We recently noticed a new account on the Twitter, @colarion, a "bank-centric avatar," tweeting about a subject we've been thinking about recently: small banks. Here's our interview with the author, Sam Haskell of Colarion Partners.
Tell us about yourself and Colarion Partners... what do you do and how do did you get started?
Colarion Partners, named for two daughters, isn’t actually a partnership but an advisory managing separate accounts. The name was a twist of history back when I considered a fund, but ultimately chose an advisory because the structure was more client friendly.
I spent two years after college at Morgan Stanley in New York, before coming to help grow the bank-focused capital markets business at a hometown brokerage firm of Sterne Agee. I worked with financial-focused fund managers there from 2002 until 2014. After leaving, a former client with a large account we worked on successfully together through the years reached out for some help, and that began Colarion.
The firm manages both bank-specific strategies and broad-market strategies. As a result I have two jobs: (1) Get clients’ asset allocations right by turning the “aggression” dial. The most common tools are stocks, cash, and metals; we do little bonds outside of a handful of preferreds. (2) Outperform the financials sector. Not every client has the same approach but we generally have been able to do with room to spare, particularly in the first quarter of this year.
A statistic we saw is that "75% of banks today trade below TBV — more than 2011 (71%) and 2009 (66%)". What are you seeing? Do you think this is a singular opportunity?
To your first question, the market strongly dislikes spread revenues. The short-term concern is over credit and margins. However, credit marks in recent mergers are 1/6 the level of 2009 mergers. In other words, PNC took a 17% loan mark when purchasing National City, but the average of 6 recent merger credit marks is around 3%. This is after a deep third-party dive from people whose job is to mark loans. It’s not clear the broader market has grasped this signal. On margins, again the market is downbeat, but many banks forecast slight margin rebounds in 3Q and 4Q as PPP is forgiven and deposit surges are spent down. Still, keeping margins up will require intensive management in the years ahead.
Longer-term, there is an underlying concern that our debt levels are slowing growth and building fragility, while we are becoming European or Japanese. I address this at my blog, with the point being that our economy may have excess debt but our banks are too well incented to step on rakes to the same degree foreign banks have.
On your second question of opportunity the answer is generally yes. Both good and bad banks are being bunched together under book value, and over the course of 2021 their performances will diverge widely. On the one hand, broken business models such as Ameriserv or Carter Bank and Trust are prone to maintain wide discounts until or unless they are fixed. Others, such as MVB Financial or FS Bancorp are motivated and differentiated and could return to a multiple above tangible.
Most Colarion bank portfolios are in that latter group of banks - carrying a catalyst to bring money flows in, yet trading below tangible book value.
Finally and to be more specific on catalysts, these will include repurchases, followed by both pickup in mergers and upward EPS revisions, which in turn bring quant and allocator monies back into the sector. In combination these inflows could be sufficient to rerate the sector 20-30% higher, with management teams that repurchase earlier seeing more EPS pickup than management teams who wait.
Would you agree with the notion that some sectors like FAANG/tech are a bubble, and some like banks are an "anti-bubble" right now?
I don’t foresee a FAANG collapse, just a broader dispersion of the Federal Reserve’s $4 trillion springtime injection that was forced into that element of the market. Just as US consumers shut off travel spending and piled into durables sold by Home Depot et al in mid-2020, so the market shut off financials and energy and piled into tech and utilities, among others, for short-term gains. Today, travel spending has gradually rebounded, and so too have some of the cyclical stocks started to show life.
With that said, investors are still looking for these themes in banks. Live Oak Bank, which focuses on fintech, is up over 100% in the past year, and First Republic Bank, which caters to wealthy investors and is seen as particularly stable, is up 33%. Do not be surprised if investors begin to look deeper into the sector and spend on other differentiated banks in the months ahead.
What are the features that distinguish between banks at a premium to TBV and banks at a big discount? Is the market right to distinguish but just wrong on price?
“Management” is the simplest answer, because managements can control capital use, efficiency, credit and net interest margin. Together these drive long-term profitability and valuation.
One of the most important tools of management today is capital management. At deep discounts to tangible book, at which banks are akin to the “Net nets” that Benjamin Graham sought, is management doubling down on a low-value loan strategy or will they add to tangible book by repurchasing shares?
Use two Richmond banks as examples - Bay Banks and Essex Bank. BAYK, which recently chose a merger partner, has chosen to take risk at small spreads by growing loans. The management, which owns little stock, has even considered a dilutive equity offering. ESXB however is working to protect margin and would like to repurchase with its excess capital. Over time ESXB shareholders may be happier with their investment.
It looks like there are a set of unprofitable or barely profitable small banks trading at half to two-thirds of TBV and a set of solidly profitable (7%+ ROE) banks trading at more like three quarters of TBV. Would you agree? How do you decide between them, or do you buy both?
Many of the cheapest banks are value traps because they put shareholders down the list of priorities. Some, like Ameriserv or Amalgamated, are upfront about that but most, like Glen Burnie or Peoples of Biloxi, think they are executing as they should. The only reason many of these are even as high as 50-60% of tangible book is the possibility of a 70% premium merger, as happened with Standard Bank (STND) in Pittsburgh a few weeks ago. Still, these mergers are usually too slow and too infrequent to warrant ownership.
It is another story if there is a twist, such as the new management at First Bancshares of Missouri a few years ago, a buyback at First Financial of the Northwest, or a potential “double barrel” like buyback and ultimately Russell inclusion, which is a possibility at 3-4 banks trading in this range.
We did a blog post about the big share repurchase at Crazy Woman Creek Bancorp. You've been tweeting about a big Hilltop Holdings repurchase. Are these cannibals the best bet? What else is in your "bank buyback basket"?
