Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

July 2017

While technology stocks grabbed the market’s attention this year, it is bank stocks that have stood out during the last twelve months. The large banking institutions provided yet another fillip for their owners in late June—as some of them increased rewards to shareholders by substantial amounts—all with the imprimatur of the Federal Reserve. Dividends went up significantly—in one case by 100%. In the name of “returning capital to shareholders,” the banks announced large stock buybacks as well. Buybacks, most often made at high prices to boost stock prices and the value of management compensation schemes, might, for once, actually make sense. Even after making significant gains, many bank stocks were still selling for less than accounting “book value” (net worth) per share, which can be an indicator of depressed valuation. Banks typically sold for about two times book value prior to the financial crisis.

In some ways banking is a unique business, which, done well, is highly profitable; done badly it is prone to disaster. At its core it acquires funds on a short-term basis (bank CDs for example), and then uses that money to make long-term loans (e.g., 30-year mortgages) and investments. Since long-term interest rates are normally higher than those on the short end, banks earn a “spread” on the difference. However, there is a risk inherent in this arrangement. Since long-term loans “reprice” (adjust to changing market interest rates) more slowly than short-term obligations, banks are at risk of seeing their funding costs (those CDs) rise more quickly than the income from their earning assets (the mortgages). The situation can be further exacerbated if the loans are made recklessly and the bank does not earn what it had expected, or worse, never gets its money back. Well-run banks hedge these risks by holding adequate amounts of capital as a cushion, and by making loans in a careful and prudent fashion, i.e., lending money only to people “who don’t need it.” Well-run banks are not in the business of lending to high-risk borrowers or taking part in ventures; that is the province of Wall Street and venture capitalists.

The recent history of the banking business suggests a reason for the renewed interest in bank shares. Too many of the larger institutions had forgotten what being “well-run” meant. As a consequence, banks were at the epicenter of the world financial crisis that began ten years ago and nearly crushed the international financial system. Too much debt, seedy loans, and shaky investments led to the collapse of a few major institutions (most notably Lehman Brothers), with many of those remaining requiring taxpayer support totaling hundreds of billions of dollars. In the aftermath of the crisis, regulators subjected the banks to more stringent oversight, and legislators restricted the scope of bank activities with the goal of forcing banks to increase their capital cushions to make them more resilient and prevent future taxpayer bailouts. Dividends were slashed and any sort of payment to shareholders was supervised. Activities that might deplete capital, such as speculating in securities for the bank’s own account, were targeted by legislation such as the “Volker Rule.” The fact that U.S. banks in the aggregate had to pay tens of billions of dollars in fines and other penalties goes to show the extent of the unwise and often illegal practices that had permeated the industry. The banks had brought opprobrium, and the increase in oversight that they abhor, upon themselves.

As part of the increased scrutiny, for the past several years the Federal Reserve has subjected the country’s largest banking groups to annual “stress tests” designed to gauge their ability to withstand a future financial crisis. A few banks stumbled along the way, but all passed this June’s review, which subjected the institutions hypothetically to a withering crisis which included a stock market collapse and high unemployment. All came through with their capital cushions intact. In addition, the Fed approved banks’ “capital plans” permitting the increased dividends and stock repurchases so appreciated by investors at quarter’s end.

While the regulator’s verdict was certainly good news for the banks, it had already been anticipated by the market. Share prices for many of the big banks had appreciated substantially, often in the 50% to 100% range. Boosting the growing positive sentiment towards the sector was the belief that its regulatory burdens would soon be lightened, and that fiscal stimulus programs expected out of Washington would boost loan demand and lift interest rates, thereby improving profitability by increasing lending spreads.

