In today's episode, we (Joe Fenech & Kevin Swanson) discuss
Summary:
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Our thoughts on the bank sector outlook and bank stocks
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Update on portfolio positioning amidst continued volatility
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Bad first half / good second half bank stock performance pattern playing out again?
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The long-awaited bank sector M&A wave is kicking off, but it will look different this time.
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In the weeds on bank M&A accounting and the implications for stock performance
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Thoughts on the passing of long-time VLY CEO Gerry Lipkin
This session is also available on Spotify or Youtube
Transcript
Kevin Swanson
Welcome and thanks for tuning into the Talking Banks podcast. I'm Kevin Swanson, Senior Analyst with GenOppp Capital Management and joining me today is Joe Fenech, our Founder and Chief Investment Officer
Kevin Swanson
Before we start, a quick disclosure. Joe Fenech, Kevin Swanson, and Jeff Wallenius are employees of GenOpp Capital Management, an investment advisor that maintains exempt reporting status in the state of Indiana. This podcast represents the views, beliefs, and opinions of GenOpp members and does not assert to be complete. The information presented in this podcast is provided to you as the dates indicated and opinions presented may change. You should not rely on this podcast as a basis upon which to make an investment decision. This podcast is not intended to provide and should not be relied upon for tax, legal, accounting, or investment advice. GenOpp’s clients or its members may hold or recommend to GenOpp’s private fund clients the purchase or sale of securities of companies discussed in episodes of this podcast.
Kevin Swanson
So last time we talked about these sort of dueling considerations, where on the one hand, the banking industry in a vacuum is in the best shape in over 20 years. The fundamentals of the business, centered around margin improvement, a new era of bank regulation, M&A consolidation wave kicking off, and historically attractive valuations. On the other hand, the main risk is this sort of perpetual state of crisis we’ve been living in for awhile now, and banks being at the tip of the spear are uniquely exposed in a negative way to this constant turmoil. So, Joe, why we don’t start there with an update on where you think things stand in that regard.
Joe Fenech
Thanks Kevin. So we made those comments in a podcast a few months ago, and I think both sides of that debate have continued to play out. The fundamental story is compelling really for all banks at this point. The smaller banks which are more reliant on traditional spread banking, the incremental margin of that business today is the best it’s been since prior to the ’08 crisis, almost 20 years ago. You’ve probably got a few rate cuts here on the medium term horizon, so the short end probably comes down a bit, but the economy still seems pretty resilient, so if you assume the long-end holds in this range, the yield curve is set to steepen even more. In past cycles, we’ve made the point that the process to get to a steep yield curve is typically pretty painful b/c the Fed is usually looking to solve for some sort of credit dislocation, and you don’t have that this time around. So you’re smaller banks reliant on spread income, really up through the regional banks, that’s going to be beneficial to them. For the largest banks, those stocks have performed better so far to date, but the capital markets businesses are just beginning to bloom so to speak, and at the same time, the stress test results have made clear the enormous pile of excess capital these banks have to work with, to put to use for the benefit of shareholders – so you have this capital markets story coupled with the benefits of deregulation. So the bottom line is nothing has changed relative to the favorable backdrop for the sector that we outlined last time, in fact it’s probably even a little better and happening at a quicker pace than we thought it would just a few months ago.
At the same time, the main risk that we identified has also played out over the last few months as well, and kept things on edge. So just like tariffs earlier this year, and the irrational fears over commercial real estate last year, and the liquidity challenges of the 2023 crisis, and the geopolitical conflicts that erupted in 2022, and the pandemic before that, the situation in Iran last month just sort of popped up and was in keeping with this perpetual state of crisis that we seem to be living under for the last half decade for sure but I would argue stretches back to the 2008 financial crisis. And that series of crises has continued to mask what is otherwise a really attractive story for the banking sector.
