Last year was a rollercoaster for bank stocks. We were fortunate to be underweight the sector relative to our history heading into the pandemic. By March 2020, the regional bank index declined over 50% from the start of the year as the pandemic instilled fears of a major recession and credit losses not seen since the Great Financial Crisis. You may recall we began to warm back up to banks during Q3 2020 for a number of reasons and significantly increased net exposure. From the end of Q3 2020 to now, the regional bank index has increased 86% due to unprecedented stimulus, higher rates, the mass vaccination effort, benign credit quality, and a gradual return to normal.
The stunning performance over the past six months begs to ask the question “is the bank rally over”? While the “easy money” has been made, we believe the sector has further upside. Arguably the largest source of potential upside is the continued improvement in the interest rate environment. Last year, the 10-year Treasury yield hit an intra-day low of 32 basis points in March and has since rallied to 164 basis points. A continued increase in the long end of the curve is beneficial to reinvestment rates on securities and loan yields to retail customers. Inflation concerns are also starting to influence the market and there is discussion of a Fed Funds hike in 2022 - the Dallas Fed President expects a rate hike next year along with three other FOMC members. This would be a boon to commercial banks which price commercial loans off short-term rates.
We are also encouraged by the resumption of bank merger activity in Q4 2020. In a post-COVID environment, achieving economies of scale and digital synergies via M&A (and internally for the matter) is a path to higher profitability. Based on conversations with management teams and commentary from investment bankers, we expect M&A to meaningfully accelerate.
While loan growth has been muted given the impact of the pandemic and subdued economic activity, a continued recovery should be supportive of loan growth. Some bankers we’ve spoken with are optimistic regarding growth in the back half of 2021, given improving pipelines and conversations with potential borrowers. Notably, banks are sitting on excess amounts of liquidity and can meet a spike in loan demand. Banks are also resuming share repurchase programs and the Fed announced they will be removing temporary restrictions on shareholder returns for most banks on June 30th. As a result, it’s possible for some banks to achieve mid to high-single digit yields on dividends + buybacks relative to current prices, which we view as highly attractive in today’s market environment.
Despite these tailwinds, the sector retains defensive attributes as mentioned in previous writings. To summarize, banks remain overcapitalized relative to history, even with massive loss reserves built over the course of 2020 (which we expect to be released over time). The sector continues to retain low-risk loan books and is awash in excess liquidity given government and monetary stimulus. While valuations for the sector have recovered from bottom decile relative to history, they remain inexpensive. Since 1992, bank stocks remain cheap at the 26th percentile at just under 13x forward earnings. On a price-to-tangible-book-value basis, the sector is valued below average at the 42nd percentile or 1.9x. Assuming the aforementioned earnings tailwinds continue to take hold and multiples expand, there is meaningful upside. For aspirational purposes, at the 70th percentile of historical valuations, the sector would command a P/E of 16x and 3.3x on a price-to-tangible-book-value basis.
Editor’s note: The blog above is an excerpt (lightly edited) from our Q1 client letter that was written in late March 2021. We believe the information remains relevant at the time of publishing.