground.  The landing left a mark, a scar that took years to fade away.  My friends rode down without issue, they enjoyed the thrill.  At 12 I didn't want to look like a wuss, so I got on my bike and slowly followed through the woods.

The hill wasn't any bigger than it had been in the past, and others navigated it with ease on the day I crashed.  Risk is unfair.  That hill was too risky and I knew it, but I was too young and dumb at the time to not ride.  I took a risk and felt the literal pain of that decision for weeks.  Just because my friends made it down the hill without incident didn't mean the risk was nonexistent.  It just hadn't shown up yet.

The markets are full of risk.  Some might even content that the only thing that matters is risk.  Investors who are riskier earn more, investors who earn less took less risk.  Risk is the storyline academics use to explain market movements.

One thing markets do incredibly well is hide risk.  Millions of investors might buy and sell a company without issue before the company suddenly announces their largest product failed.  If you're the unlucky investor sitting in those shares on that day risk appears in a large way you could face a significant loss.  What was a safe company is suddenly risky with investors running to the exits.  Questions about the company's viability begin to appear.  Investors question themselves on whether they want to continue to hold.

I'm convinced that humans are terrible at assessing risk.  True risk, not the statistical likelihood of failure.  If there is a large enough sample size we can estimate failure.  But even then failure doesn't always happen the same way.  And an exogenous event might increase the failure rate in a way we never understood.

Many investors pride themselves on their ability to predict the future.  I read the recent interview with Stanley Druckenmiller and he calls this one of his greatest assets.  The ability to see a future event clearly and bet the farm on it.  If one has that ability, and judging by his returns he seems to, it would be foolish to not bet the farm.  But not only your farm, the neighbor's farm, the farms of relatives and anyone else's capital you can get a hold of.

I'm terrible at predicting the future.  I can do alright with softball predictions like "more people will use phones in the future compared to now."  But those aren't actionable insights.  Some macro trends are very predictable but impossible to act on.  Like the high school football player trumpeting their success 30 years later I have one prediction I made in college that was 100% spot-on.  I predicted in 2001 that in 10-15 years the internet will fill the air and we'd be able to connect everywhere.  I had imagined some sort of wifi system, but it was the phone system that filled the gap.  I was right, but there was no way to capitalize on it.  Most of the wireless companies at the time are gone now, and the technology has dramatically changed.

While I'm not good at predicting the future I am good at one thing; determining the worst case scenario.  I have a wild imagination and it's not too hard for me to start thinking about driving somewhere for a vacation and end up imagining a collapse of civilization and me sleeping in a tent on the side of the road.

I prefer to view risk in terms of the worst case scenario for a company.  Obviously the survivalist societal breakdown storyline might be entertaining, but it's not a true worst case for investors.  If we are reduced to drinking from streams and eating berries I don't think we'll care much about stocks.

For some companies a worst case scenario is a loss of confidence by their customers.  Business isn't build on the premise of the highest quality item for the lowest price.  It's built on relationships.  A company might work with a higher cost supplier because they like the sales rep, or the supplier is more flexible with some aspect of their process.  Another worse case for a company could be the loss of a critical supplier.  A piece so critical that without it production ceases.

Every business has one or more critical failure points.  Some companies need water, others types of metal, some reliable servers.  The list is endless.

Assessing risk means looking at the worst case scenario and then determining the likelihood that the company can overcome that issue.  If a brewery loses their water supply they can't make beer.  But do they have enough cash that they can pay to have it trucked in for a period?  If they are living paycheck to paycheck the loss of water for a week due to a water main break could be the difference between making interest payments and missing an interest payment.

The riskiest investments are ones where if the worst case scenario were to take place the company could end up in bankruptcy court or in liquidation.  A loss of a critical supplier when no replacement is available, or the loss of consumer confidence due to a fatal error can cripple a company forever.

Companies have the ability to rebound from a variety of problems.  When I was looking at Japanese net-nets there were companies that could last for 20-30 years without another cent of revenue.  Outside of a Japanese Yen devaluation or outright fraud those companies were almost risk-proof.