Now, Iran seemed to get settled fairly quickly, and I’m certainly not in the business of predicting what if anything happens next, but it does seem that finally, finally that the skies seem to be clearing a bit. The Big Beautiful Bill, no matter what anyone might think about the longer-term debt implications, is probably short and medium term stimulative, rate cuts as I said earlier do seem to be on the horizon, the economy is holding up pretty well, the geopolitical situation is by no means settled around the world, but barring any new surprises, we at least know what that is, tariffs are still a big wildcard, especially with the extension deadline coming up here, but for every contentious situation, there seems to be sort of an offsetting announcement of a settlement with this country or that. And so I don’t think it’s coincidental that when we get to a place where the banking sector story looks like it’s beginning to outweigh the perpetual macro crisis story, you see the stocks perform really well, and that’s what I think we’ve seen over the last few weeks and what I think you’ll see continue over the second half of this year, with second quarter earnings coming up in late July sort of adding the next log of fuel to the fire.
Kevin Swanson:
So the stocks have been acting much better. The largest banks led by JP Morgan are making new highs, they’ve continued to outperform as they have through this entire cycle, but the rest of the sector seems to be perking up as well. So maybe walk us through what that decision tree looks like from a portfolio management standpoint?
Joe Fenech:
It’s interesting, so in the 2008 crisis, the largest banks were the worst place to be, and then the problems over the few years after that made their way down to the smaller institutions in the real estate hot spots like Florida and Nevada and the Pacific Northwest. In this cycle, which really unfolded when the rate environment changed in early 2022, the biggest banks have been the best place to be. The regulatory changes enacted in the aftermath of 2008 on the one hand handcuffed the biggest banks to a certain extent and you’re seeing those shackles taken off really right now for the first time since then, but on the other hand, those changes also made the biggest banks essentially bulletproof from a safety and soundness standpoint. And so they were the safe havens for sure during the 2023 liquidity crisis after Silicon Valley Bank and the others went down, but I think what’s overlooked is they also benefited tremendously from the interest rate environment we were in. So they were simultaneously the best defensive play in the bank sector as well as the best way to play offense, which is a combination that you rarely see. So I don’t think it will surprise people that JP Morgan’s stock for example has crushed the banking index, but it’s also beaten the S&P by a considerable margin since the start of 2020, through what’s been a very very difficult period for the banking sector as a whole. Thankfully, we’ve had plenty of exposure to the big banks through these last 5 years.
But I think we’re at a unique inflection point right now. Where I think that the big banks are going to continue to perform very well. I don’t think for instance that people are fully appreciating the extent to which capital is going to be freed up for these companies. The capital markets story again is unique to the big banks, the little banks don’t have capital markets businesses to speak of, and so all of this M&A and the IPO market opening up, they are going to disproportionately benefit from that. And then also, as generalist investors get more excited about the bank sector, they aren’t going to initially sell Apple and buy Main Street Community Bank, they’re going to pile into the sector’s headliners, JP Morgan, Wells Fargo, Bank of America, etc. The benefits of AI are also going to accrue initially to the biggest banks. So I don’t want my comments misconstrued here on the biggest banks, no one has been a bigger proponent of these stocks than we have, my only regret from these past few years has been not owning even more of them than we did.
But I do think we’re at that point where the relative outperformance is mostly behind us. And that’s a tough call to make after all the things I just said. But JP Morgan is now at 15x 2026 earnings and 3x tangible book value. I can make the case that those multiples should go higher, especially with the market trading over 21x forward earnings, and with JP Morgan producing relatively better returns on capital. But I think that from here, that’s a tougher argument to make than to say that you’re average regional bank trading at 10 and a half times ’26 earnings and then the next level down from that, you’re larger community banks trading at 9.5 to 10x earnings, and below that your small community banks that no one really is paying any attention to a lot of them still trading below tangible book value, I think it’s a tougher argument to make than to say that those banks will re-rate over the next 2-3 years to 13x earnings and 1.5 or so of tangible book value. So I think you still make money in the big banks, you probably make good money, but the play to me is in the regionals and larger community banks, where you’re going to see continued fundamental improvement, they’re going to be in focus from an M&A standpoint, and the stocks are much cheaper, and then below that level, the small community banks will continue to lag for now for a bit, but there will be a time when I think the attention will shift to those valuation laggards, and that will be an opportunity to really generate some alpha when the index settles in and you get these catch-up trades, both fundamentally and through M&A.
