In today’s episode, we discuss our outlook for 2025, thoughts post-election, the coming M&A wave, and our views on where we think bank stock valuations will ultimately settle in. As always, we welcome your candid feedback on what you like and didn’t like, as well as thoughts on topics you’d like to see addressed in the future.
Below is a quick synopsis of the podcast episode:
- We’re as bullish as we’ve been since launching the Fund in late 2020, and looking further back, more bullish than at any point in the post-2008 era.
- We think the stage was set for a positive outcome for bank stocks regardless of the election, though the results clearly alter our view of M&A and regulation, providing some additional tailwinds to the bullish thesis.
- We agree with the consensus view that a significant M&A wave is close at hand, but we differ on the likely complexion of bank sector consolidation, and how to play it.
- We think sector fundamentals are entering a “normalization” phase that will extend into the next decade and that bank stock valuations will ultimately meet or exceed the long-term historical average.
This session is also available on Spotify or Youtube
Chapters:
00:00 Introduction and Overview of Talking Banks
01:24 Post-Election Landscape for Bank Stocks
05:16 Market Cycles and Bank Stock Recovery
07:57 Regulatory Changes and M&A Outlook
14:29 Investment Strategies in the Current Market
16:04 Where Do Bank Stocks Trade From Here?
Transcript
Kevin Swanson (00:05)
Welcome everyone. And thanks for tuning into our first Talking Banks podcast. I'm Kevin Swanson, senior analyst with GenOpp Capital Management, and I'm here with Joe Fenech our founder and chief investment officer. Just by way of quick background, in late 2020, we launched the GenOpp Financial Fund, which is focused primarily on banks. Prior to founding the firm, I worked with Joe for nearly a decade in equity research, and Joe has worked for over two decades, primarily in research, also in investment banking at leading firms serving the financial sector.
Joe also serves on the board of a publicly traded bank in the Indianapolis area, where our firm is based. With that said, a quick disclosure.
Kevin Swanson (00:42)
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 Mr. Fenech and Mr. Swanson and does not purport to be complete. The information presented in this podcast is provided to you as of the dates indicated and opinions presented may change. You should not rely on this podcast as the 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, Mr. Fenech and or Mr. Swanson may hold or recommend to GenOpp's private fund clients, the purchase or sales of securities of companies discussed in the episodes of this podcast.
Kevin Swanson (01:24)
So earlier this year, we started our Talking Banks newsletter and this new podcast is meant to compliment the written content we've been producing. For today, we want to focus on the post-election landscape for the bank sector and the setup heading into 2025. So maybe Joe, any high level thoughts to kick it off?
Joe Fenech (01:42)
Thanks, Kevin. Yeah, so from a high level, we're bullish on the sector. I'd go so far as to say it's the most bullish certainly that we've been since launching the firm in late 2020. And looking further back than that, more bullish than any point in the post 2008 period.
Kevin Swanson (01:59)
So maybe take a minute and unpack that a bit for the audience.
Joe Fenech (02:02)
Sure thing. So maybe taking a step back, if you think about bank stock investment cycles, the circumstances and the events that take place are always different from one cycle to the next, but how they play out in terms of the markets is fairly predictable. And so even though the events that took place this go around have been unprecedented, right? Starting with the pandemic, the 10 trillion or so of fiscal and monetary stimulus in response to that, then inflation, higher rates.
quantitative easing that then flipped to an aggressive pace of quantitative tightening. All of those events and the policy responses to it were unprecedented. And that all culminated in the panic we saw last year with Silicon Valley Bank. But what I'd argue is that since then, markets have played out fairly predictably and in line with past cycles. with bank stocks, the bear market for the stocks typically ends when the news is darkest, right? So First Republic failed in early
May 2023, the stocks bottomed that month. So even though we felt the reverberations from that event for quite a while after May, the fact of the matter is the bank stock index is up almost 90 % from the lows 18 months ago. The same thing happened during the financial crisis of 2008. So the stocks bottomed in March 2009 and started moving higher, even though banks were still failing through that year and through 2010.
I think over 150 banks failed in 2010, two years after Lehman. So the stock's bottom first, but the fear lingers. And the same thing happened this time around. I would say the fear lingered pretty intensely until March of this year when Steve Mnuchin stepped in to rescue New York Community Bank, now Flagstar. The liquidity panic last year had sort of morphed into this irrational fear around commercial real estate, and Mnuchin stepped into that.
