William Waller and Jason Stock, founding partners of M3 Funds, recently wrapped up their presentation at the Value Investing Congress, entitledBanks: Have We Seen the Worst of It? The following are our notes.
M3 Funds: Investing in Under-followed Banks
- Manage a long/short equity fund focused on the U.S. Banking Thrift Sector. M3 focuses on under-followed banks. There are 1,300 publicly traded banks, 5,500 private banks, 700 mutual banks and 7,900 credit unions. M3 focuses on publicly traded banks—93% of which have a market cap below $500 million. Jason believes he has a competitive advantage in investing in under-followed banks.
- He views a bank as a leveraged play on the market in which it operates. M3 conducts research on individual banks through extensive travel, public records searches, private banks and credit unions, FDIC data—call reports, real estate agents and developers.
State of U.S. Banking Sector
- Sector is significantly under-capitalized. This is the sector’s #1 problem.
- Credit quality has deteriorated and will continue to deteriorate.
- The number of bank failures is accelerating.
- Tangible equity/asset ratios have “fallen off a cliff” in 2007-08 and are 4%-5% vs. historical levels of 6%-7%. These ratios are not sufficient to handle the losses that will come in the future.
- Total delinquencies: Construction 12%, 1-4 Family 8%, CRE 2.6%, C&I 2.8%, consumer 5%.
- Jason says that call reports are the best way to analyze banks.
- Where we are headed: Commercial real estate (CRE), consumer loans (auto, credit cards)—have yet to see meaningful deterioration on many banks’ balance sheets. Auto loans have held up rather well but he’s starting to see deterioration in this category of loans.
- Jason sees a significant amount of bank failures in the future. There have been about 30 bank failures YTD. He sees this number rising to 150+ by the end of the year. He said that regulators might be overwhelmed (not enough staff) and thinks that they could shut down over 100 banks right now if they had enough people.
- Can TARP, TALF, PPIP, accounting changes help? They will help some banks, but not all.
State of Commercial Real Estate
- Unemployment will continue to rise and commercial real estate is the next shoe to drop.
- Roughly 25% of all CRE is securitized, most of which was originated between 2002-07 and is now beginning to come due.
- CRE vacancies are rising—commercial foreclosure process is just beginning, which will impact all commercial values and CAP rates.
- The primary problem areas include: retail strip centers and office.
Investment Approach: Criteria for Long Positions
- Low price to tangible book value, excess capital
- Low loan to deposit ratio
- Attractive markets (looks at real estate and employment trends—likes state capitals and university towns for longs since these provide a very stable job base)
- Bearish management team
- Share repurchase plan
- Attractive deposit base
- Excess capital is the number one statistic that M3 focuses on
- Jason also said that a bank’s biggest asset is its liability base (deposits) and a bank’s biggest liability can be its asset base (loans)—he views the deposit base as a hidden asset.
Long Investment Idea: First of Long Island (FLIC)
- $1.25 billion asset bank headquartered in Glen Head, NY.
- 140% of tangible book value and 11x LTM earnings. Hidden value in branch ownership would increase TBV by 15%.
- Excess capital: 8.5% common tangible equity/assets.
- 68.5% loan to deposit ratio—very disciplined underwriter. $1 billion of high quality deposits with a 1% cost. Pristine credit quality: very low non-performing assets at 3/31/09.
- Near term catalyst: Russell 2000 addition requires 400K+ shares.
Investment Approach: Criteria for Short Positions
- Overstated or declining tangible book value, thin capital structure
- Negative credit trends—rising early stage delinquencies, out of market exposure—high severity loss markets
- Bullish management team
- High-cost deposit base and wholesale funding
- Aggressive underwriting—high growth rates and risky securities portfolio
Short Investment Idea: FNB Corporation (FNB)
- Do not think it’s a zero, just trading too high given credit risk they have.
- Trades at over 2x tangible book and 20x LTM earnings.
- Thin capital structure—4.5% common tangible equity/assets ($357M). $294 million of loans in FL of which 50% are land loans.
- Credit quality is deteriorating—over 2% of assets are non-performing.
- High severity of loss on the FL exposure—reserves are insufficient.
- Loan mix—33% consumer, 30% CRE, and 20% C&I.
- The company should trade down to book value and will need to raise additional capital in the future.
- The U.S. banking sector remains under-capitalized.
- Commercial real estate and C&I loans pose a serious threat to the banking sector.
- The Fed’s current actions are creating long-term risks for the banking sector and the broader economy. Common stockholders are at risk in the majority of banks.
- Recommendations for investors: Find a niche and become the ultimate expert. Utilize technology and creative strategies to gather information. Timing the market is difficult; develop a firm thesis and be disciplined. Manage risk well—never concentrate a portfolio in one investment. Always ask yourself if you have a competitive advantage. Don’t just read it or hear it—go see it for yourself.
- Q&A: Which banks do you think are zeros? Very small, obscure community banks would be high on the list. He thinks that Citigroup (C)and Bank of America (BAC) common shareholders could potentially get wiped out.