Kevin Swanson:
Before we move on to M&A, now is probably a good time to highlight some interesting data that I think supports what you’ve just outlined. We certainly aren’t basing our outlook on this but there’s a chance it plays out the same way this year. Since the pandemic, with 2021 the only exception, bank stocks significantly underperformed on a relative and absolute basis in the first half of the year but then outperformed significantly on a relative and absolute basis in the second half of the year. Specifically, the regional bank index, on average is down about 12% versus the S&P up 8%, so a 20% differential in stock performance, including this year’s first half of the year. Whereas in the second half of the year, bank stocks on average are up 23%, versus 8% for the S&P, so 15% outperformance by bank stocks in the second half of the year.
Now, the reasons why differ every year, so you certainly could make the case that it’s coincidental. A pandemic happens in March 2020, Russia invades Ukraine in February 2022, Silicon Valley Bank fails in March 2023, New York Community now Flagstar is recapped in March 2024, and this year you had all the tariff Liberation Day in early April. So those are all obviously idiosyncratic events not connected to each other, they just all coincidentally occurred in the first half of the year. And then on the flip side, you had the vaccine announcement in November 2020, you had the early recovery from the liquidity crisis in 2023, you had the surprise Fed rate cut and the disinversion of the yield curve in September last year. And this year, you have some of the macro clouds clearing like Joe talked about and probably a couple Fed rate cuts in the back half of this year. So all the bad stuff in the last 6 years has occurred in the first half of the year and all the good stuff is in the back half of the year.
Joe Fenech:
Yeah, so I think it’s probably impossible to say for sure. So the events could certainly be coincidental, but the data is also the data. And so I wonder about a few things related to this and whether there is maybe an explanation. For most of my career, the months of trepidation, the months where people were always most concerned were October and to a lesser extent September. I’m not sure how much of that was just market lore, the big crash in 1929, October 1987, Lehman in September 2008. But it was definitely a thing.
But it does seem like that’s been less of an issue in recent years and March has sort of been the month to watch, at least for the banks. And I wonder if that is maybe tied to the Fed, where the Fed is now so involved in markets, to a much greater extent than ever in the past. The Fed’s balance sheet for example was less than $1 trillion in 2008, it went to $4 trillion in response to 2008, and then it exploded to $9 trillion with COVID. Couple that with all the fiscal stimulus. The Fed also flipped the script from Quantitative Easing to Quantitative Tightening and also started to raise rates in March 2022. And banks as we’ve pointed out in the past are much more sensitive to Fed action than most other sectors. Also, as we all know, we have elections in November. And I think the Fed has certainly become more politicized along with everything else these last few years, so maybe you get bad news in the first half of the year and good news in the second half of the year into election season? But I do think there is maybe something to this, because this year is shaping up in our view to play out just like it has in 5 of the last 6 years, since the Fed’s involvement in the economy really went into overdrive. So again, it doesn’t in any way drive our thesis on the sector or how we invest, but I think it’s something to keep an eye on. Like I said earlier, the data is the data.
Kevin Swanson:
So let’s move to M&A. We haven’t seen much of it in the bank sector in the last 5 years, due to the pandemic and then the volatility that was unleashed in the aftermath, and that continues to this day. But if you’re right about the macro clouds finally clearing here, and regulation easing, which we’ll talk about later, it would seem that there is quite a bit of pent-up demand for M&A
The M&A wave in 2021 resembled prior cycles in a lot of ways, where you had a community bank that raised its hand when it was ready to sell, and if it was a clean bank with a good market footprint, even if it was a subpar performer, the chances were high that an acquiror would come along and pay a substantial premium to market, and that price for your typical community bank in a good market was around 1.7 or so of tangible book value. Also, since 2020 was really the only year of interruption in the M&A cycle to that point, there wasn’t all that much pent-up demand.
