Why Banks are Undervalued

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David Ellison manages the Hennessy Large Cap Financial Fund - HLFNX and the Small Cap Financial Fund – HSFNX. As of 11/30/19, since their inception on 1/3/97, HLFNX has outperformed the Russell 1000® Financial Services Index by 75 basis points annually, and HSFNX has outperformed the Russell 2000® Financial Services Index by 125 basis points annually. Ellison has over three decades of investment management experience and has been recognized by Morningstar as the most tenured mutual fund portfolio manager in the financial services sector.

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Prior to joining Hennessy Funds in 2012, Dave served as president and chief investment officer of the FBR Funds, where he launched and oversaw the line-up of FBR Funds. David began his career at Fidelity, where he managed the Select Home Finance Fund, and he developed his investing discipline and strategy under the tutelage of famed value investor, Peter Lynch.

Dave received a BA in Economics from St. Lawrence University and an MBA from Rochester Institute of Technology.

I spoke with Dave on December 12.

What are the mandates of the Hennessy Small Cap and Large Cap Financial Funds, and what are your general guidelines for buying and selling securities and constructing the portfolios?

These are both financial sector funds. They have to be 80% invested in the sector. The market cap breakpoint is $3 billion between the two funds. They can invest in any financial companies.

We don't try to do too much buying and selling. We hold for the long term. We're looking for companies that can grow book value and capital over a period of time, those that are paying attention to all the things that you would hope they'd pay attention to, like costs, credit, and liquidity. The well-run companies tend to stay well-run and the poorly run company stay poorly run. That tends to make for low turnover in the portfolio. . The small-cap fund is comprised primarily of traditional banks as opposed to other types of companies.

The smaller you get, the more important it is to have a stable liability structure, and an insured-deposit structure gives them the ability to generate liquidity, the same as with Citibank or Bank of America. You don't see that in other non-depository institutions. Our large-cap fund is more of a mix. In the last four or five years, it's gotten less bank-like and more transactional or “fintech.” That's the nature of how the industry is progressing.

Given your focus on banks in both funds, how strong are the fundamentals in the banking industry?

Fundamentals generally are at the high end of their historical range. Non-performing loans are at the low end of the range. Capital ratios are the high end of the range, historically. Lending margins are about in the middle, even though rates are much lower than they were a couple of years ago. I've been doing this since the early 1980s, and the way I perceive the world is in that timeframe. I believe the industry is in great shape. The regulatory structures that were put in place post-2008 have created a much more stable system. That's helped generate or create the recovery that we've had since 2008, and it's sustaining the growth in the economy that we have now.

What is the relationship between interest rates and profitability among banks? Since you mentioned the fact that rates are historically low, given the fear that many have, how would rising rates affect banks?

If you look at smaller banks, the smaller you get, the more important the lending margin is, or the spread between the cost of funds and the yield on assets. For a typical smaller bank, the net interest that they earn off their portfolio could be 80% to a 100% of their revenues. Obviously, the direction of rates and the nature of the yield curve is very important. For larger banks, Citicorp, JP Morgan, and the like, the spread accounts for around 50% of their revenue. . Rates are obviously very important. It's not just the rate at one point, but it's a rate across the whole curve.

There's been some talk lately about the yield curve inverting, but it's not inverted for the banks. The Treasury curve may invert, but the bank curve is not inverted. The prime rate is still well above the cost of funds. Interest rates have become a big issue primarily because they've come down so much. They're low and close to zero. If rates were 100 basis points, then 25 basis points is low. I started when Fed funds were 18%, and now they're effectively 1% or 2%. They're so close to zero that the presumption is that your cost of funds isn't going to go below zero. It starts to hurt spreads. The big boogeyman in the industry now, the thing that's keeping the companies from attaining an above average valuation on book and earnings, is the prospect of rates going lower and squeezing that margin. You've seen what's happened in Europe. The European banks trade at about half the valuation of the U.S. banks for that reason.

Read the full article here by Robert Huebscher, Advisor Perspectives

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