By Christopher McGratty
Nearly seven years since the federal funds rate was effectively cut to zero, it is widely believed that interest rates are set to slowly move higher later this year. Whether the inaugural 25 basis point move-up occurs in September or December, timing is now being measured in months, not years.
This expectation for rates—both absolute yields and the shape of the yield curve—remains a driving factor in the performance of small and mid-cap (SMID) banks, stalling the rally in Q1 when rates fell and the curve flattened and subsequently reigniting interest in Q2 when this trend reversed. At mid-year, the KBW Nasdaq Regional Bank Index (KRX)—our proxy for small and mid-cap bank performance—was up 10 percent in 2015 compared to just a 3 percent move-up in the S&P 500. To us, this renewed enthusiasm reflects the anticipated benefit on net interest margins from higher rates, which remains the primary driver of bank profitability today.
That being said, although the group is seemingly back in favor again, we are also respectful of the long-term correlation of bank stock performance and the direction of consensus forward estimate revisions, which this year have fallen by about 3 percent for the KRX versus a 10 percent move up in SMID-cap bank stocks. The result of this divergence has been fairly significant multiple expansion for the group since the start of the year (15.0x versus 13.6x), most notably for banks with above-average growth characteristics and/or those with asset sensitive balance sheets—two investment themes that remain in favor. This development over the past six months has pushed the KRX’s forward P/E above its long-term average (15x versus 14x), leading many investors to question whether this multiple expansion is warranted or if the banks may be ahead of themselves.
To answer this, we first look back at what occurred to the KRX’s multiple—both absolute and relative—during the last tightening period of 2004-06, a two-year horizon where the Fed raised rates in 25 basis point increments on 17 separate occasions by a cumulative 425 basis points. On an absolute basis, the forward P/E multiple of the current KRX constituents was largely unchanged at around 15.5x; however, the multiple on the S&P 500 compressed fairly materially, from 17.0x to 14.5x.
Intuitively, the stability of the banks’ multiple makes sense given the associated earnings benefit from higher short-term rates, while the compression in the S&P 500’s multiple is also understandable given the ensuing slowdown in corporate earnings growth, which declined from 20–25 percent pre-tightening to the mid-teens in the following years. This dynamic drove the KRX’s relative multiple from its long-term average of about 90 percent pre-tightening to over 100 percent by the middle of 2006, implying that today’s 93 percent relative multiple isn’t necessarily cheap, though in the same light, it is not in unprecedented territory.
Said another way, while we believe long-term performance of the banks will ultimately be tied to the direction of forward estimates, we also believe core bank fundamentals today remain quite healthy and that margins—the primary culprit behind the recent downdraft in consensus estimates—is primarily an issue of timing with the trough seemingly within sight.
In fact, capital levels remain at historic highs, allowing for significant deployment flexibility through rising dividends, opportunistic share repurchases or strategic M&A—the latter historically a key consideration for investing in the SMID-cap bank space. In addition, as it relates to growth, we also believe SMID-cap banks have a structural advantage compared to the largest financial institutions—particularly post financial crisis—as banks under $50 billion in assets have consistently shown an ability to grow loans at a faster rate relative to both nominal gross domestic product and their larger peers.
This trend, which has been occurring for several years, is supported by the fact that the largest (and often systemically important) banks continue to exit businesses and divest assets, thereby opening the door for the smaller, more nimble, institutions to step in and opportunistically take market share.
That said, the group isn’t without its challenges—in our view, most notably a lower return profile today relative to pre-crisis, which is a function of the revenue implications from the persistently low interest rate environment, an upward bias on expenses due to greater financial regulation and higher capital requirements altogether. In fact, according to Keefe, Bruyette and Woods research, SMID-cap banks are estimated to produce a median return on average assets of approximately 0.95-1.00 percent (compared to the group’s long-term average of about 1.10 percent) and a return on tangible common equity (ROTCE) of 11 percent in 2015 and 2016 (versus a longer-term average closer to 14 percent). And while a more favorable interest rate environment is likely to help bridge a portion of this return gap, the reduction in balance sheet leverage is likely to permanently weigh on the ROTCE outlook for the group.
All told, in the context of valuations that could be described as neither overly cheap or grossly expensive, we believe SMID-cap bank investors should be highly selective in constructing portfolios today. To us—and in the context of an industry that remains fairly commoditized and highly regulated—this means obtaining exposure to differentiated business models with strong growth characteristics, the ability to grow market share and those positioned to perform as well, if not materially better, once short-term rates increase.
In many situations, we are positively biased to niche business models that innovate, utilize technology to their competitive advantage and ultimately are able to deliver superior risk-adjusted returns over a cycle. In addition, we are firm believers in investing alongside proven management teams that have historically been strong stewards of shareholder capital, as well as those whose personal incentives are most closely aligned with achieving corporate financial targets.
Christopher McGratty is managing director of equity research at Keefe, Bruyette and Woods.