I believe the opportunity is mostly behind us for those two. While their tangible book and earnings per share will now jump, they appear to be spending most or all their excess cash. Ideally we want to own banks at the front end of this catalyst. There are about 35 banks repurchasing and another 50 or so who may soon begin, so we should soon have plenty to choose from.
To be more specific on buyback catalysts, the ones we like include: (1) Thrift conversions with stable credit and 15%+ capital well under TBV. Clients own 3 of these. These companies can repurchase for years, generally up to tangible book. (2) High quality management teams. Holdings in Washington state and West Virginia fit this criteria. Mortgage gains fuel recent buyback activity at these two companies. (3) “Double barrels”: 10-15 banks are repurchasing or will soon repurchase and are possible entrants into the Russell 2000 index in coming years. Colarion is currently raising funds to allocate into this strategy.
In contrast, highly inefficient banks, banks with limited excess capital, or banks trading at or above tangible book value are less appealing buyback candidates.
How would you construct a bank portfolio right now to take advantage of the valuations and negative sentiment? Would you do a big diversified basket, or concentrate based on quality or some other feature?
There are too many flawed companies in the sector to pursue a diverse basket.
Current themes in client portfolios include accretive buybacks, fintech elements, Puerto Rican oligopoly / stimulus / buyback trade, and Russell 2000 potential. A commonality across these positions is to locate a future significant buyer (buyback, ETF, spinoff or merger) for a given position.
What do you think of activism for banks? Is "elbow grease," kicking out management, the way to create value? Do you see easy ways to improve profitability if you could get control of a small bank? Or is it better to go with a diversified basket strategy?
I am increasingly writing letters to boards in the event there are easily remedied issues. A California bank that historically has posted strong results recently had issues with a merger, decided against joining the Russell 2000 without knowing exactly why, and fired a strong CEO without having a successor in place. Colarion shared some thoughts with the board and I may become more proactive depending on their response.
Activists typically use force and fear with management teams, but I try to use greed, done outside the public eye. This is the same strategy that has been used very successfully by two long-term investors in the sector.
Do you have any overlap with the Stilwell bank portfolio? We took a look at the eight banks he mentions in his Section 13 filings as current targets, and we see that they are almost all profitable, between half and 85% of book, and do not have majority owners.
I often overlap with Joe, including three positions in 2019, but part of the trick with these positions is it helps to be in an active M&A market, and it helps to be in positions he is focused on. His portfolio is much broader than in years past and he cannot fight 10 proxy fights at once.
Also - and I believe Joe understands this - the M&A market is changing, as branches used to be considered an asset but may now be considered a liability. We can’t simply own thrift conversions and assume a buyer will appear in the third year. The value is often in the underlying commercial relationships, not the brick.
Do you like banks as a business for the long term, or just the cheapness right now?
I like unique stories with motivated managements, and appreciate that many are currently at low multiples. I dislike most commodity banks. Clients don’t own Regions or Key today and likely won’t in the future. Truxton (TRUX), Esquire (ESQ), or Live Oak (LOB) are the types of banks typically in client portfolios.
How exposed would a basket of undervalued banks be to a big macroeconomic shift, like a big rise or fall in interest rates, or a bad recession?
It depends on the positioning. In 2009 both the balance sheets and the shares were demolished, because bank capital levels too low, the recession hit the wealthy, and investors entered the turnover-exposed.
In 2020 balance sheets held up because the recession largely spared the wealthy and capital levels are 40% higher. Shares were hit however because again, many investors were fully allocated / levered.
If another recession hit, I would expect far less impact on shares and bank results, if only because both investors and companies have been de-risking as regularly happens in a cycle. The more time passes however, the more susceptible the group would be to a shock.
A final point here – Louisiana Bancorp was an example of an overcapitalized conversion that made it through 2008 down 2% if memory serves, outperforming the S&P by 80% over its life before selling in 2015. Consistent repurchase capacity is usually undervalued in the market.
What distinctions do you draw between banks like CRZY or HTH and the mega-cap low P/TBV banks that you'd see in this S&P list of low P/TBV banks. Are CIT and C cheap too, or just superficially cheap?
Citi has a 2.14% margin and CIT is at 1.70%. In other words, their baseline customer is borrowing at Libor + 200, and if either bank is adding any value, they certainly are not charging for it on either side of the balance sheet. Further, when margins are this thin, it’s difficult to earn 10% return on equity without using elevated leverage. The bank is therefore in a trap and the market has accurately diagnosed their ongoing business as being basically worthless and suggesting the bank wind up.
However, these banks haven’t gotten the message and attempt to continue to grow. So instead of running off low margin business, building capital and repurchasing, as Bank of Hawaii and City Holdings of West Virginia did in years past to drive shares much higher, they have become call options on higher interest rates, which is how I would use them in a portfolio.
Crazy Woman and Hilltop have different models with much more flexibility, though Crazy Woman seems to need scale.
Sometimes we liken small banks trading below TBV to closed end funds trading at discounts. Except you'd probably never see a fixed income closed end fund with non-defaulted debt trading at half of NAV. Is this an apt comparison? You wonder why Bulldog Investors / Special Opportunities Fund doesn't trade out of their discounted CEFs and into banks at a bigger discount?
Banks are closed end microcap bond funds but with a special funding stream added on. To the degree banks can continue to lower expenses by closing branches but holding onto customers, they will become more like these funds. Many could then reduce their discount assuming proper underwriting. In meantime, any fund or bank can grow per share NAV by using excess capital to buy those shares in. It’s valuable information in the near and long-term to see who chooses this route.
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