Investing in Bank Stocks

Richard Lashley: 

Good morning, Elana. 

Elana Margulies-Snyderman: 

Rich, to kick off the conversation, love to hear more about yourself and PL Capital. I know that PL Capital is one of a small number of investment firms which uses shareholder activism in the banking sector. 

Richard Lashley: 

Yeah, so PL Capital, the P and the L stands for John Palmer, my partner, and myself. The two of us started at KPMG, the accounting firm, back in the 1980s and early 1990s. We were CPAs in the Audit Practice at KPMG, and then from 1993 to 1996, we were in a very unusual group. It was fairly cutting edge for a CPA firm. We were doing full-scope financial advisory for banks around the country. So, we learned about bank M&A at that time. And then we left KPMG in late 1995, early 1996, to start PL Capital. We've been doing the same thing ever since, so almost 30 years now. We're a niche RIA that specializes in U.S. bank stocks. Now to set the universe, there's about 4,500 banks in the country. We only invest in publicly traded banks, which is about 300 or so that have enough volume to be investable, and we specialize in community banks. So, what's a community bank? A community bank is generally a bank with assets over a billion and let's say less than $25 or $30 billion. So, it's not the regional banks, not the money centers, it's your typical community bank and your typical market around the country. In terms of market caps, those banks typically have $100 million to several billion in market cap. And to size that, the Russell 2000 is typically cut off at around $150 million. So, we often have banks that are trading on either side of the Russell cutoff. We concentrate our capital. It's sort of like a PE firm. Top 10 positions are typically three-quarters of our capital. And then we look to make money by two ways, and we ride the wave of banks making money. So, they improve their earnings, they create a tangible book, they pay dividends, the normal way you would make money from a stock. And then the second way we make money is through M&A when these banks decide it's time to find a merger partner. And then as you mentioned, we use shareholder activism where we need to, to help these banks make the decisions about what they should do. So, what is shareholder activism? You probably appreciate that there's really two types of shareholder activists. They're the ones that are very public, make a lot of noise, run proxy contests, use litigation, are very aggressive basically. And then there's the type of shareholder activists that are less aggressive, do more things behind the scenes. I'll admit, when we first started PL Capital, we were a much more aggressive firm. We were using proxy contests and public debates with the management teams and boards to try to effect change. What we've learned over the last 15 years or so is we can actually get more done by working behind the scenes privately, so you don't see us filing for proxy contests very often. The last time we actually went to a vote at an annual meeting was 2011. So, it's a different firm today than when we started. We typically like to have board representation on banks that we have a significant amount of capital in. Any given time, we're typically on half the boards of the top 10 or 12 positions. 

Elana Margulies-Snyderman: 

Rich, in recent years, banks have faced a slew of challenges, from COVID-19 to fluctuating interest rates to several high-profile bank failures in early 2023. Love to hear your thoughts on the current state of the industry. 

Richard Lashley:

