A Bank Portfolio Of 12 High Quality 'Buffett Banks'

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Includes: BOH, BOKF, BRK.A, BRK.B, CFR, KRE, LKFN, NTRS, SBNY, SIVB, SYBT, TCBI, USB, WASH, WFC, XLY
by: Richard J. Parsons
Summary

In this second in a series of posts about long-term banking investing, I describe Warren Buffett's enthusiasm for banks at a time of record earnings but awful stock price action.

In this post, I overview the investment selection criteria used by Buffett's mentor, Benjamin Graham, and apply that to 12 banks I deem to be "High Quality."

Investors indiscriminately dumped banks during the second half of 2018, creating an opportunity for Buffett and prudent investors to buy High Quality banks at reasonable valuations.

A dozen banks with superior Risk-Adjusted Returns of Equity are now selling at Price to Tangible Book Value ratios worthy of investor attention.

In this post, I identify those 12 High Quality banks and show why they are "Buffett Banks" using the investment criteria of his mentor, Benjamin Graham.

Goals

This is the second in a series of article discussing long-term bank investing. Material for this series will be used for a second edition of my book about bank investing (Investing in Banks, RMA, 2016) that the publisher plans to release this year.

Objectives for this post:

  • First, provide a snapshot of Warren Buffett's bank investment portfolio as well as an explanation why individual investors have an advantage over Buffett when it comes to bank investing.
  • Second, describe your advantage as a bank investor over Buffett.
  • Third, highlight the criteria for investment selection used by Buffett's mentor, Benjamin Graham.
  • Fourth, apply that criteria to 12 High Quality banks with 15-year industry leading Risk-Adjusted Return of Equity and also are currently priced at valuations favorable to history.
  • Fifth, offer a high level overview of the pluses and minuses associated with 8 of the 12 High Quality banks.
  • Finally, identify two principal risks associated with this strategy.

I. Buffett and Berkshire Hathaway

Ten years ago, Buffett owned four banks, Wells Fargo (WFC), American Express (AXP), U.S. Bancorp (USB), and M&T Bank Corp. (MTB). Since 2008 he has added six more banks. In Q3, 2018, Berkshire (NYSE:BRK.A) (NYSE:BRK.B) made major investments in JPMorgan Chase (JPM) and PNC (PNC) for the first time. For an informative overview of Berkshire Hathaway's 3Q 2018 holdings, check out this recent Seeking Alpha article by John Vincent.

What does Buffett know that you might know? Why would he own so many banks? Is he crazy?

That's obviously a loaded question. It's been interesting to read Seeking Alpha commentary and reader comments that question Buffett's acumen. Most note quite accurately that Berkshire Hathaway suffered enormous paper losses in 4Q. One particularly compelling Seeking Alpha article posted in December posed this reasonable question: "Berkshire Hathaway: Are Warren Buffett & Co. Losing Their Midas Touch?"

By the way, the same question was asked, I'm sure, back at the end of 1973 when the Berkshire investment portfolio shrank by more than -50% over a two-year period. At the time he even failed to beat the S&P 500. Everyone seems to have forgotten those dreadful days. It's hard to imagine many investors thought young (at the time) Buffett had the "Midas Touch" back then.

Let's take a leap of faith for a moment and assume Buffett actually knows what he is doing and his massive and expanding investment in banks reflects his deep knowledge of value investing.

Clearly, big banks did not do well last year for investors as chart 1 attests. However, as badly as big banks performed last year, it should be noted that 7 of the 8 "Buffett Banks" beat the average performance of the 21 big banks and that only WFC lagged the big bank average. See chart 1.

Chart 1

II. Your Advantage as an Investor Over Buffett

By virtue of Berkshire's massive wealth, Buffett faces a challenge mere mortals do not. Banking laws block companies like his from owning more than 10% of a bank. Consequently, he only has access as an investor to the banks with massive market caps.

Unlike Buffett, mere mortals can invest in any of the roughly 700 publicly traded banks in the U.S. The broader investment universe should mean the rest of us have the potential for better returns from bank investments than Buffett.

