Street Talk | Episode 146: Strong fundamentals, increasing M&A activity set the table for small cap bank stocks

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Nathan Stovall

Welcome to Street Talk, S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.

I'm Nathan Stovall. And on this episode, we're talking about the operating environment for banks in 2026, what that will mean for bank fundamentals and whether or not current valuations reflect that performance.

We recently hosted a webinar where we presented our outlook for the banking industry and then had the opportunity to interview Jonah Marcus, a partner and portfolio manager at Endeavor Capital to get his perspective on the space. In addition to thoughts on the operating environment and the impact on fundamentals, the veteran investor shared his views on the valuation disparity between large and small banks, his outlook for credit quality and the importance of technology in a bank's data strategy. Here's the conversation.

Nathan Stovall

Jonah, thank you for being here. Let's start on valuations. How do you feel about valuations? Where do you feel about the group? And how do you think they compare to fundamentals? The last time I saw you on the circuit was an event in November, and that was a big talking point that valuations don't match fundamentals. How do you feel about it today, particularly given the nice little rally we saw at the end of the year?

Jonah Marcus

Yes. So first, Nathan, thank you, obviously, for having me into S&P Global for having me here. Well, Nathan, I mean, you and I have been doing this for over 20 years, focused on the community and regional banking space. So I think we're considered homers. So I think everything we share about valuations should be left with the caveat that if rooting for valuations to work, they would trade at 25x earnings. But I think you'll be surprised that I don't spend a lot of time actually focused on where I think valuations will go. I spend most of my time on fundamentals. And the reason for that is valuations have 2 components, right? Part of it is science and part of it is art. On the science part, which would be profitability, the level of earnings, expected growth rate and the track record of growth rate of earnings and some of those metrics, those trends seem very good right now. Now they've been very good, obviously, for about a year and the projections, as you kind of laid out in your presentation, expect to be good. And so when we're -- you're solely focused on the space, you want that valuation as soon as things get good. The second part of it, however, is the art. And the art is focused on sentiment and psychology of markets. And there, I agree with the audience poll, the section about generalist and broad money apathy for investing in smaller banks. And what I think that leaves us is that this is a stock pickers market. Fundamentals are good. They're getting better. I can enumerate a whole host of tailwinds that played out last year. And I can't name that many headwinds that happened last year actually. I mean we can always be fearful, and I'm sure we'll talk about credit. If we were doing like a health check, like it would be a bunch of checks in the good column and nothing in the bad column, yet we're still frustrated generally about valuation. And so what I believe is to get the valuation, you've got to be a real winner and stick out from the crowd. And that is focused on differentiated profitability, growth, unique business niches I'm sure

we'll talk about technology, but a technology infrastructure that drives ultimately the bottom line performance that will garner that valuation. But from a broad perspective, I don't believe, and I'm certainly not relying on for our fund, valuation levitation to take place. And if it happens, that's terrific. Valuations are certainly below historic average. That presents some downside protection to us. So maybe that's the good news. But do I think that the fundamentals are divorced from the valuations? I don't know. I mean the market ultimately adjudicates and there's not a thing that I can say can go from red light to green light that is to fly in the ointment. I mean even the poll answers, which I agree with the audience, none of those things were things that are actually negative today. It's obviously always going to be fear of a future ditch, but also there's tremendous opportunities out there. So I wouldn't bet on valuation improvement in the space. I think that we're going to focus more on the science side, like banks have to earn it by putting up numbers and hopefully, valuations will stick out. I'll say the one thing where we've seen valuations become extraordinary is where you're unique and different. If you really have an extraordinary return on assets and equity and a secular growth story, those banks are garnering high valuations, but those are few and far between.

Nathan Stovall

And with those, picking on that a little bit, I mean, you already kind of said this, most of those -- or maybe they're not, please tell me if they're not, but it felt like you were saying a lot of those are truly doing something different, really focused on a niche. I know we had talked a little bit on the front end about some of these guys, but I mean something where they're like really focused on a specific business line and have created a differentiated mousetrap opposed to saying that I'm a CRE lender and market, not to pick out a community bank. But is that kind of fair?

