Banking's Total Return Top 5: 2014 Edition

For the past three years I searched for the Top 5 financial institutions in five-year total return to shareholders because I grew weary of the "get big or get out" mentality of many bankers and industry pundits. If their platitudes about scale and all that goes with it are correct, then the largest FIs should logically demonstrate better shareholder returns. Right?

Not so over the three years I have been keeping track.

My method was to search for the best banks based on total return to shareholders over the past five years... capital appreciation and dividends. However, to exclude trading inefficiencies associated with illiquidity, I filtered for those FIs that trade over 1,000 shares per day. This, naturally, eliminated many of the smaller, illiquid FIs.

For comparison purposes, here are last year's top five, as measured as of December, 2013:

#1.  BofI Holdings, Inc.
#2.  Marlin Business Services Corp.
#3.  Fidelity Southern Corp.
#4.  Eagle Bancorp, Inc.
#5.  Bancorp, Inc.

This year's list is in the table below:

BofI Holdings celebrates its third straight year on this august list. Congratulations to them. A summary of the banks, their strategies, and links to their website are below. 

#1. Open Bank (OTCQB: OPBK)

Open Bank commenced operations in 2005 as First Standard Bank in the Koreatown section of Los Angeles. They are built as a relationship bank serving the Korean community in LA and surrounding areas. It is a significant SBA 7(a) lender, ranking in the top 100 (#54) in the country in that category, ahead of much larger financial institutions like Bank of America. Year to date through September 30th, Open Bank had $4.5 million gain on sale of loans, representing 24% of its total revenue for that period. The lion's share of their growth, profitability, and capital have come since their re-branding to Open Bank in 2010. In June, the bank raised an additional $30 million of common equity, positioning it to continue its strong growth.


#2. BofI Holding, Inc. (Nasdaq: BOFI)

BofI Holdings Inc. and its subsidiary BofI Federal Bank aspire to be the most innovative branchless bank in the United States providing products and services superior to their competitors, branch-based or otherwise. In its latest investor presentation, BofI claims that its business model is more profitable because its costs are lower. It supports the claim by highlighting its efficiency ratio is in the top 2% of UBPR peers, and its operating expenses as a percent of average assets are in the top 12% of peer banks. So, as a branchless bank, BofI has leveraged its significantly lower operating expenses into profit. That profit led to the top spot in five year total return to shareholders, three years running. Well done!

#3. BNCCORP, Inc. (OTCQX: BNCC)

BNCCORP, Inc., through its subsidiary BNC National Bank, offers community banking and wealth management services in Arizona, Minnesota, and North Dakota from 14 locations. It also conducts mortgage banking from 12 offices in Illinois, Kansas, Nebraska, Missouri, Minnesota, Arizona, and North Dakota. BNC suffered significant credit woes during 2008-09 which led to material losses in '09-10, and the decline in their tangible book value to $5.09/share at the end of 2010. Growth, supported by the oil boom in North Dakota's Bakken formation, and a robust mortgage refinance business resulted in a tangible book value per share at September 30th of $17.18... a significant recovery and turnaround story that landed BNC in our top 5 for the first time.

#4. Western Alliance Bancorporation (NYSE: WAL)

Western Alliance, through its subsidiary Western Alliance Bank, provides comprehensive business banking and related financial services, operating full service banking divisions in local markets as Alliance Bank of Arizona, Bank of Nevada, First Independent Bank, and Torrey Pines Bank. It also has a national platform of specialized finance units in homeowners' associations, public finance, resort finance, and warehouse lending. Its diversified and primarily commercial loan portfolio and a loan/deposit ratio of 91% resulted in a year to date net interest margin of 4.41%. This margin plus a 2.07% operating expense ratio resulted in a YTD efficiency ratio of 47%. That type of financial performance plus picking yourself up from credit problems leads to top 5 total returns for your shareholders. Well done!

#5. Mercantile Bank Corporation (Nasdaq: MBWM)

In June, Mercantile Bank and Firstbank Corporation closed on a merger of equals to form the fourth largest Michigan-based bank by deposit market share. Firstbank traced its roots back to the 1800's, while Mercantile was founded in 1997. As part of the transaction, Mercantile shareholders received a $2/share special dividend prior to closing, shaving off of tangible book value. But the total return story is similar to others on the list. Mercantile suffered through its share of credit snafus, losing a collective $70 million 2008-10, only to recover and negotiate a franchise changing merger of equals. Best of luck on the integration and congratulations for landing on the JFB top 5 total return to shareholders list! 

There you have it! The JFB all stars in top 5, five-year total return. The largest of the lot is $10 billion in total assets. No SIFI banks on the list. What about that economies of scale crowd? Hmm.

The flavor of this year's winners is recovery, with the exception of our consistent top performer, BofI. Congratulations to all of the above that developed a specific strategy and is clearly executing well. Your shareholders have been rewarded!

Are you noticing themes that led to these banks' performance?

~ Jeff

Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.

Bankers: What is the value of your strategy?