Following the release of the stress test results in June, the financial media devoted much attention to Warren Buffett’s Berkshire Hathaway, which had already made $18 billion from an initial $13 billion commitment to banks. Buffett famously supplied tens of billions of dollars of capital to financial institutions during the crisis and its aftermath, in the process becoming the largest shareholder of two of the biggest banks in the world. Being capital rich in the middle of a crisis permitted Berkshire to drive hard bargains, and some have maintained that Buffett obtained “special” deals unavailable to anyone else.  This was not entirely the case, however. Bank securities traded freely in the public markets and anyone could have purchased them, sometimes at prices as good or better than the ones Buffett obtained.

That few emulated Buffett at the time was largely due to fear. Banks were indeed frightening entities: they had suffered large losses, and there were fines, large legal settlements, stress test failures, new regulations, etc. The economic environment of low interest rates was of concern as it made it more difficult for banks to earn their way out of difficulty. Additionally there was the institutional investor fear of poor “performance,” that precluded getting involved in a sector with questionable prospects. Some even feared for banks’ viability; perhaps there was more trouble lurking within their balance sheets.

For all of these reasons few investors were willing or able to take the long-term view: banks had been through the wringer, but with more capital, restrictions on speculative activities, and new managements, they were now different and safer institutions. Economic conditions would eventually become more favorable, allowing their earning power to come through. As for “performance,” it was now possible to buy bank stocks so cheaply that good returns were possible even if they were years in the making. Eventually this vista of possibilities opened more eyes to the potential of looking beyond current difficulties.

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The expected higher interest rates never did materialize. The promised stimulus package has yet to be enacted. Events abroad have also reinforced a tendency to lower rates. Europe and Japan (which have themselves experienced negative interest rates over the last year) are still pursuing substantial monetary stimulus programs, forcing “yield refugees” from those lands to seek higher returns in the U.S. Sabre-rattling in various hotspots around the world is a source of “safe haven” buying. The resulting demand for U.S securities helps to keep our rates low.

Meanwhile, our Federal Reserve policymakers continue to pursue a policy of higher short-term rates (the rates over which they have the most control), as part of a goal of returning to policy “normalization” after being in crisis recovery mode. The resulting flattening of the “yield curve” as short-term rates rise and long-term rates stabilize or decline has some observers worried. A narrowing of the difference between long and short rates has historically presaged economic downturns. Whether the extraordinary monetary policies since the crisis have reduced the usefulness of this indicator remains to be seen.

Interest rates were not the only thing that prognosticators got wrong in this year’s first half.  At the beginning of the year speculators (mostly hedge funds) had amassed a record bet on rising oil prices. Following the collapse at the end of 2015, the commodity’s price rose strongly to the low to mid fifty dollar range by the end of last year, at which point it stalled due to rising U.S. “shale” oil production. Frustrated with the persistently low prices, oil producing nations agreed to cut their output in order to reduce the global inventory glut brought on by their prior policy aimed at shutting down those shale drillers. Encouraged by the prior price momentum, and by oil producers’ restraint, traders bet on continued price increases, only to see their dreams of lucre evaporate.

As so often happens in finance and the markets, when many players pile on to the same position, the opposite occurs. Oil prices declined. Those shale drillers did not go out of business entirely; instead, the survivors got more efficient and their production grew. Other producers, such as Libya and Iran, increased output as well. The wished-for inventory reduction occurred only slowly, if at all. Market players have now accumulated a large short position in oil, betting the price will continue to decline.

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We have always maintained that a long-term perspective is the prerequisite for successful equity investing. Those possessing the patience to adhere to this position continue to reap the rewards as the stock markets are now into the eighth year of the second-longest bull run in history. The S&P 500 equity index has posted gains for seven consecutive quarters, and the first six months of 2017 proved to be the best first half of a year since 2013. Since the market bottom in 2009 we have experienced armed conflicts, currency crises, terrorism, political instability, and a host of other challenges severe enough to unsettle financial markets and investors. The fact is, change, turmoil, and the like are inevitable facts of life. Through this tumultuous period, businesses in the aggregate continued to prosper, and long-term shareholders were rewarded.

 

Dennis Butler, MBA, CFA