And I think the signal that sent was very important, which was, okay, the large bank that was the most distressed by far, New York Community Bank, was just rescued with one billion in new capital, which sounds like a lot, but we looked at that and said, if that's all it takes to save the most distressed company, then this fearful cloud hanging over the sector is irrational. Okay, so while the stocks were already moving higher before that in fits and starts, to us,
The real positive inflection point that indicated it was safe to go back in the water was the rescue of New York Community Bank, which again, these cycles always rhyme, right? So Mnuchin stepping in was the equivalent really of John Canis and the Carlisle Group stepping in to recap Bank United in May 2009. And that opened the door to the recapitalization of the sector. So then fast forward to July of this year, the irrational fears by that point had mostly subsided.
The stocks are super cheap, but everyone's wondering what the catalyst is. And the stocks then take off higher in July. What that was anticipating was the steepening of the yield curve in September, the Fed cuts rates. And what we had been saying heading into that was don't wait for an obvious catalyst. Once the irrational fear subsides, which it did back in March with the rescue of New York Community Bank, you need to be buying these stocks.
Kevin Swanson (05:16)
I think there's this tendency to think bank stocks were dead in the water and the election sort of changed everything. But what I hear you saying is that the building blocks for a good outcome here were already in place.
Joe Fenech (05:29)
Exactly right. If you look at this long bear market in bank stocks, it's almost directly correlated to the inversion of the yield curve. So the stocks peaked in January 2022. The Fed starts raising rates in March 2022. The yield curve inverts in June 2022. And then we hit peak inversion in June 2023, one month after the stocks bottom. So
The yield curve and the performance of bank stocks have been sort of tied at the hip through this cycle. So now you get the disinversion of the yield curve in September. And what also happens? know, net interest margins bottom for the industry for most banks in the second and third quarter of this year. So what we've said for a while now is that the absolute level of interest rates has not been the problem. know, banks operated very successfully and traded at much higher valuations historically.
when interest rates were at these levels and higher. The problem was that the balance sheets were built for the era of record low rates we were just coming out of. And so that needed to be unwound and that adjustment period was going to take some time. That process was just about complete by the end of the third quarter in terms of the painful aspects of it, which was funding costs continuing the ratchet higher while banks still had all these long-term fixed rate assets on their books that weren't moving conventionally with that.
The process on the asset side, think, still has longer to run, but the liability side finally settling down, enabled banks to see margins stabilize. So layer on to all that, just about record low bank stock valuations, especially on a relative basis. And so this cake was just about baked by the time the election rolled around. It's interesting, know, Betsy Graseck has been the large cap bank analyst at Morgan Stanley for over two decades.
Really good analyst not thrown the hyperbole to make her point. So I was a little taken aback when she said in her review of third quarter earnings this year for the big banks that the third quarter of 2024 was the strongest quarter for large banks in her 22 years of covering the sector. That's a really extraordinary statement and I agree with that you know the fundamentals if you think about the fundamentals for the big banks especially are really really strong.
and yet we were sitting at near record low stock valuation. So the takeaway I think here from a big picture perspective is that we were already sitting in a very good place.
Kevin Swanson (07:58)
Okay, so the fundamental picture was already setting up nicely, but there are two areas where I think it's fair to say the outlook has changed somewhat. And that would be with respect to regulation and then to &A. And there are some overlapping considerations there as well.
Joe Fenech (08:13)
For sure. So the specifics on regulation we've yet to see, we don't even have nominations in place yet to run the various banking agencies, but I think we can safely assume that as it relates to capital requirements, tech forward banking, the allowable size and scope of &A, the deal approval process, all of that will be treated with a lighter hand, I think it's fair to say under a Trump administration than it would have been under a Harris administration.
Now, this consolidation wave, this &A wave among community banks was going to happen anyway. One of the major challenges the banking industry faces today is management and board succession. It's pretty amazing. One quarter of all bank CEOs are at least 65 years old. The average CEO, I think, is 61 years old. And the boards, as we all know, tend to skew older than the management teams. And later on to that, only 7 % of public bank CEOs today are under 50.
And when I started my career in the late 90s, there were 11,000 banks. Today we have 4,500 banks, give or take. So consolidation has been a major theme in the industry over my 25-year career, but it's mostly been on hold for the last several years because of all the volatility and turmoil. So really, as soon as we saw any signs of stability in operating fundamentals and a lift in stock prices, we were going to see consolidation.
And I think no matter who won the election, the number of banks was likely to get cut in half again over the next several years. I think the difference in terms of the election outcome is the complexion that that &A wave is likely to take going forward. So with Harris, I think what would have happened is we would have returned to the type of &A environment we saw under Obama, meaning no large bank &A and then a lot of activity at the smaller community bank level to help solve for the succession issue.
