Have Banks Hit Their High Water Mark?


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Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 17 years of industry experience, 14 at Heartland.


Over the last six months, we’ve seen significant multiple expansion within the bank industry. Broadly speaking, large-, mid-, and small-cap banks since the election have seen their multiples on earnings and on book value increase pretty significantly.

Commercial Banks: P/B Multiples

Heartland Advisors Value Investing Market Insight Banks Price to Book Chart

Source: FactSet Research Systems Inc. and Standard & Poor's, 5/25/2012 to 5/19/2017. S&P 500 represents large-cap banks, S&P Mid Cap 400 represents mid-cap banks, S&P Small Cap 600 represents small-cap banks. All Indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.

Really what’s driving this are three things post the election:

  1. We saw interest rates work higher
  2. We saw business confidence move higher—this is suggesting, potentially, increased loan demand
  3. And there’s been some talk of some regulatory relief associated with diluting or removing some of the oversight that was put in place in the industry post the financial crisis

Clearly the multiple expansion has been more pronounced within small-cap stocks or small-cap banks.

That’s really not that surprising. Small-caps are more of a beta trade, if you will. But the multiple expansion has been noteworthy.

For instance small-cap banks have seen their multiples, pre the election until today, around this time frame or so, increase five points on a price/earnings basis. Large-cap banks to a lesser extent, about two points.

Why is that? I think two things really stand out:

  1. Small-cap banks are little bit more domestic-oriented, a lot of talk in terms of infrastructure spending. Perhaps small-cap banks have more exposure to that in terms of future loan growth than a multi-national enterprise.
  2. And also the regulatory burden perhaps being diluted or going away, that would have a larger impact on smaller-cap institutions given they have less resources than a large multi-national banking group.

Coming into the election, the Select Value Fund was overweight banks. And this was a lonely place to be.

Interest rates were really weighing on the relative performance of the group.

Obviously post the election—interest rates moving higher, some of the enthusiasm around future loan growth, business spending, less regulatory oversight has moved the group higher. We’ve seen this multiple expansion.

When we look at the broader risk and reward in the banking universe today, clearly the pronounced move that we’ve seen in small-cap stocks gives us a little bit of pause.

The bar has been raised. Expectations are very elevated around future loan growth, regulatory relief, etc. So we don't think that the risk/reward is as attractive, perhaps, in some of the smaller-cap banks out there.

Heartland Advisors Value Investing Market Insight Bank Weighting Graphic

Source: FactSet Research Systems Inc. and Russell®, as of 10/31/2016. Shown as percentage of Equity Investments. Index weighting does not include unassigned holdings. Portfolio holdings are subject to change. Current and future holdings are subject to risk. View a complete list of the Fund’s portfolio securities as of the most recent quarter end.

We think that we need to be mindful that we’re perhaps late in the game from a credit cycle.

Lending standards have been tightening for some time. That's usually a precursor to future weakness in overall credit.

We’re seeing signs of the foundation in some places starting to crack. For instance, auto loans have been getting a lot of press here recently.

What could be other pockets of weakness? It could be in the multi-family space, as a lot of capital has flowed into building departments across the United States.

Overall we think the risk/reward is a little bit more challenge.

We’ve been taking our exposure down in some of the smaller-cap banks because the valuation has exceeded what we think is an attractive risk/reward. And we’re putting that capital in some larger-cap Institutions within the banking universe that we think are a little bit more diversified from a revenue standpoint, and have shown a history of success managing through a credit cycle.

Heartland Advisors Value Investing Market Insight 3 Bank Impacts IconsI think for banks to continue to be a relative outperformer versus the broader market over the next six to 36 months, there's three items that are out of their control that are going to be very important:

  1. What happens with interest rates?
  2. Does credit continue to be in a good spot?
  3. And what kind of regulatory relief are we going to see out of Washington, DC?

We’re going to be monitoring those. But we think by looking at the company specifics, and unearthing those ideas or companies that are attractively priced versus peers, and perhaps with a really definable catalyst for recognition—that’s how you outperform this particular industry going forward.

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