This article originally appeared on thestreet.com.
There are currently over 900 publicly-traded banks and thrifts in the US. Which are solid performers? It's a complicated question, but the place to start is return on tangible common equity ("ROTCE"). The better the bank, the higher the ROTCE. Why? Because banks pay out a percentage of their earnings as dividends, and retain the rest to support asset growth. Higher ROTCE banks can grow faster and/or pay higher dividends than low ROTCE banks. Of course, banks that use aggressive leverage or take on excessive risk to boost ROTCE can end up destroying shareholder value, a painful lesson that bank stock investors learned in recent years.
But the story doesn't end there. Every bank stock has a price, and in theory price reflects operating performance, but not necessarily in practice. So price can trump performance; at the extremes, a great bank may be just too expensive to own, or a mediocre one may be too cheap not to.
Which brings me to Lake Success, NY-based thrift Astoria Financial Corporation (AF). On January 2nd, thestreet.com ran an article titled "'Meaningful Upside' for Astoria Financial in 2014, Says KBW." KBW analyst Brian Kleinhanzl raised his 2015 EPS estimate for AF from $0.85 to $1.00, based upon a repositioning of AF's balance sheet that should enable the company to benefit from increases in interest rates. His 2014 estimate remained unchanged, at $0.70. He also raised his 12-month price target from $13 to $17.
Should an increase in projected EPS lead to an increase in expected share price? Sure, unless the stock you're looking at was overvalued to begin with. It's hard not to think AF is overvalued given its longstanding mediocre operating performance. AF's market cap at the January 6th market close was $1.36 billion. For the 84 banks and thrifts with market cap between $500 million and $2 billion, the average price/tangible book value multiple is 1.9x. AF's is only 1.2x. So AF must be cheap, right? Not so fast. The average ROTCE year-to-date through Q3 for this peer group is 11.9%. AF's is only 4.9%, and it hasn't been materially above this since the beginning of 2011. So AF isn't cheap. It has a relatively low trading multiple for very good reasons.
AF's assets at the end of Q3 2013 were $16 billion, 32% below the Q4 2004 peak of $23.4 billion. Its assets at Q1 2000 and Q4 2008 were essentially the same, astonishing when you think about the robust asset growth many banks and thrifts delivered during this period. Sure, that robust growth turned out to be problematic or fatal for some institutions, but isn't 32% asset shrinkage awful?
While AF's asset shrinkage has lessened recently, AF still has grown assets only three times in the last twelve quarters, and only once at an attractive level. The thrift has been shrinking its securities portfolio, shrinking its 1-4 family loan portfolio (not an especially lucrative loan category) and growing multifamily, commercial real estate and other loans, all in an attempt to boost net interest margin ("NIM"). And NIM has improved relative to the lows of 2007, but at 2.28% in Q3 2013, it's still slightly worse than the 2.40% way back in Q1 2000. Both are horrible in absolute terms (in fairness, this is a problem for many thrifts, not just AF). But here's the bigger problem: AF's non-interest expense has grown even as assets have shrunk. Its overhead is much too big for its current asset base. And that will be a huge, ongoing drag on AF's return on assets and equity.
If AF hits Kleinhanzl's $1.00 EPS estimate in 2015, that would give AF roughly an 8% ROTCE in 2015, more if AF increases its per share dividend. That's better, but still far from good. Note that Kleinhanzl revised his 2015 estimate upward by $0.15 and his price target by $4.00. How does one map into the other? I have no idea. If you assume that the entire $0.15 increase is paid as dividends, 4% dividend growth and a 7% discount rate gets you $3.51. But those are three very aggressive assumptions for AF. Kleinhanzl predicts 43% EPS growth for 2015. His 2015 estimate is far from a sure thing, but even if AF hits it, where does EPS growth come from after that? More NIM expansion? Asset growth?
I have to believe that the 48% increase in AF's share price in 2013 is the real reason for Kleinhanzl's optimism. But AF's shares traded at 83% of tangible book value at year-end 2012. Enough investors considered it irrational for a thrift to trade below its theoretical "liquidation value", even one with a terrible ROTCE, to close that gap and then some. AF's operating performance in 2013 hasn't been that much better than that of 2012, and thrifts in general, several with operating performance far superior to AF's, appreciated significantly this year, if not as much as AF. And even with its massive 2013 price appreciation, the $1.35 billion AF spent on share buybacks from 2001 to 2006 appears to have been wasted; the weighted average repurchase price over this period was $23. AF hasn't repurchased shares since 2008, even when they traded below tangible book value, despite the availability of excess capital.
One final point. Even with AF's depressed late 2012 valuation, short interest in its shares in mid-December was 11.6%. Short interest fell steadily during 2013, and now stands at a much lower, although still high, 4.9%. So there's some skepticism in the market about where AF's price might go from here.
I've just presented what I consider several useful facts about AF. Maybe Kleinhanzl believes other facts matter more, and maybe those other facts will propel AF to $17 per share and beyond in the near term. Or maybe facts don't matter. If a plane runs out of fuel, what happens to it is independent of its passengers' hopes, but in the stock market, investor hope can be enough to sustain prices, at least for awhile. An investor may choose to bet on hope, but mistaking this for a bet on fundamentals can lead to poor returns, in tech stocks and bank stocks alike.
2014 may be the year that bank and thrift investors relearn this lesson.