As I will document shortly, Buffett's preference for mega banks is not just a function of his massive wealth, but also reflects the teaching of his mentor, Benjamin Graham.

III. Benjamin Graham's Criteria for Investment Selection

Benjamin Graham was Buffett's mentor as well as the author of the investment classic, The Intelligent Investor.

In my book about bank investing, two chapters are devoted to Graham's criteria for investment selection. The first of the two chapters applies Graham's investment selection criteria to WFC and USB.

In that chapter I describe in detail Graham's seven criteria for investment selection and how WFC and USB fit that criteria to a glove. As I show, Buffett's periodic purchases of both stocks over time almost always occurred when each bank's valuations met Graham's definition of deep value.

In the second chapter addressing Graham's and Buffett's bank selection model, I identify 20 publicly traded banks in addition to WFC and USB that met most of Graham's seven criteria for investment selection. I call these banks "Buffett Banks." Buffett would be proud to own many of these bank, but in almost every case, they are too small for him to acquire a meaningful investment position.

Before going any further, let's review Graham's seven criteria.

  • Size
  • Financial Condition
  • Earnings Stability
  • Dividend Record
  • Earnings Growth
  • Moderate Price to Earnings Ratio (<15x)
  • Moderate Price to Book Value (<1.5x)

Regarding the last two criteria, Graham noted that he would be willing to own an investment that exceeded his thresholds provided the investment met a certain requirement that I call the "Graham Multiple." The Graham Multiple is calculated by multiplying the P/E by the Price to Book. Graham noted that he would consider any investment with a multiple that did not exceed 22.5.

For a much more detailed description of the Graham investment criteria, see his book. For a detailed overview of how I applied the Graham criteria to banks, a topic Graham did not review in his book, see my book, chapters 9 and 10.

IV. Constructing a Buffett-like Portfolio Using Benjamin Graham's Criteria for Investment Selection

For this series of articles about long-term bank investing, I will identify banks that meet most of Graham's criteria for investment selection. In this post I have screened for banks that have demonstrated superior financial condition for 15 years and appear undervalued based on historic comparisons.

In my last post I overviewed a process for screening 663 publicly traded banks. For a full description of the process, see my January 10, 2018 Seeking Alpha post. Here are the three factors.

  • High current (9/30/2018) Return on Equity
  • High RAROE (measures the volatility of ROE over 15 years)
  • Price to Tangible Book Value (P/TBV)

Chart 2 is a scatterplot of the 85 publicly traded banks with the highest ROEs in Q3 2018. The banks have been further screened based on each bank's current P/TBV compared to history (X-axis) and RAROE (Y-axis). Banks in the lower right hand quadrant have the statistical attributes that investors should find most intriguing at year-end 2018. These banks are priced as of year-end at valuations (P/TBV) lower than history and have demonstrated consistently excellent ROEs for 15 years. By virtue of their superior RAROEs, the 12 in the lower right quadrant are deemed "High Quality" banks.

Chart 2

Here are the 12 banks:

  • Bank of Hawaii Corporation (BOH)
  • BOK Financial Corporation (BOKF)
  • Cullen/Frost Investors, Inc. (CFR)
  • Lakeland Financial Corporation (LKFN)
  • Northern Trust Corporation (NTRS)
  • Signature Bank (SBNY)
  • Stock Yards Bancorp (SYBT)
  • SVB Financial Group (SIVB)
  • Texas Capital Bancshares, Inc. (TCBI)
  • U.S. Bancorp (USB)
  • Washington Trust Bancorp. (WASH)
  • Wells Fargo (WFC)

Even seasoned bank investors may not realize just how difficult it has been over the past 15 years for a bank to maintain a consistently strong ROE. Check out the blue line in Chart 3 which shows the average quarterly ROE for each of the 12 banks from Q4 2003 through Q3 2018. Note that the average ROE of the 12 banks has never fallen below 10% during any quarter, including during the Financial Crisis. In contrast, note the volatility of the industry during the same time. Chart 3 is further evidence that these 12 banks as a group constitute a High Quality bank portfolio.