Joe Fenech:
I think that’s right. But now with the window opening up, things are different. You didn’t have interest rate marks to deal with in 2021 that makes the deal math today really challenging. Meaning that tangible book value really only reflects a subset of the securities portfolio that is already marked to market. It doesn’t reflect the fixed rate loan portfolio that is probably still substantially underwater today b/c of the rise in interest rates nor does it reflect the held to maturity investment portfolio on a mark to market basis. And at the same time, you’ve now had 4 of the last 5 years with no real M&A activity to speak of, so those CEO’s and Boards that wanted to sell 3-4-5 years ago are now 3-4-5 years older and the succession challenges in terms of management talent and depth haven’t resolved. And there just aren’t enough buyers with a management team and Board that has the appetite, the depth of talent, and the stock currency to absorb all of the banks that want to sell. So the balance of buyers and sellers is out of whack, there are more sellers than buyers.
So for a lot of community banks, the dual challenge of those interest rate marks and the imbalance of buyers and sellers, is going to limit the market premiums paid for most community banks that we’re going to see in this cycle relative to prior cycles, especially in the early phase of the cycle. Now there will be exceptions: we saw a deal in Virginia not too long ago where Towne Bank paid a multiple in line with prior cycles for a small bank called Old Point. So there will be situations where a selling bank doesn’t have prohibitive interest rate marks, they’re in a market that is desirable, and just as importantly, there are several other banks that want in that market and have the capacity and the currency to do the deal. In those instances, you will see big premiums to market, and valuation multiples more in line with what we’ve seen in the past. But it’s not going to be a frenzied M&A market where everyone is going to get the multiple they want or think they deserve.
Kevin Swanson:
So that seems to make the case for owning a select group of community bank sellers but the acquirors are going to see some good deals here too.
Joe Fenech:
Yeah, I think there is a real opportunity to own the intelligent acquirors here, especially because these interest rate marks are a temporary phenomenon right? The balance sheets are going to remix over time, and these are customers that the acquirors are going to want to keep, unlike in 2008, when you put a big credit mark on the target’s portfolio and those are customers you didn’t want to necessarily keep. But with a rate mark, these are good customers, they just have to be repriced to reflect the current rate environment. But you don’t have to pay the target for that today. So if you can make the math work, and better yet, the target has a management succession issue too that they need to solve, the acquiror gets a pretty good deal and they spend the next few years remixing the balance sheet. I think of SouthState’s acquisition of Independent Bank in Texas as a great example of that dynamic.
Kevin Swanson:
Speaking of SouthState, and not to get too “in the weeds” on the accounting here, but another point in favor of the acquiror’s here is this evolving philosophy on how to value EPS accretion in a merger deal. Maybe to simplify this explanation a bit, in the aftermath of 2008, companies would take a huge credit mark in an acquisition, and there would be what’s called an “accretion cliff”, where a credit mark on a loan would result in an asset yielding let’s say 20%. But that asset couldn’t be replaced at anywhere near that yield, so you’d have this earnings juice for lack of a better term, for a period of time, but then when a 5% yielding asset replaced that 20% yielding asset, the income would fall off. And so the market would rightly value that temporary earnings stream with a lower multiple.
Joe Fenech:
Right, and what SouthState has rightly pointed out, and I’d point everyone to their first quarter 2025 earnings call transcript for their explanation on this, which we agree with, is that with an interest rate mark, you’re writing up the value of let’s say a 3% yielding loan to current market rates. But when that asset matures or pays off, you’re now able to originate a new loan at a comparable yield, so there is no accretion cliff like before, so in effect it’s no different than a bond restructuring, except this is even better b/c it’s not a permanent destruction of capital like we see in a bond portfolio restructuring. And there’s no “accretion cliff”, but the asset is being replaced at a comparable rate. So you value the accretion differently in that instance than you would with a big credit mark. I believe that 80% of the mark in the SouthState deal was interest rate mark and 20% was credit. Bottom line, some of these acquiror’s are going to get really good deals, but you’ve really need to understand the circumstances of each and every bank, more so than in past M&A cycles. And that’s going to lead to opportunities to play this M&A theme both long and short over the next couple years.
