Talking Banks Podcast - Episode 4

In today's episode, we (⁠⁠Joe Fenech & ⁠⁠⁠Kevin Swanson⁠⁠⁠⁠) discuss 

Summary:

• Bank stock performance has been volatile…or does it make perfect sense and give us a clear roadmap for what's ahead?

• Bank sector fundamentals continue to improve; How good can it get?

• The M&A wave is underway; An inauspicious start for regionals, but more encouraging for smaller banks

• Opportunities abound in this evolving M&A landscape

This session is also available on Spotify or Youtube

Transcript

Intro

In today's episode, we have a number of topics we’d like to touch on, including a review of the last few months of bank stock performance, fundamentals, and what we see as the outlook for each, we want to present what we think is an interesting comparison to prior cycles and where we think things could be headed this time. We’ll touch on M&A and some opportunities we see there, and then we’ll close with some commentary on the evolution of franchise value and how we see that tying into geography.

Kevin Swanson

Welcome and thanks for tuning into the Talking Banks podcast, Episode #4. I'm Kevin Swanson, Senior Analyst with GenOpp and I’m joined by our Chief Investment Officer, Joe Fenech.

Kevin Swanson

Before we start, a quick disclosure. Joe Fenech and Kevin Swanson 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 at GenOpp we are approaching our five year launch anniversary. The first four years were interesting in the sense that each was literally either feast or famine for bank stocks. 2021 was a great year, 2022 was a terrible year for banks, and the broader market. 2023 of course was the liquidity crisis and the failure of 3 large banks. And then 2024 was volatile but was in the end a strong year for the stocks. 2025 so far has had a little bit of everything, a plunge early in the year into Liberation Day and then a sharp rebound, so the net result is sort of a ho hum average type of year, regional bank stocks are up about 8% on the year through mid-September despite the volatility., So Joe, entering soon the fourth quarter, how would you characterize the year so far to date?

Joe Fenech

So you’re exactly right Kevin, in that high level review of the last 5 years. I think what’s been unusual about this year is the extent to which the fundamental performance has been very strong, and consistent, it’s been sort of this strong upward trajectory. And that really extends back to the second quarter of last year when margins bottomed for the banking industry. Margins have been up for 5 straight quarters since then, after contracting basically for 14 years, and we think margins will continue to go higher through this year and into 2026. In the 4 years prior to this one, the fundamentals really sort of correlated to the stock performance. This year, the fundamentals are going one way, up, and the stock performance has been sort of middling, 8% is solid don’t get me wrong, but not against the backdrop of the fundamental performance we’re seeing out of this group.

Kevin Swanson

We’ve made the point on this podcast and in our investor letters, that there has been a disconnect between the fundamentals and stock performance and that the disconnect ties in to the main risk we see to our bullish stance on the sector that being persistent instability. Where we’ve seen especially in the last 5 years, this cascading series of unprecedented events around risk assets, and banks are super sensitive to the gyrations. And so the question becomes, can we get to a period of normalcy where these stocks can perform well for an extended period aside from just fits and starts?

Joe Fenech

Well so I think that broader risk is still out there and it’s unresolved. A senior bank executive that I really respect I think said it best, he compared bank stocks to Charlie Brown and the football. And bank investors are Charlie Brown, where each time we all think, ok finally, we’re finally set up well here, this time we’re gonna do it, and then something happens out of nowhere, and the football gets yanked away and we fall on our head and go back into the defensive crouch. 0 interest rates for a 14 years after 2008, the pandemic, record liquidity and then a liquidity crunch all within 18 months, rates up at the fastest pace in history, a commercial real estate scare, tariffs. The broader stock market just continues to power through all this stuff and bank stocks seem to suffer all alone.

But let’s for a minute here do some intra-sector analysis. So if you segment banks by size, what we find is that the very biggest banks have performed extremely well fundamentally and it’s been matched by stock performance. And everyone points to JP Morgan, it’s the biggest bank, it’s the best managed bank, and so I think people sort of look at it like an extreme outlier. But if you look at the 4 too big to fail banks, JP Morgan, Wells Fargo, Bank of America, and Citigroup, they’re up on average almost 30% this year, that’s the average. And the leader is not JPMorgan, it’s Citigroup, which is up 46% year to date. So Nvidia gets all the hype, that’s also up around 30% on the year, the Nasdaq is up 17%, the S&P is up 13% and regional banks are up 8%. So the too big to fail banks are performing really as well as anything else in the market this year.