Chart 3

Chart 4 shows the 60 quarter ROE trend for each bank. My key observation from this chart is that it is possible during any given quarter for any one of these banks to have a down quarter. However, as a group, as the prior chart revealed, overall profitability remained steady.

Chart 4

Chart 5 shows the 2018 change in stock price for the 12 banks. Despite the impressive history, this group of banks last year experienced an average stock price decline of nearly -21%, a drop worse than peer banks. The relatively large decline in stock price perhaps suggests that investors think some or all of the these banks are particularly vulnerable to a weakening economy. Perhaps that is true. The challenge for buy-and-hold bank investors is to determine which, if any, of these High Quality banks have been punished by the market indiscriminately, and therefore, provide an opportunity for investors to buy shares today "on sale."

Chart 5

The Case for a Portfolio of High Quality Banks

My recommendation to someone interested in gaining investment exposure to the banking industry is to build a portfolio of 10 to 20 High Quality banks and plan to hold them for a long time. Ideally, the banks should diversify by U.S. geographies and business models as a means to reduce risk.

I believe a strong case can be made that the 12 banks in the lower right quadrant of Chart 6 will, as a group, meet these two objectives and offer attractive risk-return potential over the next 3-5 years.

Table 1 applies Benjamin Graham's investment selection criteria to each bank as of year-end 2018. An "X" denotes that a bank meets the criterion.

Table 1

Benjamin Graham Equity Selection Model. Sources: YCharts, The Intelligent Investor (Graham), Investing in Banks (Parsons)

Size

Financial Cond.

Earnings Stability

Dividend Record

Earnings Growth

Price/

Earnings

Price/

Book

BOH

X

X

X

X

X

X

BOKF

X

X

X

X

X

X

CFR

X

X

X

X

X

X

LKFN

X

X

X

X

X

NTRS

X

X

X

X

X

X

SBNY

X

X

X

X

X

X

X

SIVB

X

X

X

X

X

SYBT

X

X

X

X

X

TCBI

X

X

X

X

X

X

USB

X

X

X

X

X

X

WASH

X

X

X

X

X

WFC

X

X

X

X

X

X

X

Summarizing Table 1:

  • Two banks meet all 7 criteria: WFC, SBNY
  • Six banks meet 6 criteria: BOH, BOKF, CFR, NTRS, TCBI, USB
  • Four banks meet 5 criteria: LKFN, SIVB, SYBT, WASH

You can see from Table 1 that three banks as of December 31, 2018 had a Price/Book ratio less than Graham's 1.5 threshold. Here is where the "Graham Multiple" (P/B x P/E) comes into consideration. Graham used this ratio to give investors greater investment selection flexibility. Chart 6 shows the Graham Ratios for the 12 banks as of year-end 2018. Banks with green bars all have Graham Ratios less than 22.5.

If the Graham Multiple is substituted for the P/B and P/E ratios, which Graham suggests makes sense, BOKF joins WFC and SBNY in meeting all seven of the investment selection criteria.

In addition, it should be noted that TCBI would meet all seven criteria if the bank paid a dividend. (If TCBI directors are reading this post, let me suggest you start paying a dividend, which should expand investor interest.)

Chart 6

V. High Level Comments about Individual Banks

U.S. Bancorp. I wrote about USB in August 2017 when I suggested investors avoid the bank. From the time the article was published to 12/31/2018, the bank’s stock price fell from $52 to $45.70. Since then three factors have emerged to make USB more attractive. First, the great news is that the OCC (bank regulator) has released the bank from its AML Consent Order. As I documented in the 2017 Seeking Alpha article, the Consent Order created an enormous economic burden on USB. Non-bankers simply do not understand the ordeal created when a bank is subject to a Consent Order. Second, USB, like all its big bank peers, announced massive returns of capital to shareholders in June 2018. Buybacks mean fewer shares and the potential for higher EPS. Third, UBs has maintained superior RAROE for 15+ years. At year-end 2018 it was priced significantly below historic valuations. Off-setting these positives, insiders continue to sell shares and the board remains disturbingly underinvested in the bank. Related, the composition of the USB board looks too much like the board at WFC prior to the big blow-up. I would like to see not only greater equity ownership among USB directors, but the addition of several banking and investment experts. As noted, the bank’s ROE, while still an industry leader, is reverting slowly to the mean of peer banks. The mean reversion is disconcerting, but at today’s price, that fact can be overlooked. While I have no problem owning USB, other banks look more attractive to me. However, I see two good reasons to accumulate USB: A Forward P/E of 10.7 and a current dividend yield is 3.18%, Should the board be reconstituted with an improved mix of banking and investment acumen like you see at most big banks today, I could make a case for USB being a Strong Buy. Don't be surprised to learn Berkshire Hathaway acquired more shares in 4Q 2018.

