This article has been adapted from the post “Bill Gross, Carl Ichan and Share Repurchases,” which originally appeared November 7, 2013 in the “Nashville Notes” blog on SNL.com. Republished with permission.
Many bank analysts have been arguing that investors should buy bank stocks because capital is building faster than it can be deployed. The Federal Reserve, unlike during the pre-crisis era, is governing the amount of capital returned to shareholders. Basel III is another governor, especially given the enhanced leverage ratio requirement large U.S. banks are facing.
But are buybacks a good idea for bank managers today? I question the wisdom of many of the repurchases that are occurring when bank stocks are trading at price-to-earnings ratios in the mid-teens and at 1.5x to 2.0x price to tangible book value. The bane of buybacks, and M&A for that matter, is the human propensity to engage in risky behavior at the top of the market when all is well and risks seem minimal.
Share buybacks are not high finance. They use excess capital or cheap debt to fund the repurchase of shares. From a flow-of-funds perspective, repurchases also support share price — especially for small-cap banks that are thinly traded. Nevertheless, I do not think it is simply a constant P/E ratio and higher EPS from a reduced share count that yields a higher stock price. Value matters as well for repurchases.
Ideally buybacks will occur when a stock is depressed, not when it is pressing a 52-week or multiyear high because the Fed has had the monetary spigots wide open for five years. The majority of publicly traded banks today are producing a return on tangible common equity in the range of 9% to 15%. If the shares are trading at 1.5x to 2.0x tangible book value, the effective return for new money is about 6% to 8% (based on the return on tangible equity divided by the price-to-tangible book value multiple) if the bank can reinvest retained earnings at a comparable return on tangible equity. Of course, returns could increase, but that seems doubtful to me when the mortgage refinancing boom is over, loan yields are grinding lower, and credit costs for many banks are low.
Banks that repurchased shares in 2012 have seen varied results. It may be that banks producing the lowest returns, such as First Horizon National Corp., acquired shares in 2012 at a bargain price compared to banks that trade at higher multiples, such as Bank of Hawaii Corp.
JPMorgan Chase & Co. is an unanswered question too. Repurchases made in 2012 may prove to be money well spent provided it is not going to be needed to shore up capital for litigation-related losses. JPMorgan’s 2012 repurchases occurred at an average price of $42.19 per share, which was a modest premium to tangible book value. Today, the shares trade around $52, even though the company’s outlook may be cloudier than it was in 2008.
CapitalSource Inc., Huntington Bancshares Inc., Fifth Third Bancorp and KeyCorp appear to have spent excess capital well in 2012 given a combination of low valuations and adjusted returns in the low teens. The home run among the group is CapitalSource, which repurchased 17.2% of its year-end 2011 shares during 2012 for an average price of $6.91 per share and has bought back 7.0% of its year-end 2012 shares during 2013 for an average price of $9.14 per share. The company subsequently agreed to be acquired by PacWest Bancorp on July 22. Its share price was $13.11 at the closing bell Nov. 4.
Having capital and the willpower not to repurchase requires discipline. It is also a tacit admission by the management team that the company’s shares may be over-valued.
So what is the alternative in the context of capital, profitability, and growth “in that order,” as ex-Whitney Holding Corp. CEO Bill Marks used to say?
One option is to sit on capital waiting for the inevitable cyclical downturn, though that may be a long wait given the lack of loan growth and Fed actions that are indirectly supporting credit quality.
A second option is to do acquisitions using excess capital and richly-valued shares.
A third option is to return capital via special dividends. However, Wall Street has never been as excited about special dividends compared to buybacks because they are one-time events with no impact on EPS or market demand.
If the Fed manages to engineer further appreciation in asset prices, including bank stocks, the sector may see more boards electing to use special dividends to return capital — provided the Fed is agreeable.
Mercer Capital has three decades of experience of advising banks, non-depository financial institutions and corporations in matters related to share repurchases, capital planning and valuation for a variety of purposes. Whether considering an acquisition, a sale, or simply planning for future growth, Mercer Capital can help financial institution accomplish their objectives through informed decision making.
