When any turmoil arises, as it has in the banking sector this year, we begin our analysis with a deep risk assessment. Our conclusion: While we are not actively increasing the overall exposure to banks in our U.S. value equity portfolios, we continue to use the market’s short-term volatility as an opportunity to potentially upgrade the quality of the portfolios’ holdings.
Entering the Year
Banks have been well represented across the value indices. Going into the start of the year, they made up about 18% of the Russell 2000 Value Index, 11% of the Russell 2500 Value Index, and 6% of the Russell Midcap Value Index.
But the composition changes between the size of the indices. The midcap value index tracks about 30 super regionals. But smaller regional and community banks—more than 300 of them—dominate the small-cap value index.
The sheer number of banks in the small-cap value index tells us that U.S. banking is still a regional, relationship-based network serving local communities. And while consolidation and roll-ups are likely over time, we believe regional banking will still have a role to play. In other words, the United States is unlikely to look like Canada or Europe, with only a few dominant players. The U.S. economy is much more heterogeneous than the rest of the world, and smaller banks play a role in supporting the diverse local economies in which they reside.
As we started 2023, we were underweight the banking subsector of financials across our Small Cap Value, Small-Mid Cap Value, and Mid Cap Value strategies. This underweight was most pronounced in our Small Cap Value strategy, which had a 15% allocation to banking vs. 18% in the Russell 2000 Value Index.
While our underweight positioning has contributed to relative performance, we by no means were predicting a run on several midsize lenders. So why the underweight?
While earnings pressure and regulation could weigh on returns, we believe most banks should be well equipped to exceed their costs of capital and live to see another day or cycle.
We entered the year cautious about banks because the drivers of their fundamentals didn’t look overly attractive to us. What really drives banks’ share price is loan growth, net interest margin (NIM, which is the difference between deposits rates and other capital costs and the interest rates the bank gets on loans), and credit quality.
As we entered 2023, the first of those fundamentals—loan growth—was still healthy. However, banks took in enormous sums of deposits during the pandemic (due to excess stimulus and the surge in M2[1]), and we believed loan growth would not be able to keep pace. As their deposits grew, some banks responded by purchasing long-dated U.S. Treasurys as their loan-to-deposit ratios were out of whack. Unfortunately, some failed to properly hedge their interest-rate exposure and were forced to mark these assets down as nervous depositors sought liquidity.
Just as important, we believed NIM expansion was peaking or had limited upside—in part because there is now much more competition for deposits. After a decade of not considering an alternative to a checking account rate, investors and savers have more attractive options in money markets or short-dated fixed income. We don’t believe banks will lose all their deposits; they will likely just have to pay more to retain them.
Lastly, credit quality has been pristine to this point, and only has one direction to go if we are entering a period of economic weakness.
So, we entered the year underweight banking, and remain underweight today.
Where Are We Today?
Immediately after JP Morgan Chase rescued First Republic Bank (FRC), market skepticism shifted to the next-most-exposed banks based on deposit risk and liquidity concerns (such as PacWest). Since the U.S. Federal Reserve (Fed) and Treasury were willing to take FRC into receivership and effectively wipe out the equity, short sellers and other market participants have recently bet heavily against other banks that look similar to those that failed.
As patient, long-term value investors, however, we don’t believe all regional and smaller banks should be tarnished. Yes, some of these banks in the crosshairs have similar profiles, but in general, we believe regional banks’ troubles are earnings issues rather than liquidity issues. And from a longer-term perspective, while earnings pressure and regulation could weigh on returns, we believe most banks should be well equipped to exceed their costs of capital and live to see another day or cycle.
And that’s what we’ve heard from the banks we own in our portfolios. The majority have reported first-quarter results—some have shown deposits down by the low single digits, while others actually have witnessed deposit growth. The first quarter was all about the vector of deposits, and for the banks we own, so far so good. As of the week ended in May 10, the latest H.8 data from the Fed (which presents an estimate of weekly aggregate balance sheets for all U.S. commercial banks) indicates that the pace of deposit outflows seems to have stabilized, although it is still falling, since the turmoil began in March. In fact, most of last week’s outflows were concentrated in large banks, not the smaller regionals. Now, that refers to absolute deposit dollars; however, the mix of deposits is clearly changing, with non-interest-bearing deposits coming down as deposits move to higher-yielding alternatives within banks, such as CDs or money markets.
This should continue to pressure NIMs. In terms of their outlook, all of the banks we heard from assumed that the Fed would raise rates in May, further impacting NIM compression in the second quarter (albeit not as much as we have already experienced). But the banks are expecting that situation to stabilize as the Fed is predicted to pause in the second half of the year.
It is important to remember that in the bank universe, not all commercial real estate is created equal.