Jonah Marcus

It could be. I mean, look, there are banks that are just highly efficient in their delivery systems or in how they manage expenses. But you're right, a lot of the business models that are garnering valuation premiums have some niche business that's driving really differentiated outcomes, whether it's growth and/or profitability, durability of earnings, right? Like we don't talk enough about like standard deviations of returns, but some of the fee businesses or some of the incredible deposit bases just offer a higher durability of revenue and profitability. And yes, those are the ones that are going to garner higher valuations. Some of them present higher risk as well, right? If you talk about business lines like some of the digital banking solutions or some of the niches. In some cases, those are what caused bank failures in 2023. So some of those come with 2 sides. But by and large, we believe that if you built your bank off of durable efficiency advantages, high revenue growth driven by core deposits and fee businesses and differentiated lending niches that you have sustainable valuation premiums. And by standing out from the crowd, and maybe you'll hear that from me more than a couple of times today. But I think that's what it takes to get the valuation because I'm not sure that the broad group is going to garner the attention from generalist investors. So it really takes that specialization and that special traits to get people to dig in a little deeper, spend the time, take the single stock risk and earn that higher valuation.

Nathan Stovall

Yes. And some of those you mentioned, we put out deposit rankings. We did twice last year, and we'll do them again this year. And you look at some of those names with some of the best deposit franchises from a rate-sensitive standpoint, noninterest-bearing, whether it's like a CVBF or a City Holding, they trade at

some of the highest valuations and they're steady Eddies in almost every single cycle. So it's like there's a price for certainty. It's higher, and they've earned it over time.

Jonah Marcus

Yes. And absolutely -- and what's fascinating is a lot of investors, and I'm guilty of it as well, we talk a lot about markets, fast-growth markets, demographic markets. If you look at the highest valuations in the industry, they're in some of the slowest growth markets. I mean you referenced a couple there, but those are markets that have very slow growth and in some cases, maybe even negative growth. But because of their market position and because of the management teams and the mousetrap that's being executed upon, they generate return profiles that are incredible. And if you look at the industry today and you had some numbers of, we look at banks with $1 billion to $5 billion valuations or market caps and the profitability, and I'm sure we'll get into large and small, but they're very good. And while demographics can be important for M&A, it doesn't seem to have a high correlation to stock multiple.

Nathan Stovall

Yes. Let's talk a little bit about large and small because I mean, one place it feels like over the last year or last 3 years, I showed there at the end, is that large banks sort of did benefit -- the rising tide kind of lifted them all and the regionals and smaller guys weren't in there. Is that simply driven, you think, by generalists just floating to there and feeling safer in there? And is some of that an offshoot of or maybe an unfortunate offshoot for those who like to look at regionals and community banks post the '23 failures. What do you think has drive that big valuation disparity that wasn't always there when you go back a long time, right?

Jonah Marcus

Yes. I think there's a couple of pieces. So first, the dollars in ETFs today are bigger than the dollars in actively managed mutual funds. And so the ETFs and the quantitative money is always going to be attracted to liquidity, right, liquidity of shares. And so I think there's some natural advantage for large over small that maybe didn't exist a decade ago. Second to that, obviously, there's business lines that did great that the large banks have, right? I mean you've seen the results today in Goldman and whether it's investment banking, capital markets activity, that's a niche that is doing very well that large banks have and a theme that investors can focus on. So I think that is the story of 2025. I think the good news is, and not to be a homer myself, but I actually think the tide is turning right now. If you look at the key themes in the space, M&A, deregulation, net interest margin expansion and benefits of the yield curve, some of the secular growth or the resuming loan growth that is evident in the environment, those are decidedly going to benefit small and mid-cap banks. And so while I think last year, some of the attraction from capital coming back into the space after a tough environment in 2023, certainly, there was like the "regional banking scare that didn't happen with Jamie Dimon's cockroach comments in October with the NDFI loans. But I just think that when you look at the catalysts in place and the themes and drivers, and these are multiyear drivers, they're distinctly benefiting small and mid-cap banks. And so I see that tide turning. I think expectations for large banks are probably at peak when you think about even just this quarter's results versus expectations and the fine point. And I do think that more dollars are starting to focus on some of the small and mid-cap banks. And I think that actually, you'll see the investment dollars will follow the bottom line dollars and the bottom line dollars and the growth in earnings and revenue are really

picking up for smaller banks, and I think that will garner more attention kind of on a relative to the large bank perception.

