The June 2014 issue of Bank Watch is available now, which features the article “Complacent Investors May Need to Reassess the Earning Power of Some Acquirers” written by Jeff Davis. Jeff is a regular editorial contributor to SNL Financial. This article was originally published June 5, 2014 at SNL Financial. It is reprinted in this newsletter with permission.
Portfolio manager Grant Williams remarked at John Mauldin’s Strategic Investment Conference in mid-May that there may be a bubble in complacency. Maybe so with the CBOE Volatility Index (VIX) below 12, high yield credit trading at tight spreads to Treasurys and other risk measures that are comparable to the period leading up to the 2007-2009 financial crisis.
The recent drop in the 10-year yield to about 2.4% from around 2.7% in late April has begun to raise questions about the economy with some investors. Bank stocks have underperformed this quarter even though the rally in bonds may produce better gains on the sale of mortgages and bonds than expected. The SNL U.S. Bank Index declined 4.9% quarter-to-date through May 30 compared to a 2.6% gain in the S&P 500. I think the complacency surrounding the prospects for most banks’ earnings is finally catching up with reality that returns are as good as they are going to get in the current low-rate, low-credit cost environment …
But where the complacency may be painful is among smaller regional banks that emerged from the financial crisis as big winners. One of the hallmarks of these institutions was the acquisition of failed and troubled banks for nominal prices during 2009-2011. These acquisitions may have been cheap and even produced big bargain purchase gains, but the accounting made it tough to discern earning power. Many of these institutions still have NIMs that are significantly above peer margins due to accretion of loans that were marked down for both credit and rate characteristics. Eventually the accretion will end as discounted loans are repaid, refinanced or charged off. …
There are many banks that face this issue…. But are investors really processing the information and is the sell-side willing or even capable of doing so? After all, the bias for forward estimates is almost always higher. Stocks look cheaper that way. And who wants to buy shares of a bank whose earnings are going to fall?
In theory, an efficient market would discount the loss of accretion earnings if not disregard it, but I do not believe that is the case for small cap stocks with limited analyst coverage. So the punchline is this: a number of well-managed banks are poised to experience underperformance in their shares as the Street will be forced to revise lower 2015 estimates and general earning power expectations as the accounting accretion from the post-crisis deals wanes. Conversely, the low NIM banks may be poised to outperform on a relative basis, at least for a while.
This issue also contains links to various articles of interest, as well as public market indicators, M&A market indicators, and key indices of the top financial institutions in the U.S., providing insight into financial institution valuation issues.
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