When looking at risk from a portfolio perspective it's important to dig into the worst case scenario of each holding.  But a potential danger for investors is that they will become too pessimistic and never invest in anything.  I temper my worst case evaluation with my optimistic belief that humans are creative, inventive and resourceful, and when put in a tough situation usually find a way to get out with the least pain.

When considering a new investment I like to think about potential worst case scenarios and their implications for the stock.  Am I comfortable with the downside in each of those scenarios?  If I am and the stock is undervalued then it's very likely I'll buy a position.  Is my risk analysis as precise as mathematical models?  Absolutely not, but I also believe it captures a lot of situations models fail to catch too.  One of the keys to making money in small undervalued stocks is avoiding losses.  While my risk assessment methods might be unorthodox they do seem to work with avoiding losses.

A banking survey of Alaska

What often classifies as an "oddball stock" is simply a company that not many investors have an interest in truly investigating.  Typically these are stocks that are too small for most investors or companies where information is hard to obtain.  Another situation where stocks could be classified as oddballs is when they operate far off the beaten path.  In the US there is one place about as far off the beaten path as possible, Alaska.

Alaska is an enormous state filled with plenty of wildlife, mountains, oil, cold weather and hardy individuals.  The state is more than double the size of Texas.  If the state were a country it would be 33rd in terms of total size, or roughly double the size of Sweden.  The state is disconnected from the rest of the continental US.  An American needs to drive through Canada to access Alaska by land.

The exposure most Americans have to Alaska is a series of shows in the Discovery channel featuring "crazy" individuals who live off the land, drive trucks on ice, or mine for gold.  Alaska in many ways is still considered the frontier and isn't generally thought of as a business destination unless you're working in oil & gas, mining or something related to wildlife.

Even though Alaska isn't  a hot bed of business there are still people who live and work there who need loans and have money to deposit.  In general the state is overlooked, and I imagined their banks would be even more overlooked.  It turns out I was right.

The state has five bank headquartered there and three are publicly traded.  The banks headquartered in Alaska are shown below:

Outside of the five banks headquartered in the state Wells Fargo and KeyBank also branches in the state.  Statewide there are only 130 total bank branches with Wells Fargo claiming the most at 50.  Runner up in the branch count is First National Bank Alaska with 30 braches.  The other six alaskian banks all have 16 or less branches.

The easiest way to look at all of the banks in Alaska is to divide them up between the non-traded and traded banks and look at each.

Traded Banks

Here is a simple comparison showing the historical returns on equity for all three traded Alaskan banks from CompleteBankData.com (Bloomberg Terminal: APPS BANKS <GO>):

Alaska is set apart from the US and their banks appear to be as well.  All three are very healthy and avoided problems during the financial crisis.  Both Northrim and Denali Bancorporation are earning returns on equity above the national average.  All three banks are profitable as well.  And lastly all three have more than 10% equity to assets with low to non-existent non-performing assets.

These are safe and profitable banks.  Is it any surprise that once an investor leaves the mainstream opportunities suddenly present themselves?

Northrim Bancorp (NRIM)

Northrim is a $1.4b bank headquartered in Anchorage, AK founded in 1990.  The bank recently purchase and integrated Alaska Pacific Bankshares (formerly AKPB).

The bank has $966m in loans with the majority of them lent to residential borrowers.  The bank has been profitable since 2003 and sailed through the financial crisis without any issues.  Their Tier 1 capital has remained above 10% since 2004 and non-current loans to loans peaked at 3.66% in 2008.

The bank trades for 1.11x TBV and 12.25 times earnings with a $167m market cap.  Shares are fairly liquid with about 15,000 trading daily.

Our CompleteBankData valuation model (available on the Bloomberg Terminal version) has the bank's estimated intrinsic value at $30.81 compared to the most recent close of $24.44.  The valuation model is shown below:

If Northrim were to be acquired, or to trade in line with the bank index multiples shares should trade higher.  Even without multiple expansion the bank looks attractive.  They are conservative but have been growing steadily over the past decade.  The bank's equity has more than doubled in a decade.

First National Bank Alaska (FBAK)

There is a stigma attached to companies whose stock price is over $100 a share.  An even greater stigma exists for companies with share prices higher than $1,000 per share.  First National Bank Alaska takes it a notch further with their $1,550 share price.