Nathan Stovall

Yes. And to your point there, we saw pretty good results out of the large guys, but you saw a little bit of a sell-off. And some of that, we had a question come through about this about potential card legislation -- or not legislation, excuse me, card caps from the President put out some of that. But still like they just were priced maybe too perfection to a degree. And so there's almost no level of results that can deliver on that. But you also mentioned credit. In Q3, we came out everybody was all spooked, group sold off, recovered and we've kind of kind of come back down the earth. I feel like a little bit now. How do you feel about credit? Is it a big concern for you? I mean, I'm looking everywhere, not that I want to be bearish, but I just -- I feel like I've been trained over the years to look, right? And everybody I talk to feels okay, I feel like from a management standpoint.

Jonah Marcus

Yes. Look, credit quality is always front and center. It is the sleeping volcano in our industry, right? We're always -- as analysts in the space, we're trained and especially people who grew up around the GFC, trained to focus on that as the main risk factor for our space. So I think we've always got to be diligent and cognizant around that. I'll tell you the good news from my seat is when we look at the kind of real-time credit trends, which would be nonperforming loans, net charge-offs, whether we look quarter-to-quarter, year-over-year, very stable. I mean you have to get a magnifying glass out to find the delta there. When we look at the early warning signs, criticized assets, classified assets, special mention assets, again, the increases year-over-year or quarter-to-quarter are negligible. And so I think that speaks well to where we are in credit. The forward looks from the large and small banks is positive. The industry seems well reserved today. And so from the metrics perspective, we feel very comfortable. I think the other piece of good news, and this is good and bad news, but I actually think banks have done a great job of maintaining underwriting standards since the financial crisis. And while that has caused some seeding of market share probably to private credit, at least around the edges for small banks and maybe even more than around the edges for larger banks and for consumer banks, I think that sticking to their knitting and staying in an appropriate credit box will serve banks well when the economy does have a recession or some growth issues where the durability of credit and therefore, profitability will be good. So I feel that that's an area that we're always going to have some anxiety on. We're always going to shoot first and ask questions later. And we're talking internally at our firm, management teams always explain credit issues as idiosyncratic and one-off and investors always view them as the tip of the iceberg. And most of the time, it's somewhere in the middle. And I just believe that on the geography of where we are today on credit quality, it's something that we -- as I said before, we have to always be mindful of and have some level of anxiety about, but the trends and the outlook remain good, and I feel very comfortable with the underwriting standards that -- and the concentration limits that banks have managed to. So I think that when there is a recession or a negative credit event, that things will turn out much better than obviously some prior cycles.

Nathan Stovall

I totally agree. You mentioned the last point on concentration. I didn't have it in there, but if you look at like CRE concentration, it's declined 8, 10 straight quarters, something like that. You continue to hear

banks complain about losing deals to private credit, but maybe that's good to your point, risk going out of the system. And as long as I've been doing this, the banks who make money have money when no one else has money. And what feels kind of weird about this one is that when a cycle eventually does occur, the industry might not delever. It might be able to lean in and regain market share, which we haven't really seen that, but it's a different setup than we've seen before. So it does feel like the lessons from GFC are kind of still holding true for a lot of these operators.

Jonah Marcus

I think that's right. And balance sheets are in great shape. Capital levels are far better for small and mid-cap banks than they are larger banks. And actually kind of coming back to the point about the large versus the small, when you just think about your ability to lean in, it's capital and its profitability. The 4 largest banks, the money centers generated return on assets of 0.88% in Q4. The banks in that $1 billion to $5 billion market cap are expected to have an ROA of 1.35% in 2026. So almost a 40% to 50% higher profitability for small versus large. And that plus higher capital levels, I think, will allow, to your point, some of the small banks to really lean into growth when there's a growth scare and some sort of a pullback just given the conservative nature of balance sheet strength and profitability that they possess alongside, as you mentioned, that lack of over concentration to more volatile asset classes of loans.

Nathan Stovall

Let's shift a little bit. Let's talk about technology. You hear tons about, again, large versus small, the big guys being able to invest in technology. How important is tech when you look at investment in a portfolio company and thinking about their progression or their tech progression of their data strategy?