And underlying that stock performance is extraordinary fundamental performance. These banks are as rock-solid as they’ve ever been in my 25 years in the business. So for these 4 big banks, I would argue that the stock performance has been highly correlated to the their fundamental performance. But that took some time. The fact is that these banks have had every fundamental tailwind in their favor now for several years. Higher rates were good for all of these companies b/c of how their balance sheets were positioned. When the liquidity crisis hit, people took their money out of regional banks and they moved them to the banks that were perceived to be too big to fail, so they benefited from that. Capital markets and trading activity has been off the charts, that’s been a tailwind. JP Morgan got the gift of the First Republic acquisition when that bank failed. And this year, now, the regulatory shackles are coming off these companies, Basel III is being scrapped, so they have all of this excess capital they’ve had to hold all these years, and a good portion of that they’re now going to be able to put to use.

The point is that this just didn’t happen overnight, it’s been building, and now the stock performance and the valuations are matching what’s been the fundamental reality for several years now.

Kevin Swanson

So what I hear you saying, is that at some point for the smaller banks if the fundamentals remain strong, stock price performance and valuation will eventually follow?

Joe Fenech

I think that’s exactly right. So small banks are basically pure plays on the shape of the yield curve and basically margin performance. The yield curve inverted in June 2022, it was deeply inverted in 2023, the peak of that inversion was not surprisingly in June 2023, one month after First Republic failed, so May of 2023 regional bank stocks bottomed, so the stocks anticipated by one month the peak inversion of the yield curve. The yield curve remained inverted until September 2024, and lo and behold regional bank stocks started to turn up two months before, in July of last year, which is also the exact period when margins bottomed. So when you start to piece this all out, the market makes perfect sense. Even among those 4 big banks – the two that are most tied to the yield curve are Bank of America and Wells Fargo, Citigroup and JP Morgan less so, Wells and B of A are the two weaker performers of the big 4.

Kevin Swanson

The yield curve started to untangle itself in September last year, and we got the first rate cut this month, and the yield curve now has really started to steepen. So the small banks are just on a lag in terms of realizing the benefits to their business model, and it’s going to play out similarly over time to what we’ve seen with the largest banks, where eventually the market recognizes the positioning which leads to valuations and stock performance more closely correlated to the fundamentals.

Joe Fenech

I think so, yeah. We wondered for awhile while JP Morgan despite extraordinary performance still traded at 10x forward earnings. Well, now the stock trades almost 15 and a half times ’26 earnings. I’m not saying the regional banks are going to 15x but they don’t need to. They’re a little over 10x ’26 today, and a lot of the smaller ones are less than that. So assuming again that we don’t get another Charlie Brown and the football event that comes out of left field, our call for ’26 is that we start to see a tighter correlation for the regionals and the community banks to their strong fundamental performance. It’s really amazing how stock prices, valuations, and stock performance all align nearly perfectly to size in this cycle.

Kevin Swanson

To sum that up, the largest banks have performed the best and are valued highest. Stock price performance for the large regionals has been a little better than the average, and so has their fundamental performance, they’re a little less tied to the yield curve than the smaller banks, and they carry the next highest level valuation. Then the smaller regionals and the community banks are sort of bringing up the rear, they are valued lowest, they’ve performed worse than average, and they are most dependent on the shape of the yield curve and interest rate policy, and that only started to improve a year ago.

Joe Fenech

Yes, and so our portfolio management strategy has followed that blueprint and how we think it plays out. We had significant exposure to the largest banks, which we think will continue to perform very well on an absolute basis, but we’ve shifted a bit over these past few months, paring back that exposure a little bit in anticipation of this inflection point in favor of the smaller banks, which are also going to benefit from M&A, which has already started to pick up.

Kevin Swanson

So then shifting gears a bit, it becomes a question of how much can things improve fundamentally for these smaller banks?

Joe Fenech

So I like to think about it very simple terms. In some recent presentations I’ve done to community bank Board of Directors, two in particular, we compared the current composition of their net interest margin to what it looked like back in December 2007, right before everything went haywire. And the rationale for that was if you look back to that period, the average rate for the 10 year Treasury was 4.10, just about exactly where we are today. And yet for these two banks, their earning asset yields today are 100-200 basis points lower than they were then. And so on the one hand, yes, both of these banks look pretty different now than they did then, they’re larger today, but neither one of them was doing crazy stuff back then that inflated the yields. And at the same time, their funding costs then were comparable to slightly higher than they are today. The difference is that in late 2007, we weren’t coming off a period of very low rates right? Right now, a lot of banks, including these two, still have loans and securities on their books that are remnants of the low rate period, before rates started to move in early ’22. So the exercise we did for the Boards and management is we said, if you can even get back half of that gap in earning asset yield from late 2007, think about how much of that income you get to drop to the bottom line? So again, a very simple exercise, using assumptions that aren’t heroic at all, to illustrate that there is plenty of fundamental improvement still ahead. If that happens as we expect, over time, stock prices are going to catch-up to the fundamental picture, just like they have for the largest banks.