With Trump, I think the regional banks are in play now as well. So the CEO of PNC, Bill Demchak, has talked about how the large regional banks are at a severe disadvantage relative to their too big to fail counterparts last year during the liquidity crisis. I'm not going to rehash all his comments, but basically the premise is that the crisis exposed a critical flaw in the regional bank business model.
I think there's going to be a push by some of the higher quality regional banks, the PNCs, the US bank corps, the fifth thirds, the &Ts to look to gain significantly more scale. And I think the regulatory regime that we're moving towards under the new administration is likely going to allow consolidation at that scale.
Kevin Swanson (10:51)
So if that's correct, then the scarcity value in this &A cycle is going to rest with these regional banks because there are so few of them. Meanwhile, for the smaller banks, like you said earlier, there are issues as the &A wave takes hold. A lot of these banks have succession challenges, so there are a lot of sellers and not nearly as many qualified buyers. And then there's the challenge of the interest rate marks. The regional banks don't have as many long-term fixed rate loans and securities.
They've been a bit more sophisticated for the most part in managing the challenges with AOCI with some obvious exceptions. So the hurdle to overcome the interest rate marks in an &A deal is lower to acquire a regional bank than it is to acquire most community banks, which enables the buyer in theory to pay more and still make that math work.
Joe Fenech (11:38)
Right, so on that last point on the interest rate marks, the largest bank based in Maryland, Sandy Spring, just sold for 1.3 times tangible book value. In the old days, five or 10 or 15 years ago, a franchise like that with that type of attractive tagline, largest bank based in Maryland would have commanded a much higher multiple.
Similar situation up in Buffalo, Evans Bank, which is really the only community bank opportunity left to acquire into that Buffalo MSA in a significant way, announced the sale a couple of months ago, similar price, 1.3 times tangible book. Now, look at the situation with the regional banks. Let's say you're a large regional and you want to require scale on the Southeast.
There are literally only seven or so banks, I think, based in the Southeast, arguably the most attractive demographic region in the US, that are over $50 billion in assets. You have Truist, First Citizens, Regions, First Horizons, Sinovus, South State. Once they complete the IBTX deal, South State, and then Pinnacle, that's it. So some of those banks likely aren't willing sellers. There are Choir Wars.
So now you're down to say what, three, four, five banks maybe with scale that could be acquired in the Southeast. And if those banks are gone, you can make the argument that a large bank coming down from the Northeast or the Midwest wanting scale in the Southeast, that market is arguably closed off to them for a generation or more if they can't acquire one of those banks I mentioned because they can't get the scale. So what are those banks worth that are left?
Kevin Swanson (13:19)
So the difference here is that community banks are struggling more with succession and challenges. So there's likely to be more sellers and buyers. And then you layer on top of that the challenges of interest rate marks, especially if rates stay higher for longer. Whereas the regional banks don't have those challenges to quite the same extent. And there is also more scarcity value assigned to those regional banks with scale.
Joe Fenech (13:42)
Yeah, I think that's right. At least for the next 6 to 12 months. Now, obviously just the passage of time will help to resolve those interest rate marks. So that'll help the deal math as we look 2 to 3 years out for some of these community banks. And also, I think the fundamental and regulatory outlook is so favorable right now that we, or at least that we're heading into, that we could get into a bit of a frenzy where stock prices go up, giving buyers stronger currencies to wield an &A, which could then result in higher market premiums.
But for now, it's going to be this strange dynamic, I think, that we haven't seen in past &A cycles where the operating environment is really healthy. Valuations are still very reasonable, so the stocks go up. But the value that some of these community banks would command in an &A deal today is not going to fully reflect that.
Kevin Swanson (14:30)
So from a portfolio management standpoint, that would seem to suggest that if you're playing the consolidation theme in banking as an aspect of your strategy, you want to own the regional bank targets, but be more selective in playing the &A on the community bank side.
Joe Fenech (14:44)
Yeah, so in past cycles, you know, we weren't managing a fund at that time, but as a research analyst, I always had an eye on recommending stocks as though you were managing a portfolio. And in the past, you could definitely say, okay, so Community Bank A sort of has lackluster fundamental performance, but the stock's cheap. It's got a nice franchise. I think the board's a willing seller. And you could reasonably surmise that someone would come along and take that company out at a decent premium. I think the calculus is different today.
There will certainly be some community banks that get taken out at really nice market premiums. I'd mentioned maybe the German-American Heartland deal as an example. But the expectation of a big market premium sort of being the crux of your thesis on a stock, I don't think will work as well in this cycle as it's worked in past &A cycles. So I think from a portfolio management perspective as it relates to &A, I like a strategy of long some of these regional banks with scarcity value.
long some of the well-positioned community bank acquire wars that are going to get some really attractive deals here, especially in the early stages of the &A wave, and long but very selectively some of the traditional community bank acquisition targets with the caveat that you also have to be comfortable owning them long-term as standalone entities.