Wells Fargo. WFC reminds me of the “Rocky” movies. Like the boxer, WFC is blooded and battered and seems down for the count. But Rocky always emerged from the 15th round victorious. Over the past two years it seems WFC has been down for the 10-count. My educated guess is that WFC fights another day and shareholders will do just fine over the next decade. As I have written, no megabank has announced bigger buybacks than WFC. The great news for shareholders is that a falling stock price means the bank (and other banks) have been buying back shares much cheaper in the second half of 2018 than the board thought it would when the buy backs were announced in late June. In addition, the dividend is wonderful (yielding 3.6% as of January 8). However, like USB, while I see the case for ownership, I do not own WFC nor plan to buy any shares. Again, I like other banks more. Plus, I struggle owning a bank that has so blatantly disregarded the public good. But like Buffett, I would not let my distaste for unsavory behavior in Wells' case prevent me from owning the bank provided there is evidence of redemptive behaviors. As I have written, I am seriously bothered by the bank’s board lack of meaningful industry expertise. My concern was heightened recently when one of the board's two industry experts announced she will not run for re-election in 2019. Investors need to ask why is she leaving. More troubling, as can be seen in the bank's 2018 Proxy, the board as a group owns hardly any WFC shares despite the big drop in stock price. I am especially troubled by the fact that board members on the Risk Committee own an incredibly puny number of shares. Frankly, and this may sound harsh, but I directors should be embarrassed. How can WFC bank directors not be buying shares when the bank is priced at a forward P/E of 9.34? Do they know something other investors do not? I don't have any problem holding WFC shares in a portfolio of banks; I just would not want it to be my only bank holding or my principal bank investment.

I am a long-time owner of a modest number of BOK Financial Corporation shares. The bank goes by the trade name Bank of Oklahoma. As I noted in my 2016 book, BOKF was the only bank in the country a few years ago to meet all seven of the Graham criteria. For that reason I called BOKF a “Buffett Bank” in the book. Late in the 4th quarter of 2018 after BOKF shares sank, I added a few shares to my existing position. The knock on BOKF is its lending exposure to oil and gas. Actually, I am not bothered by this lending for two reasons. First, I like the exposure to this lending category since fewer and fewer banks do this kind of lending since 2015-16 when oil prices plummeted. In fact, I consider it a strength for credit diversification in my portfolio of banks. Second, BOKF has been in the oil and gas lending business for a long time, and from what I can tell, they know what they are doing. The forward P/E is 10.7 and the current yield is 2.60%. Finally, this is a family-controlled bank which I consider a major plus. BOKF is great bank to be included in a portfolio of 10 to 20 banks.

Cullen/Frost Bankers, Inc. is clearly one of my favorite High Quality-Dividend Champion banks as I documented on these pages on September 28, 2018. If you were one of those investors who was kind enough to part with CFR shares at less than $90 recently, thank you! The board is marvelous. They own a lot of shares and act like owners. Bank investors should be so lucky to have all bank boards govern like CFR's directors. The bank's forward P/E is 12.9 and the current yield is 2.68%.

