Value in Regional Bank Stocks?

Historically in a sector bear market, all the stocks decline together as investors fail to differentiate good from bad. Recently some signs of inefficiency have begun to creep into the bear market in regional bank stocks. The "good" are seen as bullet proof, while the bad have become unanchored from all valuation support as news flow has driven the share prices lower.

I started thinking about this several weeks ago when renowned value investor Michael Price commented in regard to Wachovia (WB) that he was not interested until the stock approached or hit tangible book value. The stock was around 24 at the time, I believe, but tangible book as of 3/31/08 balance sheet is only $13.61. WB proceeded to trade relentlessly lower and hit a low of $17.34, which is a pretty vicious decline for a stock which had already been hammered by almost 56% from its 12-month high.

Regarding inefficiency, the sector has begun to show some significant "have vs. have not" tendencies. For example, US Bancorp (USB) is legitimately a "have" company, with less credit worries and a major hidden asset in its processing subsidiary. And the stock has held up superbly as investors correctly exclude it from the list of banks with significant earnings risk. However, the stock currently trades at around 5 ½ times tangible book and 2.6X stated book. To be sure, management has earned this valuation, but at some point when the credit cycle starts to improve, investors will typically rotate out of perceived safe names like this and gravitate to banks which have priced in reasonable worst case and have minimal insolvency risk.

At the other end of the spectrum, First Horizon (FHN) is a pure "have not" company. No current earnings, the cash dividend was omitted and a modest dividend is now being paid in stock, while all prior takeover spec has been evaporated. That said, the stock traded right through tangible book and even after a lift today is 59% of 3/31/08 tangible book. Management has stated a "back to basics" strategy which may not be exciting, but is pretty straightforward to execute. This may or may not be the bank to buy, but it sure has the value criteria in place. If management can just earn 12.5% on stated book, that is about $2/share in earning power, and with the stock trading at $8.69, a low multiple on recovery earnings. A multiple so low, in fact, that the reward/risk is pretty good even if one has to wait several years for the payoff.

Another bank which "traded through" on adverse news flow is Key Corp (KEY), which is slashing its dividend in half and doing external financing. The shares are 69% of tangible book. Of course the financing will dilute book value and this adjustment needs to be taken into account, but at least there is now a cushion built in.

Before jumping into apparent "great values", I would urge investors to do their homework on where the bank is trading in this spectrum of wide valuation ranges for the industry. Be wary in particular of eroding credit quality statistics. My general sense is we are currently in the teeth of the storm on credit, but it is a big storm and it will spawn other storms, e. g., the problems in residential mortgage lending have already begun to back up into construction lending and next will be small business, commercial construction, commercial perm loans, etc. Credit cycles historically have been prolonged in duration, running 3 to 4 years from start of problems to when managements finally over reserve and earnings bounce back. So we are only in the 3rd or 4th inning of this contraction, at best.

Finally, investors need to think about the supply/demand for regional banks. I have maintained that in addition to the fundamental problems, there are several negatives which make bottom fishing premature:

1) Banks are a pure value group. With the Russell 1000 Value Index down over 17% yr/yr as of last Friday, value managers are likely struggling with redemptions and thus have no net new cash to buy regardless of the attraction.

2) Hedge funds have been short, and have not begun to cover. There is no reason, as yet, to cover shorts because the stocks are still trading down on any negative news, and until they trade up on bad news, the downtrend is friend of the shorts.

3) Obviously the billions of new external financing are a supply issue for banks.

4) As discussed above, on some criteria such as tangible book, the most rigorous of value managers do not see compelling value yet. I believe value hedge funds will at some point step up, but not until they are convinced the downside is fully discounted.

5) Street estimates have been too high until recently, and earnings are still totally guesswork for 2008 until some sign of stabilization in credit quality is apparent.

6) Other asset classes have captured the lions share of investor attention. Obviously, playing "momentum" works until a sector rolls over, but for now the "safe" trades have been in agriculture, energy, gold, infrastructure, etc.

Disclosure: None

Comments

[jswede]

nice piece

[The Hammer]

So what regional banks are trading at or near tang book value?

[nycTrax]

Good piece. Thanks. I've been eyeing FHN. You've given me reason to take a second look.

[Stewie]

Very nice article, both from a fundamental evaluation and market psychology standpoint.

[squashnut]

What good is tangible book value if they face huge losses from mortgages, which is why their stock has been beaten down so far?
Sorry but this game will be going into extra innigs, maybe a doubleheader.

[toomuchgas]

Still trying to catch a falling knife, no sign in the market of a bottom. Some day, some day, but not today.

[Medici]

WB (Wachovia) is going to the single digits-

[rekfhardy]

Good piece, keep it up.

[Vegasjoe]

If Wachovia writes down most of the Golden West purchase, what book value will be left? Investors have seen the stock fall in 12 months from the mid 50's to $17 and change. FHN is cleaning up all of the stupid "we want to be a big player" mistakes and going back to basic blocking and tackling. What major bank will go bust first? Vegas odds say WaMu.

[williemo]

On Regional banking industry, what index seems to be the best for identifying the key banks in this set? I use IAT, but see KRE and others. I haven't even heard of some of the top 10 banks in KRE. comments welcome.

[ATHELSTAN]

Thank you for a most valuable analysis of regional banks as a subset of the financial sector. I still like FF (First Financial) and I intend to continue to buy it on weakness.

[10Q Detective]

Bravo! Mr. Rhodes.

Well-said about FHN. Might I add:

The investment community is like sheep, following the flock as one. Lauding improved capital ratios—resulting from common stock issuance and balance sheet reductions—not one analyst has voiced concern that First Horizon’s Fixed Income growth could hit some bumps in the wake of the Federal Reserve reversing its monetary policies.

10qdetective.blogspot....