Jonah Marcus

Yes. I think technology is a key differentiator today and a bigger differentiator going forward. It's probably way more important today than it's been over the 20-plus years of my career investing in the space. I think the promise of technology and data has 3 huge outcomes. One would be reducing costs; two, and kind of tied into reducing costs, providing for much greater scalability of banks. And then third would be wowing the customers, really impressing them with technology solutions like you see at Amazon, like the experience that you get there. And maybe a fourth to that would be utilizing the data, as you referenced, to generate more sales interactions, know more about your customers, deepen relationships, et cetera. I will tell you that the vast majority of banks today are doing well on point one. They're starting to reduce cost. They're doing okay on point. 2. They're improving scalability. And I think they're completely failing on points 3 and 4. I don't think that they are delighting their customers with solutions, which are still too highly levered to the 3 core processors. And I certainly don't think that banks are utilizing data today to be able to create more selling interactions to meet their customers in an increasingly digital world in a personal way, utilizing technology. But I think that is where we're going, and that's the promise. So where does that leave us, right? I think where that leaves us today and me as an investor is if we can identify the banks that can actually leverage technology and achieve those 3 or 4 outcomes even to a very good degree or even to a good degree, I think the outcomes are going to be huge. All future growth will be more profitable. growth will be easier, Net Promoter Scores or satisfaction of customers will be better, and that can gain all sorts of benefits from network effects. And actually, where you do see it is in fintechs, right? The fintech companies, we use them ubiquitously like I'm going to Zelle you money or do you have Cash App and things like that. And you've seen great valuations at companies like Chime and Figure,

some of the fintech IPOs of last year. And I think that as banks continue to adopt technology and data strategies, they need to move past just reducing cost and move towards mimicking some of the ways that the fintechs are leveraging technology to achieve all those outcomes with the benefit of having the Charter. And I think that executed well, we're going to see extraordinary outcomes from tech-forward banks, banks that are utilizing data. And look, we're still fairly nascent in this evolution, especially when you consider how AI is going to factor in. But I think the management teams that really get it are going to be enormous winners. And when you look at AI, it's going to really benefit industries with a high percentage of knowledge workers. And there may be no industry outside of technology itself that's more concentrated with knowledge workers than financial services and probably within there in banking. And so the opportunity is enormous. The small number of banks that I would say really get it and are executing upon it, the results are amazing. And more banks are focused on getting there. But it's always a crawl, walk, run, but we're sort of like we should be walking fast and starting to jog because of where technology is today. And management teams and boards need to fully grasp what that means and the Boards and management teams need to reflect the opportunity with people who understand the technology, both on the Board side, the management team and then push that down, obviously, to the employees and then obviously, to clients.

Nathan Stovall

Speaking of the directors, you were a founding Director at Grasshopper. We mentioned a few times that they agreed to sell not too long ago and got a great multiple on the transaction. Not so much the transaction itself, but it's supposed to be a tech-forward franchise. What are some of the traits that you think about that help create the value of the franchise? And is there anything that from the experience with Grasshopper that you think that other banks could take as they're trying to become -- lean into what we're talking about here, become more tech forward.

Jonah Marcus

Yes. Well, obviously, I was proud to be part of the journey at Grasshopper I am proud to be part of the journey at Grass Hopper, and it was a journey. So it certainly wasn't a straight line from one of the largest, if not the largest de novo bank in history to, as you mentioned, one of the richest sale prices. Grasshopper adopted an extremely innovative strategy, a digital-first strategy. But I think what underlies the success of the company were 3 philosophies that I call the Butler rules, which I named after our CEO, Mike Butler. And they are: one, risk management has to be your competitive advantage. Technology is incredible and has great opportunities to scale, to generate profitability, et cetera. But it does present risks. And by constructing that technology and the infrastructure of the bank in a way where risk management is your competitive advantage and that mindset, I think, is critical to being successful with regulators, with clients and kind of staying on the right side of all that. Second would be clear focus that core deposits create franchise value. all the products built at Grasshopper were built with a mindset of building an extremely valuable core deposit base. And then third was hire the most talented people and empower them. And so those would be how I would maybe summarize the strategy of the bank and what created so much value, I think, from the management team.

Nathan Stovall

I'm smiling because I mean, I feel like those 3 are good principles in any environment, any era when it comes to banking, control your risk, get paid back, have great deposits, hire more people, but use what's

available today in terms of technology to do that as efficiently as possible. So that makes perfect sense to me.

Nathan Stovall

Big thanks to Jonah for sharing his views on the space, and thanks for everyone for tuning in.