A colleague and I recently had a healthy discussion about what agenda items to include at strategic planning retreats. He was strongly in favor of showing summary level financial projections for "business as usual" at the financial institution. Showing value creation, or erosion, from doing the same things you have been doing will highlight the need for staying the course or strategic change, in his opinion.

He is right. So often we get bogged down in philosophical debates on what to do about branches, technology, loan growth, expense control, and yes, vision, that we forget that whatever strategic direction the group decides should find its way, long term, to the FIs bottom line to increase the value of the franchise.

It does not matter if you are a stock held bank, mutual bank, or credit union. Your strategic direction should increase the value of the franchise, whether you measure aggregate value (mutual, credit union), or shareholder value (stock bank). Why would you initiate strategic change if it doesn't result in increased value? Even the non-stock bank/CU wants to live another day. Perhaps their Boards of Trustees have a lower capital appreciation hurdle. But doing nothing and eroding the value of the franchise is a sure sign that you will not have the resources or relevance to continue serving your other, non-shareholder constituencies into the future.

So what is enhanced franchise value? Since I have been involved in banking, investors focus on two metrics: price/earnings and price/book. The market places a multiple on these metrics. For example, I used Tompkins Financial Corporation's core earnings per share in the below table. The market currently values TMP at 14.8x earnings. Assuming the market continues to value TMP at 14.8x, you can arrive at the per-share valuation of the stock. For you non-shareholder owned institutions, use an industry p/e and apply it to your aggregate earnings to come up with your franchise value.

The projected business as usual eps grew at a compound annual growth rate (CAGR) of 5.4%. The Board may have determined that this was not enough. So strategic change must take place. After debating strategy and what success would look like in executing strategy, the bank was projected to increase earnings at a 10.4% CAGR. The Board's expectations on capital appreciation was 8%, because the bank's dividend yield was 3.32%. This would equate to a shareholder total return of 11.32% (8% capital appreciation plus a 3.32% dividend yield). The strategy, therefore, is projected to increase the value of the franchise.

Now, my firm does not serve TMP so the above numbers are only hypothetical. Except that I used actual core eps from 2007-12 for the business as usual row. I also have no inside information on what the Board of TMP expects in capital appreciation or total shareholder return. I only use the above as an example.

But in the throes of developing strategic direction, and the future of your bank, is it not important to demonstrate, in financial terms, what success would look like and how it adds value to business as usual?

What are your thoughts?

~ Jeff

Note: Even though my bank stock portfolio is currently making me look like an investment genius, mostly because of industry-wide price performance, I make no investment recommendations in this blog, or anywhere for that matter. You should not invest in any security based on what I type on these pages.

Bank Shareholders Are Only One Seventh of the Equation

I am guilty. Guilty of elevating increasing shareholder value to Napoleonic heights. I annually rank the top five financial institutions by total return to shareholders. I write about developing a strategic plan that results in financial returns that satisfy shareholders. I confess, I contributed to the notion that the shareholder matters above all else.

But many, if not most state business corporation laws don't agree. Take my home state, Pennsylvania, Title 15, Subchapter B Fiduciary Duty, Section 515 Exercise of Powers Generally...

"In discharging the duties of their respective positions, the board of directors, committees of the board and individual directors of a domestic corporation may, in considering the best interests of the corporation, consider to the extent they deem appropriate:

(1)  The effects of any action upon any or all groups affected by such action, including shareholders, members, employees, suppliers, customers and creditors of the corporation, and upon communities in which offices or other establishments of the corporation are located.

(2)  The short-term and long-term interests of the corporation, including benefits that may accrue to the corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the corporation.

(3)  The resources, intent and conduct (past, stated and potential) of any person seeking to acquire control of the corporation.

(4)  All other pertinent factors."

So, as I read (1) above, shareholders are certainly in the mix of parties impacted by a board decision. But so are members, employees, suppliers, customers, creditors, and communities of a corporation. I don't think the order in which the law was written constitutes a ranking. As I read it, and mind you I've never passed the bar, all constituencies have equal weighting.

Shareholder held banks are not not-for-profits. They make money to grow, be safe and sound, invest in personnel and technology, give back to their communities, and yes increase the value of their franchise for shareholders. Boards should be mindful that profits are as much for other interested constituencies as the shareholders. In other words, to a board member, hearing an employee say "I love working here", a customer say "I love banking here", should resound similarly to a shareholder saying "this is a great investment".

Banks used to be owned primarily by retail investors. As the industry consolidated, banks became larger, and retail investors became weary due to the financial crisis, institutional owners filled the breach. These investors care little about the employee that loves to work there, or the customer that raves about extraordinary service. Well, they do care if it ends up dropping more money to the bottom line that can be returned to shareholders in some fashion.

Institutional shareholders are much stronger, and more concentrated and vocal advocates for shareholder returns than the retail shareholder, who once took pride in investing in the local bank. Just because they are louder, should they be at the front of the line? Or should we all read our respective state's business corporation law on fiduciary duty of directors?

~ 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