For smaller banks, all eyes on margins Corporate margins are at all-time highs, but not for community and regional banks
June 9, 2015
As the U.S. stock market enters the seventh year of its bull-market recovery from the financial crisis, many observers have begun to wonder when this market cycle will come to an end. For companies in many industries, operating margins are at all-time highs due to a combination of low borrowing costs, a lack of pressure on wages, and the deferral of certain expenses. Against this backdrop of supportive conditions, some market analysts warn that even a mild resurgence of margin pressure (especially when combined with possible monetary tightening by the U.S. Federal Reserve) could lead to a stock-market correction.
With these conditions in mind, we have been looking to invest in companies that we believe can sustain an increase in interest rates or even improve their performance as the Fed begins to normalize monetary policy. This includes organizations that receive relatively little attention from the investment community but could be positioned particularly well in such an environment, such as regional and community banks.
Generally speaking, regional and community banks have seen their margins move in the opposite direction of nonfinancial firms since the end of the 2008-2009 recession, contracting to all-time lows. For all U.S. banks, the net interest margin, or NIM (defined as net interest income as a percentage of returns generated by assets), was 2.95% during the quarter ended Dec. 31, 2014 — the lowest level ever recorded (see chart below).
Net interest margin for all U.S. banks
Source: Federal Reserve Bank of St. Louis.
This historic contraction has been due primarily to the Fed’s unprecedented monetary policy, which has greatly reduced the interest payments that banks receive on their loans and investments. Given that Fed Chairwoman Janet Yellen has made it abundantly clear that the central bank would like to begin raising interest rates either at the end of this year or the beginning of next year, we believe that banks’ NIMs likely have nowhere to go but up once monetary tightening begins. This leads us to believe that financials may be one of the better-performing sectors as interest rates increase.
A favorable light on smaller banks in particular
Not only do we have a positive outlook for financial stocks, we also have a particularly positive outlook for small-cap and mid-cap banks. Unlike their larger peers, which have more diversified sources of income, a majority of smaller banks’ revenues are tied to interest rate movements. Consider that during fiscal year 2014, on average, 83.2% of a small-cap bank’s revenue and 77.8% of a mid-cap bank’s revenue were composed of net interest income, versus 50.4% for an average large-cap bank.*
Regional and community banks typically earn most of their revenues from originating loans and gathering deposits, whereas the largest banks have broader business models and are less reliant on interest rates. Therefore, we believe that small-cap and mid-cap financial services companies make good candidates for investment consideration as we anticipate the Fed’s next round of interest rate adjustments.
While the interest rate scenario is a key consideration when anticipating the near-term performance of small banks, we believe the case for smaller banks can be supported by additional factors as well, such as the ongoing consolidation in the industry (in 1990, there were 15,000 banks in the United States, while today there are fewer than 7,000) and the improvement in operating efficiencies brought about by the advent of new technologies such as mobile banking.
We continue to look for companies that (1) are differentiated within this generally monolithic industry, (2) can continue to earn a return on equity that increases the company’s intrinsic value above its current market value, and (3) are well positioned for an increase in interest rates.
* Data: SNL Financial. Net interest income is defined as interest income earned from loans and securities minus interest expense paid on deposits and borrowings. It is closely related to market interest rates. For purposes of measuring the average ratio of net interest income to total revenue, we define small-cap as any bank with a market capitalization less than $4.0 billion; mid-cap as any bank with a market capitalization between $4.0 billion and $28.0 billion; and large-cap as any bank with a market capitalization greater than $28.0 billion.
The views expressed represent the Manager's assessment of the market environment as of May 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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