SVB Financial Group is a one-of-a-kind bank that I urged investors in September 2016 to consider owning when I identified it as the single best play for bank investors seeking to benefit from rising interest rates. At the time the bank sold for around $100 and today goes for about $200. In 2018 its price eclipsed $300 a share, a number that is not so crazy given its superior cost of funds. I am a long-term shareholder who likes the diversification provided by its unique business model. The chief negative is that its business model is tied closely to the ups and downs of Silicon Valley private equity activity and valuations. Again, I don't think that's bad if the bank is not your only bank holding. While I'd like to see the bank pay a dividend, my guess is that the board feels compelled to act like Silicon Valley tech companies that prefer to reinvest capital into expansion. With a forward P/E of 9.97, SIVB is a great bank to include in a portfolio.

Stock Yards Bancorp Inc. is a Kentucky community bank that I regretted not buying five plus years ago. My reason for not buying then was my sense that it was over-valued using my Graham Multiple metric. At the time it sold for around $20 a share. SYBT then got as high as $46 in early 2017. When the price fell to $37, I picked up a few shares, and when it slipped to the low $30s and then to $28-$29, as it did recently, I started buying in earnest. I consider it a best-in-class, long-term holding as it gives me exposure to a part of U.S. bank geography that I had not covered in my existing community/regional bank investments. SYBT not only has a strong commercial bank but it also has a high performing trust/asset management business. It must be emphasized that the asset management industry is under enormous pressure as investors move to index funds and scale/costs shake up the industry. But SYBT is not really an asset manager. It is a Trust bank, an activity which requires completely unique skills and is less vulnerable to pricing pressures than asset management. SYBT's management has proved to be disciplined in expense management and capable of managing credit risk through-the-cycle. The bank's size ($3.3 billion) can be viewed as a negative. The chief concern with small banks is People Risk. Often one or two executives run the bank. (I don't know if that is the case at SYBT.) At year-end the bank's long-time CFO announced her retirement. While she is succeeded by a seasoned colleague, changes in key management can sometimes add risk to smaller banks. The forward P/E is 14.2 and the current yield is 2.88%. While not cheap using Graham's criteria, I began aggressively accumulating SYBT shares in my bank portfolio when the price slipped to around $30.

Lakeland Financial Corporation is a terrific Indiana community bank that I have often considered buying for years. The principal reason I have not bought LKFN is because I own a peer Indiana bank, 1st Source Corporation (SRCE), a Dividend Champion bank that is one of only 30 banks in the U.S. that increased dividends during the dark days of the Financial Crisis. As I wrote in my investing book, Indiana is without question one of the three best states in the country, perhaps even the best, for bank investors. LKFN and SRCE are not the only well-managed banks in Indiana. At the end of 2018, LKFN's slipped close to $40, a price so low enough I thought it prudent to pick up a few shares. I like this bank as a long-term hold. It provides a bank portfolio with exposure to commercial banking in a part of Indiana where SRCE is less active. LKFN's forward P/E is 12.9 and the current yield is 2.68%.

Texas Capital Bancshares, Inc. (TCBI). While I see CFR as my principal means of exposure to commercial lending in Texas, TCBI’s fundamentals and recent modest insider buying made the bank too attractive to resist when I made a modest investment in late December. While I am always eager to read bank quarterly earnings call transcripts each quarter, I am especially keen to read TCBI’s 4Q 2018 earnings discussion scheduled for January 23 at 5 pm ET. Like Bank OZK (OZK), TCBI shareholders have been hammered recently because of credit fears. The stock fell -44% last year (Chart 5). I think the stock price action is overdone. While I see no evidence that the Dallas-Fort Worth market is struggling, I will likely hold off buying more shares until I have the opportunity to scrutinize the bank’s Q4 2018 earnings report. TCBI does not pay a dividend and its forward P/E is a very compelling and perplexing 8.11.

Northern Trust Corporation. In 2008-09, 18 of the 20 largest banks in the U.S. cut dividends. NTRS did not. (The other bank to not cut dividends was Buffett bank, M&T.) Today NTRS has a dividend yield at nearly a 15 year high (2.5%) and a forward P/E (12.5) at the low end of its historic range. This niche bank focuses on affluent banking, a segment that historically has proven recession resistant. There is a lot to like about NTRS as part of a bank investment portfolio.