When you think about what banks have gone through in really the last five years starting with COVID in early 2000, no one knew what was going to happen with the economy, with real estate. If you remember, everybody was scared that every store, every hotel, every office building would be empty. People were working at home. So, there was a lot of fear about empty office buildings. So, what did banks do? They did what they're supposed to do. They built their loan loss reserves up to a significant amount, and here we sit four or five years later, and the reality is those losses never happened. So, those loan loss reserves that have been built up have really not been used, and they're available today, which is a good thing. And why did we not have the losses that everybody thought we would? I think it comes down to what the U.S. government did between the fiscal and the monetary stimulus. The PPP, it's an acronym, I'm sure you remember, where the government gave out a lot of low interest loans through the banking system. It did two things. One, it helped the bank customers survive, helped a lot of businesses survive, and it also created a lot of income and fees for the banking system. The bad side of COVID for banks was that interest rates got cut to zero and banks are not built to withstand 0% interest rates or very low interest rates for an extended period. So, what ended up happening over the course of 2020 and 2021 and early 2222 when rates were low, a lot of the balance sheets of the banks got repriced. So, they ended up with a lot of low fixed rate assets. And then in 2022 when inflation started picking up and interest rates started to rise, they were stuck with low fixed rate assets as their borrowing costs and their funding costs started to rise. So, there was a real challenge from the whipsaw of interest rates going really low and then really high, which for banks hurts their earnings, hurts their margins, hurts their tangible book values. The other thing that happened on rates is the yield curve became inverted. So short-term rates were higher than long-term rates, which is not a good environment for banks. Banks make more money when the yield curve is positively sloped. And then now we're in 2023, banks are under pressure. What happened in March of 2023? Several large, very important banks, Silicon Valley, First Republic, Signature Bank, Silvergate all failed within a month or two, which really put a lot of concern into the system. We did not believe it would be a systemic issue for the banking system. We just weren't seeing it. And we had the benefit of sitting on boards, so we knew what was happening on the ground level, and we just did not see it becoming a systemic issue for the banking system. But it was definitely a problem for a while. So, now we're two years into it, very few other banks have failed, and it's much better today than it was two years ago, three years ago, five years ago. Interest rates have stabilized, the Fed is done raising rates. The yield curve, most importantly, is now positively sloped. So, banks can raise money with deposits at a lower rate than they can lend it out in terms of their loans, which is a great thing. It normally takes banks about three to five years to adjust their balance sheets and adjust their interest rates. So, we're a good two to four years into that three-to-five-year adjustment. Little more work to do, couple more years of restructuring and adjustments. But generally speaking, banks are making more money every day now than they were before. So, 2025 and 2026 earnings are looking really good. The fundamentals are arguably as good as they've been in the last seven or eight years. So, what does that mean? It means we're going to have more earnings. We're going to have tangible book value grow. We're going to have loans and deposits growing at normal rates. Credit risk is actually much better than people think. We don't have time to dig into all the details, but the average community bank has very good credit, a very good credit profile. So, we are not worried about credit risk. When you hear stories in the newspapers about big office buildings in downtown city areas, those are loans that are in the CMBS market. They're not in the community bank market. We're also facing a new administration, which you can debate whether it's going to be good or bad, but the one thing it will do is reduce the regulatory burden on the banking system. And banks are building excess capital, which is going to mean more dividends, stock buybacks, et cetera. So, it's actually a great time for the banking system after a tough four or five years. 

Elana Margulies-Snyderman: 

Rich, we've seen a lot of consolidation in the banking industry for the past 40 years and wanted to get your thoughts whether or not that will continue. 

Richard Lashley: 

When John and I started in the banking business in the early 1980s, there was 18,000 banks in this country. Way too many. There's about 4,500 today. Consolidation occurs at the rate of about 3%-5% a year. So, call it 120 to 200 banks a year are merging out of existence. So, it'll be years to come before we're done with M&A. And the flip side of it is, while banks are merging and the number is shrinking, we're not creating any new banks. When we started in the early 1980s and early 1990s, there were new banks being formed all the time. There's virtually no new banks being formed. So, it's just a number that's dropping every year. Big banks still dominate the business, but we still have 3,700 banks between $100 million and $10 billion in assets. That's still way too many. The really small banks, so let's define a small bank as less than $100 million in assets, in 1990, there was 10,000 banks in this country with less than $100 million in assets. That's amazing to me. Today there's only 700 left, less than $100 million. Banks that size will go away. There won't be very many banks left in this country less than $100 million. And then the banks between, say, $100 million and $50 billion, there'll be a massive amount of consolidation. So, the 3,900 banks that are in that bucket, they will shrink down to let's call it 1000 in 10, 15 years. Why do banks merge? They merge for efficiency in economies of scale. They merge for market share; they merge for growth. Most banks only grow at the rate of 5% to 10% a year on an organic basis. When they do M&A, they can grow much faster. So, M&A is part of the landscape for almost every bank in this country. In terms of validating that M&A makes a difference, when you look at the return on equity for banks, the banks that are the smallest have the lowest return on equity of any banks. And then as you increase the size of the bank, there's a correlation with higher returns. So, M&A works. It creates a more efficient bank, a more profitable bank. And if you think about COVID, in the last few years of vacillating interest rates, we had very little M&A. It was very hard to do M&A when things were changing so rapidly. And M&A occurs when the buyers have a strong stock price, and most banks didn't have a stock price that allowed them to do M&A in the last five years. That's starting to change. It's already happening as we speak. Anecdotally, we know there's a lot of conversations going on. So, you will see M&A catch up in a rapid way over the next five to 10 years. The reason M&A works, and this is a little bit of math and it's hard to do in a podcast, but the reason M&A works for banks is the cost saves are very significant. In a typical bank deal, the operating expenses get cut 25% to 50%. So, you don't need two CEOs, you don't need two headquarter buildings, you don't need two computer systems. The operating expense cost saves are very large. And the rule of thumb is that the target earnings, the bank that's the target, what their earnings are before the deal and what they are after, is you double the earnings from the cost saves. So, if a bank target is making $10 million a year on its own, after the merger adjustments, that bank will be making $20 million of earnings in the hands of the buyer, which is what allows them to pay a premium to the stockholders of the selling bank. It's really the way PL Capital makes money. M&A math is so compelling. And if you think about the math, if you're a board member and you're growing your bank, your management team is growing the bank 5% to 10% a year, and I come in as the investor and say, "I know a way you can double your earnings through selling the bank," the math is so compelling, it's very hard for those boards and management teams to fight off the inevitability of M&A. 

