Trends Watch: U.S Regional and Community Banks

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Yaron Brook, Ph.D., Co-Founder and Managing Director, BHZ Capital Management.

Why do you feel the U.S. regional/community banking sector presents attractive investment opportunities?  

We’ve been specializing and investing in the U.S. regional/community banking sector since the mid-1990s, and believe it is perfectly suited for an alpha generating event-driven, long/short equity strategy. The sector tends to be poorly covered by sell-side analysts and offers inefficiencies that can be exploited by professional investors. The COVID-19 pandemic temporarily paused the inexorable trend of consolidation among regional and community banks. However, the pressure on smaller banks to seek merger partners will only increase, and, when markets return to a more normalized state, we expect merger activity to return at an accelerated pace.

The short-term dislocation in bank stocks caused by COVD-19 created a unique set of conditions. The dispersion of bank valuations (between expensive and cheap banks) has increased significantly, creating what we believe is an extraordinary opportunity for a relative value portfolio.  Historically, this increase in dispersion is always followed by it shrinking back to normal levels.  A strategy that is short expensive bank stocks and long inexpensive bank stocks is bound to make significant excess returns as this convergence happens.

What is your outlook for the sector?

Entering 2020, banks were already considered relatively cheap compared to historical norms.  Yet these low valuations did not reflect weak financial performance.  To the contrary, despite low interest rates and a flat yield curve, the sector had returned to pre-financial crisis profitability levels.  The SNL Small Cap U.S. Bank Index recorded a return on average assets (“ROA”) of 1.15% in 2019, the highest level since 2002 and dramatically higher than the 0.88% 25-year average (source: SNL Financial).

Community and regional bank stocks have been hit hard in the current crisis.  The SPDR S&P Regional Banking ETF (“KRE”) fell 41.6% from February 20 to March 31.  During the same time period, the S&P 500 returned -23.2%.  This drop no doubt reflects fears that both COVID-19 and the subsequent economic shutdowns increase credit risk, and we certainly expect pressure on loan portfolios and bank earnings in the near-term.  However, U.S. policy responses to date provide massive support, both implicit and explicit, for the U.S. banking industry. Congress and the Federal Reserve are using banks as the critical conduit to support the economy and have designed their programs in a way that pays banks for this service.  Government is engaging three distinct but related broad initiatives to use banks to support the economy through this crisis, all of which help banks both directly and indirectly (by helping their borrowers): I. the stimulus package; II. Federal Reserve programs and III. regulatory forbearance.

What keeps you up at night?

I am concerned about the long-term growth prospects of the U.S. economy and consequences of the massive government stimulus.  If the economy ultimately struggles to recover and grow, banks will be pressured, even more than usual, to sell. While overall prospects for the sector might not be positive, we should be positioned to benefit from the increased merger activity.

There is also a possibility that loan portfolios will deteriorate significantly and more small businesses will be pressured to go out of business if there is a second wave of the virus.  This will hurt bank valuations, but is a reason to be positioned with both longs and shorts in the sector.

The views and opinions expressed above are of the interviewee only, and do not/are not intended to reflect the views of EisnerAmper.