Though it has been more than a decade, memories of the last real recession, the Great Financial Crisis (GFC), still linger when it comes to buying bank stocks. Banks were at the centre of the GFC, and as regulators compelled them to re-capitalize due to loan losses, their stock prices suffered. With another recession looming, even some expert money managers are finding it difficult to suppress their “flight” instinct to sell tiny bank stocks.
While natural, this innate response has created a very appealing entry point for intelligent investors ready to defy expectations and buy bank stocks during a recession. Here are four reasons why now could be an advantageous moment to buy stocks of US community banks.
The recession is already priced in.
Some asset sectors appear to be pricing in the possibility of a minor recession. However, the valuations of smaller banks appear to guarantee a recession. Consider that community bank stocks have only traded at their current price to tangible book values1 twice in the last three decades: briefly in 2020 at the start of the epidemic and during the Great Financial Crisis (Display). Even during the 2001 crisis and the rising rate cycle of the mid-1990s, community bank stocks troughed at valuations far higher than current levels. Essentially, when it comes to community bank stocks, the market is pricing in not just a recession, but a catastrophic recession.
US Banks Seem Ready This Time
This year, many stock sectors have seen negative earnings revisions as interest rates rise and global growth slows. However, US banks continue to report favourable earnings revisions and maintain high levels of profitability. A crucial reason? When short-term interest rates rise, most banks’ spread lending (measured by Net Interest Margin2) becomes more profitable. This is due to their ability to delay paying more for deposits while promptly charging more for loans (Display). Most investors expect the Fed to raise short-term interest rates during its next few meetings. In other words, the enhanced 2023 earnings outlook for US banks stems from a position of strength, while other industries worsen. On a relative perspective, that may make some
At the same time, we believe US bank balance sheets will remain resilient if the Fed’s approach pushes the US economy into a recession. Following the Global Financial Crisis, bank management teams and regulators increased loan underwriting. This time, the excesses are coming from outside the system, among fin-tech and other non-banks, and in industries like “buy-now-pay-later,” non-prime auto, and leveraged lending.
US Banks Are Likely to Stay Profitable—and Drive Book Values Higher
While some may consider this a bold declaration, it is actually less daring than it appears. The Great Financial Crisis remains the first recession in the last 35 years in which all US banks were unprofitable for one year. For example, according to FDIC data, industry-wide Return on Equity (ROE) was 7% in 2020, 13% in 2001, and 6% in 1991—three difficult periods for the banking industry. How does that compare with today? In sum, US banks generated a ROE of 11% in the first half of 2022, which we project to rise over the next six quarters. Finally, investors should not let concerns about profitability deter them from buying bank equities during a recession.
Expect Excess Returns as We Emerge from the Recession.
Until now, banks have not had the opportunity to definitively address investors’ worries about the GFC. However, as recessionary fears fade and US banks stay profitable (albeit not at the expense of asset quality and balance sheet health), they will be able to emerge from the shadow of their pre-GFC predecessors. From there, we can make a compelling argument for US bank stocks to regain their historical valuation multiples. For smaller community banks, the benefits of valuation re-capture could be significant. Furthermore, the stocks should reach these normalised multiples on substantially higher book values than today, compounding the gain for investors who buy microcap banks at current prices.
Are bank stocks a good buy?
While sentiment may continue low until a recession occurs, we believe this is an ideal moment to establish a position in community bank stocks. We expect bank equities to increase in book value from here, and institutions who choose to sell in the meanwhile will likely receive a big M&A premium. Waiting for the “all clear” means missing out on most of the valuation re-capture, as well as other significant sources of profit between now and then.
