Reversion to the Mean: Bogle
Vanguard's John Bogle wrote The Clash of the Cultures: Investment vs. Speculation in 2012. In this classic, Bogle offered "some investment guidance." His guidance consisted of 10 rules. He wrote: "The most important of these rules is the first one: the eternal law of reversion to the mean in the financial markets."
This post examines the concept of reversion to the mean for bank stocks since 1991. It confirms Bogle's most important rule.
Research Methodology and Key Assumptions
This post is the second of three analyzing 2016 bank investment performance and offering a data-rich framework for investors in 2017. The analysis considers 25 big banks, all with assets of at least $25 billion as of year-end 2016. The banks in the study are: JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), Citibank (NYSE:C), U.S. Bank (NYSE:USB), PNC (NYSE:PNC), BB&T (NYSE:BBT), Key (NYSE:KEY), American Express (NYSE:AXP), Regions (NYSE:RF), SunTrust (NYSE:STI), M&T (NYSE:MTB), Zions (NASDAQ:ZION), Comerica (NYSE:CMA), New York Mellon (NYSE:BK), Northern Trust (NASDAQ:NTRS), State Street (NYSE:STT), Capital One (NYSE:COF), Huntington (NASDAQ:HBAN), Fifth Third (NASDAQ:FITB), SVB Financial (NASDAQ:SIVB), Cullen Frost (NYSE:CFR), People's United (NASDAQ:PBCT), Associated (NYSE:ASB), and New York Community (NYSE:NYCB). Total return data are available since 1990, except the following: New York Community 1994, Capital One 1995, and Regions 1999.
There are two key variables in this analysis: Valuation and return. Valuation is defined as the price of a bank stock at year-end divided by its tangible book value at year-end. (The year-end 2016 tangible book value is as of September 30, 2016.) Return is defined as the total return - includes dividends and stock price change - for each bank annually as of year-end.
There are 4 key assumptions related to this analysis.
First, it is assumed that the investor invests at the beginning of each year in the five bank stocks that had the lowest valuation as of the prior December 31. At year-end, any bank that no longer had one of the lowest valuations would be sold and replaced with another low valuation bank.
Second, it is assumed that the investor invests an equal amount (and percentage) each year in all five low valuation bank stocks.
Third, it is assumed that this investment is held in a tax-free IRA. Consequently, there are no tax considerations until distribution.
Fourth, for the purposes of this analysis, it is assumed that there are no trading costs.
Charts one and two identify the five banks at year-end 2015 with the lowest and highest price to tangible book value. At year-end 2016, the five banks with the lowest valuation produced 38.4% total return versus 14.6% for the five banks with the highest valuation. The average total return for all 25 banks in 2016 was 29.6%.
Chart 1 Source: Ycharts
Chart 2 Source: Ycharts
Chart 3 shows the annual total return for 3 groups of banks in the study from 1991 to 2016. The first group is identified as the Average ("AVG") and represents the average total return by year for the 25 banks in the study. The second group is identified as the "Top 5" and represents the average total return for the five banks with the highest valuation each year. The third group is identified as the "Bottom 5" and represents the average total return for the five banks with the lowest valuation each year.
In addition, the chart is highlighted in red and green. Green boxes indicate highest return by year and red boxes indicate lowest return by year. Note that in 15 of the 26 years, the banks with the lowest valuation showed the best total return. However, also note that the lowest valuation banks had the worst performance during the financial crisis - 2006 through 2009.
Chart 3 Source: Ycharts
Chart 4 takes the data from chart 3 and shows what $100 invested at year-end 1990 would look like at the end of 2016 if an investor had adopted each of the three valuation strategies. The average bank strategy produced a $3087 investment portfolio at the end of 26 years. The lowest investment portfolio was realized by investing annually in the five banks with the highest valuation. The best total return came from investing annually in the five lowest valuation bank stocks. This strategy increased the initial year-end 1990 investment by a multiple of 95 times with a terminal value of $9574.
As highly leveraged plays on the US and global economies, bank stock prices have historically demonstrated significant volatility. Not only do bank stock prices bounce around more than the overall market, during the Financial Crisis, all but two of the 20 largest banks reduced dividends. (Northern Trust and M&T maintained dividends during the Crisis.)