I don't know Signature Bank, Washington Trust Corporation, and Bank of Hawaii as well as other High Quality Banks. SBNY investors have been pushing a boulder uphill over the past few years. Investors worry that SBNY's big multi-family lending business centered on New York City is at great risk of massive losses. But, the hard data does not seem to support the doom and gloom view. SBNY just started paying a dividend (smart move) with a current yield of 2%. Its forward P/E is under 10, which is compelling for a bank that meets all seven of Graham's investment selection criteria. WASH is a $4 billion Rhode Island company with a long history of outstanding shareholder returns. While investors should be careful owning just SBNY and WASH, both may make great sense owning as part of a 12-15 bank portfolio. WASH today has a forward P/E of 12 and an attractive dividend yield of 3.7%. BOH always looks expensive to me, but compared to history, it looks like a bargain. Its yield is 3.4% and the forward P/E is under 13.

VI. Key Risks

The chief risk with bank investing is always bad loans. Clearly there are plenty of investors who think the business cycle is long in the tooth and a recession is imminent. By such logic, credit losses will soon mount and bank profits shrink. I'm not so sure.

As detailed in my prior post, my preferred metric for measuring industry credit risk is today running at 50% of the average for this metric since 1984. If the industry's Provision expense doubles, the industry's ROA will fall from 12.5% today to just below 10%. If and when that happens, bank stocks will drop hard. Banks with the worst credit numbers will be punished severely.

While I don't want to appear too sanguine about the prospects of bank stock prices in 2019, I do not expect to see a meaningful increase in credit problems when Q4 2018 earnings are announced beginning next week. Nor do I foresee material credit issues for 2019. Here's my thinking. The economy is growing 2.5%+. In the past, banks have never seen big credit problems in an economy growing 2%+, let alone 3%. In addition, bank lending has been sluggish during the past 3 years. In fact, loan growth in U.S. banks has barely kept pace with GDP growth. My review of data for the past 35 years shows that credit problems have always been preceded by loan growth rates running more than two, if not, three times GDP growth. We're just not there.

That's not to say credit problems could not erupt in certain parts of the country where lending has been too aggressive. If this were to happen, I would expect Florida to be a possible flashpoint given the state's ignominious history of enduring bank problems every time the economy slows. But beyond Florida, no other market seems especially vulnerable at this time. And to be fair to Florida banks, the state is now dominated by megabanks which have shown no evidence of dumb lending in recent years. While I would never invest in a Florida community bank given the state's awful historic performance, I am certainly less worried about Florida community banks than I have in any time during the past 35 years. (I was a banker in Florida from 1983-89.)

Perhaps the greatest risk to bank stocks in 2019 is the same one that hurt banks in 2018: Fear of a recession and rumors that Financial Crisis II is right around the corner.

Investors were burned badly by banks from year-end 2004 to 2009. My data shows that the average bank's stock price fell more than -50% during those five years. That terrible performance actually was worse than the S&P during any five-year period of the Great Depression (source: Investing in Banks, chapter 1). Once burned, twice shy, bank investors are quick to pull the trigger and dump bank stocks. I think that's why big bank stock prices got hammered during the second half of 2018.

While banks should be expected to earn record profits in 2019, investor fears could keep a lid on bank stock prices in the short term. That's not all bad for banks buying back shares or buy-and-hold investors looking for decent dividend yields.

Final Thoughts

The world's greatest investor has made bank stocks the centerpiece of his investment holdings. You can buy the same ten banks he owns and mirror the Berkshire Hathaway holdings.

Because of the massive size of Berkshire, Buffett actually has less investment flexibility than the rest of us. Using Benjamin Graham's investment selection criteria, it is possible to create a custom portfolio of High Quality banks that meet the high standards of Graham and Buffett.

Another alternative is to buy the two big bank ETFs, XLY and KRE. In my next post, I will offer my view as to why neither serves the purpose of the buy-and-hold bank investor.

Final thought: I think investors who buy these 12 High Quality banks will be happy five years from today.

Time will tell.

Disclosure: I am/we are long BOKF, CFR, LKFN, SIVB, SYBT, BRK.B. 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.