Kevin Swanson

Let’s turn to M&A. We talked last time about an expected pick-up in M&A, and that’s certainly happening, and we think it’s going to pick-up quite a bit more. We’ve also said that regional bank M&A is where the scarcity value is this cycle and that small bank M&A is going to look somewhat different this cycle than it has in prior cycles. So far, that’s not exactly how it’s playing out. The first big regional bank deal, between Pinnacle and Synovus, has not been well received by the market, even though it’s based in arguably the most attractive demographic region of the country. Meanwhile, we saw PNC buy a large Colorado community bank at an eye-popping multiple, and we’ve seen deals in the Southeast, specifically Texas, for community banks at very attractive multiples. So what’s your take on the environment we’ve seen so far?

Joe Fenech

So I think the Pinnacle Synovus deal is another example of the Charlie Brown and the football analogy. It’s like ok, everyone is excited to see M&A, and regional bank M&A seemingly has the green light for the first time in a long time, and it’s a deal in the Southeast, where there are only like 7 banks left of size, over $50 bil. in assets. And then we get this big announcement and it’s a complete flop in terms of the market reaction. So I know this sort of false start to regional bank M&A has given the bank skeptics just more ammunition, it’s definitely unfortunate, and could it put a temporary chill on deals of this size and magnitude, yeah I think it potentially could. But I would look at this transaction as an outlier and not as sort of a harbinger of things to come.

So on the one side, you have Pinnacle, and a CEO in Terry Turner, that has done a terrific job. Just a fantastic company. This is though a 70 year old CEO and founder, who’s co-founder is 74, and whose CFO is 65. So there’s a management succession challenge here, and we’ve talked at length about the management succession challenges in the industry at large. It’s also a very distinctive culture, at Pinnacle, one that does not easily fit inside of a larger organization. It was also a stock trading at a significant valuation premium. And judging by some of the terms of the transaction they announced, without going too deep into the details here, it struck me as a situation where management was solving for succession but at the same time wasn’t quite ready to fully let go of the reins, of control. So they do a merger of equals transaction with Synovus, it creates on the one hand one of the best geographic maps in the industry, if not the best. You have a capable and younger management team at Synovus, so it technically solves for succession, but you look at the board split I think it was 8-7 in favor of Pinnacle, so there’s an element of control retention by the Pinnacle team, but day to day managed by Synovus, oh and now, double the size, and crossing the $100 bil. asset threshold, which brings with it a whole new set of challenges. And then of course merging that unique culture at Pinnacle with a similarly sized company, but very different, in Synovus. So can it work? Yes, it can. But it comes with a lot of question marks. And it’s not the deal we needed out of the chute to really inspire confidence in regional bank M&A. It’s not a neat and clean deal, which would have been say a $200 to $400 bil. bank, buying a $50-$75 bil. bank that sort of checks all the boxes that the Street would want to see. I still think we’ll see those types of deals and they’ll be well-received. But this deal was not that. So then seeing the reaction to this deal, we then see Huntington go down to Texas and do a much smaller deal in buying Veritex, the reaction to that was much better. PNC goes to Colorado and buys a small bank at a huge price, but it’s sort of viewed as a low risk deal that fills a gap on the map but doesn’t move the needle financially for PNC one way or the other. So does this lead other large regional bank CEO’s and Boards to maybe hit the pause button on larger sized deals, it definitely could. But the considerations around Pinnacle Synovus were so unique that I don’t think it would be reasonable to impute from that, this is what regional bank M&A is going to look like and this is how it’s going to be received.

Kevin Swanson

Fair enough. And then on the smaller side, the deals that will never make the front page of the Wall Street Journal, we’ve been expecting smaller bank M&A multiples to be restrained by similar dynamics ironically enough we saw in the Pinnacle deal. Needing to solve for management succession but not enough capable buyers, and then separately, interest rate marks that remain prohibitive. And yet, we’ve seen a number of smaller bank M&A deals at very healthy multiples. So does that alter your view of what we’re likely to see as this M&A wave unfolds?

Joe Fenech

A little bit, to be honest, but it really only enhances the overall M&A thesis as a component of the bull case for banks. I’ll explain why in a minute. But also, just like the Pinnacle deal I don’t think is representative of what we’re likely to see for regional bank M&A, I wouldn’t necessarily extrapolate what we’ve seen so far in small bank M&A as applicable to what we’re likely to see on a broad scale.