Kevin Swanson (16:04)
Okay, so switching gears, I know we'll dive into this more in future podcasts and newsletters, but we're obviously very bullish. But any thoughts on where bank stocks can trade and how long this cycle can extend?
Joe Fenech (16:15)
Yeah, so if you think about the bank stock investment cycle, we've talked in the past about there being four stages to the cycle. They're pretty distinct when you look back at prior cycles, but when you're in one, the lines can get blurred a bit as you cross from one stage to the next. And again, even though the circumstances and the events differ and are unpredictable as you move through the cycle, these stages are the same in every cycle, which is why if you can accurately identify
the significance of milestone events, the market reaction and how it's likely to play out is very predictable. So just to quickly review, stage one is the actual crisis event, right? The period of actual crisis typically tends to be very short. In 2008, it was the failure of Lehman Brothers and Washington Mutual, I think the week or so before, or right around the same time. This time, it was the failure of Silicon Valley.
Signature Bank and First Republic over a period of about two months from March to May 2023. The stocks always bottom during the crisis or shortly thereafter and then you get this period of fear that lingers. So the stocks go up and fits and starts off the bottom, but you get these flash points where everybody thinks the crisis is reigniting, right? So stage two, so that's stage one. Stage two is what we call the early recovery period where again,
The crisis in actuality has passed. The stocks go up, but no one seems to want to buy them, right? Everyone then reluctantly acknowledges that the crisis is over, but then everyone wonders what the catalyst is. So back to these cycles always rhyming, in 2008, that period of stage two, I would say, extended from around 2008 until around 2011. Now, the 2008 crisis was much more serious than the 2023 panic.
So it stands to reason that the period where you sit in this purgatory of early recovery, I think is going to be shorter. So I think that stage two is ending as we speak for this cycle and we're moving into stage three. Stage three is what we call the normalization phase. Fundamentals and valuations start to normalize and you actually spend most of the cycle in this stage three normalization phase. Back to the 2008 example.
Stage three extended from about 2011 until the pandemic hit in 2020. And you could argue it probably would have extended longer than that if not for the pandemic. So I think we're entering stage three this time. And I think we're gonna sit here for a good long time into the 2030s. And if you think about where we are fundamentally, with a little bit more steepness to the yield curve, this interest rate environment is much better for the industry.
than the zero rate environment we sat in last decade. It's not gonna be better for everyone, but if you have a true sticky low cost core funding base, there's actually margin back in the business now for the first time since before the 2008 financial crisis. And I'll remind you, bank stocks traded at much higher valuations pre 2008 at these levels of interest rates than they have since the 2008 crisis when rates were mostly zero.
Again, I think the misperception is that it's the absolute level of interest rates that's the problem and caused the panic last year. It's not. It's how rapidly bank balance sheets had to adjust from the zero rate environment in which those balance sheets were built. So ironically, even though higher rates was the catalyst for the problem, the end result is a much healthier environment for the sector than we've seen in a long time. if your original question was where can the stocks trade?
The long-term historical average over three plus decades is around 14 times forward earnings and 1.7 times tangible book value. Bank stocks today, the regionals are trading at about 11.5 times 2026 estimates. Smaller banks are around 10.5 times. The industry is trading around 1.4 times tangible book, about 1.2 times XAOCI. You also looked at relative multiples.
The industry historically trades with around 80 % of the market multiple. Today it's around 55%. So you look at the S &P trading at over 22 times forward earnings. It usually trades about four to five multiple points less than that. And banks are trading a little more than half that level when it normally trades, the sector normally trades three multiple points or so higher than they trade today. So again, not calling for any type of crash in the broader market.
know, markets can linger in this sort of state of stretched valuation for a while. But I do think one way or another, that relative multiple has a lot of room to converge. And again, in the favorable fundamental environment we see coming up, who's to say that the long term average earnings multiple is the right target? But I think conservatively, thinking about a 14 to 15 multiple on 2026 earnings a year from now isn't unreasonable at all.
And if we're right about this long period of normalization we're entering into in stage three of this cycle, before we hit stage four cycle maturity, where you start to sow the seeds of the next crisis, we think it bodes well, not just for the near term for these stocks, but for an extended run into the next decade.
Kevin Swanson (21:36)
Thanks, Joe. And on that note, we're going to wrap up. Thanks to everyone for listening in. We'll have more to say on these topics and others impacting the banking industry in the coming months. Hope everybody has a great holiday season. Thanks.