In December, on these pages, I recommended that investors who cannot stomach volatility should avoid bank stocks. After reading this post, investors may conclude the volatility risk is worth accepting. But recognize that risk tolerance is one thing when reading statistics and another when watching bank stock prices plummet 30% in a quarter.
The next three charts highlight bank return variation over the past 26 years. Investors know that a bell shaped curve represents a normal distribution. Bank stock performance is clearly not a normal distribution. Chart 5 takes the data from chart 3 and shows a histogram representing the frequency of annual returns. The good news is that nearly half the time banks with the lowest valuations produced an annual total return greater than 30%. The bad news is that six times the returns were negative, including twice greater than -30%.
But low valuation banks are not alone in demonstrating volatility as can be seen in chart 6, which reflects total return frequency for the average of the 25 banks from 1991 to 2016.
Reversion to the mean works two ways. Over time, high valuation bank stocks have a tendency to revert to the mean as well. This can be seen with chart 7, which shows the frequency of annual total returns for the 5 banks with the highest valuations over the 26 years. As the chart highlights, this group shows the lowest frequency of years when total return was greater than 20% while still saddled with 10 years of negative total returns.
Chart 8 provides a measurement of the volatility for the three groups of bank stocks since 1991. The first column shows the median total return for each group. Note that the lowest valuation banks had a median total return of 23% versus only 7% for the top five valuation banks. The second column shows the average total annual return. The third column shows the standard deviation of the returns with the low valuation banks having the highest absolute standard deviation.
The final column shows the coefficient of variation. By this measure, the lowest five valuation banks demonstrate volatility characteristics similar to the average of the 25 bank population. With the highest coefficient of variation, the high valuation banks show by far the worst risk-return characteristics over time.
Not all bank investors have a 26-year time horizon. Chart 9 shows the value of $100 invested in each of the three strategies over 10 years beginning January 1, 2007. The Financial Crisis decimated bank returns. Across the board, bank stocks fell approximately 50%. As of year-end 2016, as chart 9 shows, the average big bank stock produced 46% total return while the 5 low valuation banks produced 49%. The high valuation banks showed the lowest returns.
Returns Over 5 Time Frames
Chart 10 shows the comparative total annual returns over five time frames. In all cases, low-valuation banks show superior returns. Returns since 2006 have generally been in line with the average 25 banks. Though this is bad news short term, it may be good news long-term for investors drawn to low valuation bank stocks. Why? As chart 10 shows, over longer time frames, the difference in performance is magnified.
The table below identifies the ten banks with the lowest and highest valuations as of year-end 2016.
Banks with the lowest valuation are Citigroup, Capital One, Bank of America, Zions, and Regions.
By far the greatest risk with investing in low-valuation banks is bank failure. Although data is not available for year-end 2007, likely Wachovia Bank and Washington Mutual would have been among the 10 banks with the lowest valuations as of December 31, 2007. The total return reported for 2008 would have likely changed materially had these two banks been among the 5 low valuation investments in 2008.
Another risk investors in banks must consider is current valuation compared to historic average. According to data from Ycharts, from 1990-2016, the industry's 25 big banks averaged a price to tangible book value of 2.95 and a median average of 2.45. Today the industry's average multiple is 2.05 and median is 1.98, suggesting bank stocks are undervalued.
However, it is possible that the industry's current valuation is the new normal. Here's why: Valuations from the late 1990s through 2006 were once-in-a-lifetime peak multiples reflecting an industry undergoing rapid consolidation as well as benefiting from unsustainable business practices (like poor mortgage underwriting and aggressive overdraft fees).
If the industry's current valuations are indeed the new normal, upside in bank stocks is modest at best absent a surge in unexpected earnings. Therefore, investors seeking alpha must rely on individual bank stocks to drive investment returns in 2017 and beyond. As this analysis suggests, investors may want to focus on the banks with the lowest valuations as history shows these to have the best upside track record over time.
Disclosure: I am/we are long SIVB, CFR, JPM, PNC, HBAN, FITB.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Although I own no shares of BAC, as a retired employee (2011), I continue to have certain financial interests in the bank.