The company is publicly traded, but is closely held.  The bank is the largest of the Alaska banks with $3.3b in assets.  They trade for slightly more than book value and 15x earnings.  The bank has experienced loan and deposit growth in the past three years as shown below (deposits in red, loans in blue):

According to our model the bank is considered fairly valued to slightly overvalued for both our acquisition valuation model and the dividend discount model.  If the bank is valued relative to banking index multiples they are undervalued by 13%.

The advantage that First National Bank Alaska has is that they are the largest bank in the state and they're growing.  Scale in banking matters a lot and First National Bank Alaska has built scale and a brand in their region.  They are consistently growing and pay a nice dividend.  If one wished to have some exposure to Alaska in general a single share of First National Bank Alaska might fit the bill.

Denali Bancorporation (DENI)

Denali Bancorporation is much smaller than the other two, but equally attractive.  The bank trades for slightly more than TBV and 13x earnings.

The bank has $266m in assets and $133m in net loans.  They earned $1.86m this past year, or about $.68 per share.  They have an above average net interest margin and a 16% Tier 1 ratio.

The bank's assets appear to be in check outside of a curious line item in their last two financials.  The bank recorded 44% of 2014 Q3 and 68% of 2014 Q4 US Government guaranteed loans as non-current.  The bank doesn't have any government loans on their books.  This would indicate that the non-current government loans are most likely government backed bonds that have stopped paying interest.

Besides the small size of Denali Bancorporation and their inefficient operations (85% efficiency ratio) there isn't much to not like.  As you can see below they have never earned less than $1.2m in the past 11 years.

The bank has grown strongly over the past decade much like Northrim has.  The bank's size makes it an attractive acquisition target for a larger Alaska bank, or a bank that would like to enter the Alaska market.  Absent an acquisition investors own a nicely growing bank with an attractive dividend yield at 3.45%

Non-traded Banks

The state has two non-traded banks, First Bank, and Mt. McKinley Bank.  Both of these banks are less profitable compared to their public peers.  The reason for the lower profitability is both of these banks are overcapitalized with Mt. McKinley Bank coming in on top with a 39% Tier 1 ratio.

There isn't much to say about either of these banks.  Both are solid performers currently and have been historically.  Neither of these banks lost money during the financial crisis.

Mt McKinley Bank

The bank has $344m in assets and earned a 5.37% return on equity in the last year.  They've remained profitable since their start.  While they've been profitable they haven't experienced much growth.  Their equity has grown from $43m in 2006 to $73m today.  Total loans have fallen from $151m to $130m.  As loans have decreased security holdings have increased.  The bank owned $80m in securities in 2006 and owned $179m in securities at the end of 2014.

First Bank (First Bancorp)

The bank was founded in 1924 and prides itself on being locally owned and operated.  Their branches are located in Ketchikan and around Juneau.

They have $486m in assets and $215m in loans.  First Bank earned 7.34% on their equity.  The difference between Mt. McKinley's ROE and First Bank's ROE is that First Bank only has a 16% Tier 1 ratio compared to the monster 39% Tier 1 ratio that Mt. McKinley Bank has.

The bank could improve their operations some, their efficiency ratio stands at 82%.  Non-current loans to loans are under control at 1.24%.

Summary

A dive into Alaskan banks didn't turn up any banks trading for 25% of book value, which is unfortunate.  But what this exercise did turn up was a set of conservative and growing banks that avoided the housing crisis.  Investors might worry about the energy production drop harming Alaskan banks, or maybe a mining drop.  These are valid concerns, and there will always be dark clouds lurking on any investment horizon.  Alaska is physically separated from the rest of the US and their banks appear to be separated as well.  On a relative basis all are undervalued and all have experienced growth in a flat no growth environment.  Alaskan bank shares might be the perfect investment to make and tuck away in a drawer for a few years.

Want to find more information on how to find and research bank equities on your Bloomberg Terminal with APPS BANKS <GO>?  We recently put together a short video with a walk through and posted it to YouTube here.

Disclosure: Long DENI