Too Small to Succeed in Banking

Conventional wisdom: The onslaught of new banking laws, regulations, and regulatory activism requires scale to absorb costs. Or, the rapid pace of technological change and the sophistication of hackers requires resources not found in small community banks.

There is truth to conventional wisdom. But with all generalities, there are exceptions. And in banking, lots of exceptions. How do I tell the $250 million in asset client that I just visited that they are too small to make it, even though they sport a 1.47% ROA? The financial institution landscape is littered with banks and credit unions like my client.

Almost two years ago I wrote that bank shareholders were changing. (see The Coming Bank Consolidation) Community bank investors used to be the local insurance agent, mortician, and family that sits next to us in church. Today, many of traditional bank investors put their money in mutual funds, and leave the investing up to fund managers. No longer does the local barber show up at our annual meetings complaining about the pastries. Instead, professional money managers call to tell us how to run the bank.

As we migrate towards greater institutional ownership, stock liquidity is becoming increasingly important. Occasionally money managers call me with their criteria for their fund. One criteria is typically float and volume. Under 10,000 shares trading volume you say.... fuggedaboutit! 

My firm is occasionally called upon  to value banks that don't trade. Part of the valuation includes a discount for the lack of liquidity. Not a term foreign to other industries, by the way. In determining the discount, we look to trading markets to see the discounts applied, if any, to thinly traded bank stocks compared to their high volume brethren.

I recently ran an analysis of banks that trade over 10,000 shares per day, to those that trade 500-10,000 shares per day. The results are in the table below.

I controlled for financial performance (greater than 1% ROA), and asset quality (less than 2% NPAs/Assets). Of course, more performance and market data factor into trading multiples, but I couldn't control for everything. The result: Low Trading Volume financial institutions trade at a price/tangible book ratio of 110.5%, and a price/earnings ratio of 12.1x, compared to High Trading Volume FIs at 160.6% and 13.2x respectively.

What do I think community banks can do about the disparity?

1. Get a real investor relations program. Bankers think we should actively court investors when we need capital. Not so. Trading multiples are a direct result of supply and demand. If you want greater multiples, build demand... always.

2. Focus on retail investors. Community bankers think they can tap the institutional market. Investment banking firms tell them so. The truth is, institutions willing to invest in a bank that trades 2,000 shares per day are typically those that expect to exit the stock by selling the bank. How else can they exit your stock at such low trading volume? One benefit of having local, retail investors is they tend to have greater patience when implementing strategic change. To institutional investors, you are a number on a spreadsheet. If you take institutional money, plan their exit before they invest anything.

3. Perform. There is a positive correlation between financial performance and condition, and trading multiples, period. 

Banks that trade at low trading volumes trade at lower multiples and may be shut out of the institutional market for capital. Those that don't build retail investor demand for their shares may be required to sell if they need capital. You may be too small to succeed, but not because you can't deliver superior performance. But because nobody will invest in your bank.

~ Jeff

Where will banks get their next dollar of capital?

Retained earnings.

I make a living helping financial institutions be as profitable as feasible. Why? To perpetuate their business model. This is how I feed my family.

But profits have been under pressure since 2008. First, FIs experienced pressure in their investment portfolios, purchasing Fannie Mae preferred's and other FIs trust preferred securities. Next, our over-exposure to construction and land development loans came to roost. Then commercial real estate fell under pressure as the economy teetered and rent roles declined.

Many banks had to replenish lost capital. The government stepped in to help, and taught us to ignore the guy/gal that knocks on our door and says "I'm from the government, I'm here to help." Absent or in concurrence with government-injected capital, FIs sought fresh capital.

But retail investors were nowhere to be found. This was one of the points made by Lisa Schultz of Stifel, Nicolaus, Weisel, an investment banking firm that specializes in FIs, at a recent Pennsylvania bankers conference.

Ms Schultz said retail investors were absent for all industries, not just FIs. She opined that they opt instead to invest in mutual funds, hedge funds, etc. Therefore, all of the action to attract capital was in the institutional market. I made this point in a past blog post, opining that the change in our shareholder base would be a significant factor driving future bank consolidation.

The change in shareholder focus, as presented by Ms. Schultz, is represented in the tables below. But this changing focus is from the institutional shareholder perspective... not the retail investor. The future investor will be concerned with quality growth that enhances shareholder value, combined with dividend policies that are mindful of capital preservation. I'm not sure how an FI will meet the 20%-30% capital appreciation, combined with sufficient liquidity, to meet "future", i.e. institutional, investor demand.

As if the shifting focus of the institutional investor wasn't challenging enough, what about the difference in what retail versus institutional investors value, and how they plan to exit their investment (see table below).

Tough luck finding your institutional investor at the local coffee shop bragging that they own stock in your institution. They could care less about how much resources your FI dedicated to the local food bank.

Here is what I think community FIs can do now to prepare for this shift in attitude:

1. Maximize retained earnings to reduce the need to visit the capital markets.

We have gotten a multi-year pass in generating profits because of the financial crisis and the subsequent teetering economy. Now it's time to cowboy up. How productive are your front line employees? How efficient is your back office? How well have you leveraged technology? Have you over-reached with your compliance program? If you don't have the answers, you better start looking for them.

2. Get a real investor relations program.

Investor relations is marketing. Marketing is much more than advertising. And your marketing message must be delivered long before you ever need capital. You must spin a story that gets locals excited about your bank. Yes, financial performance will play a significant role, but a supporting role to the story you tell about how your FI is a critical component to local communities. Retail investors may have shifted to investing in mutual funds, but the local community bank is probably one of few chances locals can invest in a company down the street.

3. If you must tap the institutional market, choose your partners carefully.

Ms. Schultz specifically addressed this issue in her presentation. Search for institutional investors that share your FIs objectives. Where did this fund invest? How long did it hold the investment? How did it exit?

4. Prepare for the exit strategy from the time of investment.

Receiving significant institutional investor dollars does not mean a fait accompli in terms of having to sell your FI so the investor can get out of the stock. However, if you don't plan for the investor's exit when they make their investment, the clock may run out when they are ready to go. Make evaluating strategic alternatives a regular part of your strategic planning, developing financial projections for a stretch case, base case, and stress case. See my post on this subject here. Also, make financial performance, investor relations, and stock trading liquidity a part of your strategy from the git go. If not, you'll find your FI might have up and went.

Where will your FI get it's next dollar of capital? I would like to know.

~ Jeff