Sunday, 13 March 2011

Core Deposits Drive Value

The title of this post is common community FI phraseology. I hear it often, and use it often. My epiphany came when I performed research for a client that subscribed to the Return on Equity school of thinking. This FI had a high percentage of funding coming from CD's and FHLB borrowings, a relatively low loan to deposit ratio, and focused on generating profits within the investment portfolio.

The FI performed very well on an ROE basis. Its relatively low net interest margin, due to high funding costs and low yield on earning assets, was more than offset by very low operating costs. The FIs CEO lamented at his low trading multiples. I decided to dig into why his multiples were so low. It turned out that the best indicator for trading at high multiples was a low cost of deposits. I performed this research about ten years ago.

Dial forward to today and I decided to test again if the cost of deposits as value driver is still true. The results are in the table below. I searched for profitable banks & thrifts with at least 1,000 daily trading volume that had non-performing assets to assets less than 3%. The search yielded 101 banks and 30 thrifts. Not a large number but in order to get reasonable values I had to control for inefficient trading and asset quality.

Banks in the top quartile (best) cost of deposits traded at a 17.4% premium to bottom quartile performers in price to earnings multiples and a 35.5% premium in price to tangible book multiples.

Thrifts top quartile performers traded at an 18.9% and 30.2% premium on price to earnings and price to tangible book, respectively.

But could this be relating to their margin or yield on earning assets? I tested for yield on earning assets and the answer was no, there was no positive correlation between trading multiples and yield on earning assets.

There are imperfections to this analysis, though. Upon review, larger banks with greater trading volume also trade at higher multiples. This is probably the result of a greater pool of institutional investors due to volume requirements. Additionally, although trading multiples are beginning to show signs of improving, the overall trading of the banking sector has not returned to normal.

But ten years ago my analysis demonstrated that FIs with better deposit mixes and therefore lower cost of deposits enjoyed greater valuations. And today, the results are very similar. So why do so many FIs doggedly stick to asset-based business strategies?  Some, such as Sandy Spring Bancorp (see slide below), have been generating value from the liability side of their balance sheet and continue to do so.

According to Sandy Spring's latest investor presentation, the bank pursues a "strategic focus on small business, middle market and affluent retail customer relationships". Anecdotally, most small and mid-sized businesses do not borrow. So serving them, one would think, would require a focus on deposit relationships.

It appears as though Sandy Spring is winning, having 23% of their deposits in non-interest bearing DDAs and a cost of deposits of 0.49% in the fourth quarter. They trade at a 16.2x earnings multiple and at 130% of tangible book. It should be noted that Sandy Spring is headquartered in Maryland, a state that has experienced its fair share of credit challenges, hence the relatively low price to tangible book multiple from other top quartile banks.

Do you believe core deposits drive value? If so, why, and if not, why not?

~ Jeff

Special note: I am not making stock recommendations here. So don't call your broker to make a trade based on what I write. If you saw the performance of my stock portfolio, you would know what I mean.

Disclosure: My company has served as a strategic advisor to Sandy Spring within the past twelve months.

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