Good morning thread...
I appreciate the response from
@bwall and
@Grafter . A good nights sleep also helps after chaos at work and watching the account. I stick with 60% or more in index funds and am not risking my retirement in this. I also started doing a few things to my portfolio in 2017 attempting to get a little less volatility for lower return.
Right now I'm down 11.9% from the peak vs. 18% for the S&P. I didn't get the returns of the market in 2017 because I stayed partially away from tech stocks that didn't make money, this lower volatility portfolio and some strategic buys have helped this year.
What Grafter said is SPOT ON. This strategy is not for anyone. If you're going to play, play where you have an edge. I finance real estate and privately held businesses in boring industries. Some of my strategic buys this year have been: A couple of specific low leveraged REITs when the price collapsed over interest rate fears.. A specific restaurant chain with barely any debt and owning all their properties had their earnings flatten out and its underlying qualified dividend hit 7%. Why did it collapse? The entire sector did, taking down an otherwise good company with it. Even after the entire market going down nearly 20% those positions are up double digits.
Bank stocks have been hammered as a whole. There's lots of reasons to worry. The big guys can't grow anymore, continue to have to squeeze costs out, and at least one of them has an awful reputation. You don't want to be in the investment banks when economic activity slows and their fee business is under assault. I also think the Banks under $20bil are dead companies walking unless they have a core deposit base of 35-40% or more funding their loans. Those facts along with a total market decline caused the financials to lead this downturn (although that started turning Wednesday, their decline is decelerrating. I think the large regional banks are being tossed out and thrown into these same buckets. Their issues just aren't at the same level and there's a bunch of fat they can still cut out of the business. Instead of just loaning into this industry, I work in this industry and I haven't seen a discount like this since February of 2009.
Here's the math I wanted to share on why I've chosen a basket of regional banks as my next strategic move.
Hypothetical Bank - Lets call it FISH Bank
Earnings Today: $2/share/year
Regional Bank P/E: 8x
Stock Price: $16
Payout Ratio: 40% (This is basically restricted by the government through a process known as CCAR)
Dividend: $0.20/quarter, $0.80/yr
Shares Outstanding: 1.25bil
Since payout ratios are capped, banks return the rest of their earnings in share buybacks. The math works out to be $1.20 available for share buybacks times 1.25bil shares is 93.7 mil shares redeemed. That’s 7.5% of total outstanding float. Banks have been trading in the 15-16x PE before this, so they’ve only been able to reduce their float by 3-4% over the past through years. Earnings have grown from interest rates and lower corporate taxes, so the buyout amount has doubled.
To continue this example, next year’s share’s outstanding: 1.156bil. Earnings would have to decline by more than 7% for EPS not to grow at these prices. There’s lots of headwinds to top line growth, but the big 4 consulting companies are in all the major backs whacking out costs. There’s a LOT more costs they can eliminate too.
So what will happen to earnings:
- Interest rates are going up, regional banks tend to be weighted more towards variable rate loans than fixed rate loans
- Deposit costs will go up. Regional banks have more transaction accounts than other banks, so their deposit costs will go up slower than loan rates
- Defaults will go up in a bad economy. Correct. Problem loans / chargeoffs would actually have to double before banks have to increase their loss reserves. This gets into more complex accounting, but basically when problem loans tick up, the bank expenses more money into reserves. My math is showing they would need to double.
- Regional banks mainly do loans with asset coverage. These are loans on commercial real estate or to operating companies to buy a building, equipment, fund receivables. When they go bad, the entire loan isn’t charged off, only a portion of it.
- If we get inflation, it reduces problem loans. The bank’s loan amount is fixed while the underlying collateral increases in value. Inflation doesn’t hurt this industry as much as others.
- Regional Banks also do most of their business domestically. The trade wars may drag on the economy, but if it helps manufacturing then it helps producers.
My summary:
The huge risk as a shareholder and what happened to a lot of banks in 2008-2009 is they had to issue equity at the bottom to raise capital and it crushed the shareholder. The restriction of payout ratios means they can slow their buybacks if they need some capital. It would require a cataclysmic collapse for banks to have to issue equity at the bottom again. We just aren’t anywhere near that insanity on dumb loans. (I worked for this revered bank in 2008 that didn’t have to issue equity and still made money, this “revered” bank was still making 100% financing loans on spec houses to homebuilders!!).
I think many of these banks can still get 5-10% more in total top line earnings before the peak, then the buyback power will far offset any flattening of earnings. I also think once we’re through whatever this slowdown/recession/dip looks like and the banks prove themselves stable, the feds let that payout ratio tick up to 60-65%. At that point they’ll start getting utility style multiples at 14-20x PE .
Where real money is made is there is an entire generation of bank leadership retiring. Nobody went into this industry between the mid 80s and mid 90s because they didn’t pay. All the pre 1985 start bankers are retiring and there’s not enough people in the 20 year or less experience range to operate all these banks. They have to consolidate and are consolidating at the smaller end. We’ve gone from 7,000 to around 5,500. This should look like the grocery store business with a couple of competitors in small markets and 10-15 in the big metro cities. Today banking has 15 competitors is small markets and 150 in metro markets. That’s a ton of duplicate management, facility, and IT costs that will eventually be stripped out of the industry.
I’m long the basket of regional banks: BOH, CFR, KEY, RF, STI, PNC, USB