In terms of loan growth, thus far we are still seeing positive growth. Still, the pipeline has been shrinking over the last several quarters and will likely continue to shrink. Fed Chairman Jerome Powell explicitly called out the recent turmoil in the regional banks, noting that the banks’ initial reaction would be to cool loan growth and tighten credit lending standards, which in turn should help fuel the Fed’s mission of slowing the economy. This pullback was all but confirmed in the recent release of the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) data, which showed waning demand and tighter underwriting standards.
Credit, meanwhile, has been pristine thus far. Many banks have called out their commercial real estate exposures—specifically office space, as it is widely expected that this may be the next shoe to drop from a credit perspective. In addition, banks are tightening in construction, hospitality, and senior housing. But they are getting more granular, looking beyond what percentage of their loan book is allocated to office space and adding some color around their loan-to-value (LTV) ratios, occupancy levels, and debt service coverage ranges.
It is important to remember that in the bank universe, not all commercial real estate is created equal. There are many suburban medical offices in the Sunbelt that are thriving, for example. And thus far, in many places, credit issues remain benign. Banks as a whole are more diversified now than they were during the Global Financial Crisis (GFC), and underwriting standards have improved. It is also worth noting that while small banks have greater exposure to commercial real estate than large banks, much of the market is now owned by insurance companies, private loan funds, or syndicates. Nevertheless, if commercial real estate is the next source of turmoil, we believe it will materialize slowly.
Another area to consider is multifamily, which banks are still loaning into, highlighting the strong rental rates in select markets. In some areas activity is weakening, but in the Southeast activity is still humming as population migration out of the Northeast and West to the Southeast continues.
So far, then, the outlook has been better than expected, but we remain cautious given how quickly the recent turmoil ensued.
Near-Term Outlook
If all goes well, we will soon return to worrying about “normal” things like a recession as opposed to runs on banks.
Regarding valuations, some banks are currently trading below or at tangible book value (TBV), and we believe that is where we will start to see opportunities, as banks typically bottom before a recession and then begin to outperform once a recession hits.
We believe there are likely to be high-quality banks that are unfairly punished.
That’s because one thing banks tell us about the future is provisioning for loan losses, and banks typically start making those provisions (which they are ramping up now) before a slowdown occurs. These provisions impact earnings now but serve as a leading indicator of where we are headed. Banks tend to experience a “credit migration” (where classified loans on their books move to non-performing), but by the time they actually start taking the charge-offs, they have already reserved for them. And that is the time when their earnings headwind typically starts to abate. In our view, that’s when you really want to go on offense, as that’s also the time the Fed is likely cutting rates.
For banks our preferred valuation metric is price to TBV (P/TBV). Small-mid cap banks currently trade at about 1.1x P/TBV. Historically, the average for smaller banks has been 1.5x P/TBV, with the low end of valuation right at TBV (during most cycles, excluding the GFC). So, today, on an earnings basis, we are below long-term averages, but we believe TBV may have a bit more room to compress as we get closer to a possible recession, especially if it is a deeper recession than most are predicting.
One wild card is how the regulatory picture pans out. Clearly, more regulation is likely to occur as a result of the recent turmoil. We believe this will be focused on banks with assets of $100 billion or more. But even small-cap banks below that asset level usually have some additional burden placed on them as well.
So, it is yet to be seen how regulation will impact the profitability of banks. This likely precludes any merger-and-acquisition (M&A) activity until there is more clarity. Federal Deposit Insurance Corporation (FDIC) rates are likely headed higher, depending on the type of lending and deposits, which will vary. All that will factor into the future profitability of banks and what return on their assets they can generate.
Our Strategy
When any turmoil arises, we always start with a deep risk assessment. In this case we started with liquidity, uninsured deposits, deposit concentrations, and commercial real estate exposures, among other metrics.
After re-underwriting the names in our portfolios, we quickly pivoted to looking for opportunities, as we believe there are likely to be high-quality banks that are unfairly punished.
We are seeking top-quality banks trading at discounts to their peer groups and their own trading history. There are also banks that are just now starting to look interesting—ones with top-notch, sticky deposit bases in specific geographies (namely, northern California or the Southeast). We are also starting to identify a few banks that we would not have owned in the past, because they had premium valuations, but are now coming in more in line with the valuation of their peer groups.
These banks’ earnings may be suppressed over the short term, but we are willing to be patient by coming up with conservative valuations that we believe possess limited downsides before starting to nibble.
So, while we are not actively raising the banking weight in our portfolios, we continue to use the market’s short-term volatility as an opportunity to potentially upgrade the quality of the portfolio’s holdings.
Greg Czarnecki is a portfolio specialist and research coordinator on William Blair’s U.S. value equity team.
[1] M2 is a measure of the money supply that includes cash, checking deposits, and other types of deposits that are readily convertible to cash, such as certificates of deposit.