So first, yes, some of the multiples we’ve seen have been impressive. But where have they been? Primarily in Texas, where every acquisitive bank seems to want to be. And then in Colorado, where you had a large buyer that could literally pay whatever they wanted to, and a really attractive market in Colorado where there aren’t really any banks left of scale. This bank that PNC bought is really the only way left to get into that market at decent scale.

I think to be convinced that this is the M&A market, I think you need to see deals outside of the most desirable markets, at a big premium to where the stock is trading. So for me to be convinced that we’re going to see M&A multiples at these levels on a broad scale, I think you need to see a Northeast bank trading at 1.10 of book, go unexpectedly for 1.6. Could it happen, sure it could? I’m just not convinced yet. If it does happen great, it only enhances the bull case, right, b/c M&A has a way of resetting franchise values even for banks that aren’t participating in it. B/c the bank trading at 1.10 that sells for 160, leads investors to look at all of that bank’s peers and say, if that one’s worth 160 why are all these trading 50% lower. We saw that when M&A started to pick up in Florida in the mid 2010’s.

Kevin Swanson

And not only do we need to see those multiples, but we also need to see the deals work out well for the acquirors, if the acquiror pays an unexpectedly high price and then their stock suffers post-announcement, then that’s the outlier transaction that no one wants to replicate.

Another thing as it relates to M&A that we’ve found that’s interesting is how the market is valuing accretion income. In the years after the 08 crisis, the target’s balance sheet would be marked to market with the bulk of that mark tended to be credit related. In this cycle, as Joe mentioned earlier, the interest rate marks are comprising the bulk of that purchase accounting adjustment. When the mark is credit-related for a distressed company, you create a lot of high yielding assets even upwards of 30% yields, so it can really juice your earnings. But that’s only temporarily because as that asset resolves, it’s replaced with a much lower yielding asset. So the market eventually figured that out it was over-valuing the accretion income from the credit mark.

And so right out of the chute this time, the market is applying the same treatment to the accretion generated from the interest rate mark. But this time, that 3% yielding loan is only being marked to 6 or 7%, and when that asset rolls off, it can be replaced at current market rates which are similar to the mark, so there is no accretion cliff. So we’re seeing these really well run acquirors being penalized post announcement that don’t fully reflect what we think is the appropriate valuation methodology for the combined company. It’s a huge opportunity.

Joe Fenech

100%. And I’d add to that that the acquirors are also penalized by a phenomenon that we can prove through the numbers. A long time ago, a very well respected bank CEO said to me that he prefers buying private banks to public banks b/c as he put it, private bank shareholders were more loyal. And I thought about that, and he’s absolutely right, but I’m not sure loyalty is necessarily the right word to characterize what it is that happens. So when a bank buys another public bank that has an institutional following, often times, the deal gets announced, and we don’t do this b/c it locks up capital and it doesn’t always work the way you think it should, but often times, the investor in the target will continue to hold the target’s stock, and will short the stock price of the acquiror, with the theory that you’re locking in your gain from the deal. Or, the institutional shareholder will just sell the target stock and move on, b/c that’s why they were in the deal in the first place. The private bank shareholder, most likely high net worth individuals or retail investors, tends to stick with the stock after deal announcement, so you don’t sort of have this dislocation in the shareholder base of the target, and then the acquiror’s stock being shorted at the same time. Our research has shown that this dynamic is amplified when the target’s shareholder base is comprised of a certain type of institutional investor, I’m not going to get into specifics there but it’s more of the hot money crowd if you will. And it’s demonstrable. And I don’t know in today’s environment with all of the passive investing and the algorithms and the like, if that dislocation after deal announcement, what I suspect is it can lead to a hangover effect in the acquiror’s stock, and that hangover can last as long as 6 months after deal close. And we’ve proven this all out with data. And what it leads to is an extraordinary opportunity to initiate or add to long positions in some of these acquiror’s stocks. You combine that with the point on accretion that Kevin talked about, and it’s a dynamic that we haven’t really seen as much in prior cycles, but that we think is going to matter quite a bit in this one.

Kevin Swanson:

On that note, we’re going to wrap up. Thanks to everyone for listening.

Disclosures:
Of the individual stocks mentioned, our investment fund currently has positions in Citigroup  (C) and Bank of America (BAC). The authors have long-standing long positions in JPMorgan Chase & Co. (JPM) and Citigroup in their personal investment accounts, an investment that pre-dates the launch of our investment fund.

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