Elana Margulies-Snyderman: 

Rich, given that outlook for the banking industry, what is happening to bank stocks? Where are the biggest opportunities for investors in bank stocks? Is it money center banks, regional banks, community banks? Love to hear your thoughts on this. 

Richard Lashley: 

Yeah, it's tied to the fundamentals, which I already covered. So, the fundamentals were really tough for the last four or five years. They're much better now. They're going to be much better in 2025 and 2026. So, bank stocks obviously follow the fundamentals. They've already started to improve somewhat in the second half of 2024, but there's a long way to go. The fundamentals are much better than the valuations. Valuations still remain well below historical levels. We have numerous banks that are trading for less than 10x earnings, where 15, 20 years ago, a bank would normally trade at 14 to 16x earnings. And we have many banks that trade less than 100% of their tangible book when in a normal world, banks would trade for 130% to 200% of tangible book. So, valuations are low, fundamentals are good. Bank stocks should do really well over the next few years. They're building up excess capital, which means higher dividends and stock buybacks, which is good for stock prices. And probably most importantly, the really large institutional investors that have been absent from the bank stock market are definitely, definitely back. Every time we go to a bank conference in the last six months, it is more populated with large institutional investors than at any time in the last five years. In terms of where to invest, if I was an investor taking a look at the bank sector, you can really go from the largest money center banks in this country all the way down to micro-cap banks with small market caps. They're all positively positioned. Personally, I think that community banks, so-called banks with a couple hundred million in market cap up to a couple billion, those are the best positioned banks. They are the ones that probably had the most stress in the last four or five years where the big banks and the regionals were better positioned. So, I would argue that community banks are the place you want to put your money, and that's where PL Capital is putting its capital. 

Elana Margulies-Snyderman: 

Rich, we've covered a lot of ground today and wanted to see what your firm's future plans are. 

Richard Lashley: 

Really no significant changes in our business model. The business model is to invest in banks. Banks make money. They compound their earnings and their capital gradually over long periods of time. It's a wealth-creating vehicle for PL Capital and other investors. It's also a wealth-creating vehicle for a lot of families around this country who've created significant wealth over long periods of time. So, the banking model is sound. Banks are not going away. They will make money for investors over a long period. So, we will stick to our knitting of investing in U.S. publicly traded banks. And our strategy of proactive shareholder activism works. We're able to get on boards, we're able to make fundamental changes. We're able to improve the performance of the banks given our expertise and experience over the last 40 years in banking. So, the PL Capital model works. There's very few firms that do what we do, primarily because John and I have unique backgrounds, which allows us to do it. So that is not going to change. And then as I said before, bank M&A will continue for much longer than I'll probably be alive. I'm 66 years old. I'm not sure how long I'll be doing this, but PL Capital will be around for a long time and the banking system will be around for a long time. 

Elana Margulies-Snyderman: 

Rich, I wanted to thank you so much for sharing your perspective with our listeners. 

Richard Lashley: 

Yeah, thanks for inviting me. 

Elana Margulies-Snyderman: 

And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics and join us for our next EisnerAmper podcast when we get down to business. 

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