Kevin Swanson:
And how will the complexion of M&A differ for the larger banks?
Joe Fenech:
I think it will differ quite a bit, and this is where the nuance of this theme is important. So the deregulation of the sector is going to have a really important effect as it relates to M&A. You’ve got capital that is now freed up, but also, a more open-minded approach on the part of the regulators to regional bank consolidation. So first and foremost is the question of scarcity value. Outside of the 4 big trillion dollar asset banks, and excluding Goldman and Morgan Stanley, there’s only 29 banks in the country over $50 billion in assets. And of those 29 banks, only 10 are based in the Southeast and Texas, where everybody wants to be because of the demographics. So if you’re a large regional bank that wants to scale, and Bill Demchak at PNC I think articulates the rationale for this better than anyone else, and now you have the green light from the regulators, there’s not many options for you to be able to scale. And to really scale, for instance, if you’re even a half trillion in assets, and you want to join that trillion dollar plus too big to fail group, you either need one giant deal or you need to buy a few large regional banks. And so unlike with the community banks, where you have more sellers than buyers, with these larger regional banks, it’s the opposite, more buyers than sellers. The interest rate marks are also less prohibitive for these regionals than they are for the community banks. So you put all that together, and we think the nice premiums in this cycle are going to seen in the regional bank selling group. You’ll also see a few merger of equals among this group, so obviously not much premium there, but overall, the consolidation in regional banking we think is going to resemble the prior cycles of community bank M&A’s, in other words, more traditional buyer/seller M&A with nice premiums to market.
Joe Fenech:
I did want to close here with a comment on the passing of Gerry Lipkin, who was the long time CEO of Valley Bank in New Jersey. When I was a sell-side analyst earlier in my career, I was assigned coverage of Valley, and as a young analyst even though you’re covering the company and authoring opinions on it, you’re learning a lot at the same time, and I personally learned quite a bit from Gerry. He was a former regulator with the OCC before he took over as CEO of Valley, and he had a unique understanding of credit. And Gerry steered the ship at Valley very capably with that mindset, most notably warning any investor who would listen in the years before the financial crisis about the pitfalls he saw in things like subprime lending, and he was saying all of this before it became obvious to everyone else when things went haywire in 2008. One of his favorite sayings that I stole from him and still use in just about all of our marketing materials for the fund, was it’s the return of principal, not the return on principal that matters most. We did a few roadshows to London in the years after the financial crisis, not only were they a lot of fun b/c Gerry was great to be with, but with the big banks having struggled the way they did in ’08, Gerry really provided not only a retrospective of what went wrong, but also a prescription for how the industry could get back on track. And the solid footing the industry sits on today really reflects a lot of Gerry’s philosophy, which was consistent throughout his career. So I was sad to hear of his passing, just wanted to offer my condolences to his family, and his former colleagues at Valley Bank. Ira Robbins, Valley’s current CEO, has a great post on LinkedIn that articulates a lot better than I can about what Gerry meant to the company and the industry.
Kevin Swanson:
On that note, we’re going to wrap up. Thanks to everyone for listening, hope everybody has a great day.
Disclosures:
Of the individual stocks mentioned, our investment fund currently has positions in JP Morgan (JPM), Wells Fargo (WFC), Goldman Sachs (GS), MorganStanley (MS), Valley National Bancorp (VLY), TowneBank (TOWN), SouthState Bank (SSB) and Flagstar (FLG). The authors have long-standing long positions in JPMorgan Chase & Co. in their personal investment accounts, an investment that pre-dates the launch of our investment fund.
The information in this newsletter does not constitute an offer to sell or a solicitation of an offer to buy any security. This information does not purport to be complete, is subject to change, and is qualified in its entirety by the definitive offering documents related to any private fund managed by GenOpp Capital Management LP. All time-sensitive references are made as of the date set forth above, unless otherwise expressly indicated, and there is no obligation to update any such reference. The delivery of this information does not imply that the information is correct and no representation or warranty is made as to the accuracy of any information contained herein. This information is not a recommendation to buy any security and does not constitute any form of legal, tax, investment, or other advice.
