Listen: Street Talk | Episode 134: Title: KBW CEO says bank stocks still have room to run

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Nathan Stovall

I'm Nathan Stovall, -- and on this episode, we're talking about bank stocks, investor sentiment towards the sector, the considerable rally that has occurred since the election and what that means for capital raising and M&A activity. Coming back on the show is one of the leaders in the bank advisory space, KBW's CEO, Tom Micha. Tom, thanks for coming back on.

Tom Michaud

Nathan, great to be with you.

Nathan Stovall

So Tom, let's start with bank stocks and valuations and the rally that we've seen since the election. What to you is the biggest driver there as we've seen money come back in the group, less regulation, return of bank M&A activity, stronger growth or maybe a little bit of that or all of it?

Tom Michaud

I think the first thing is what is not happening. Unfortunately, I liken a lot of this at times to my golf game, which is it just needs to be less bad. And the operating environment for financials and banks, in particular, needed to be less bad. And so what was -- let's talk about what was bad. So -- and I don't know if I really want to say bad. The appropriate word, I think, is challenging. That's actually the more appropriate word. So we had the longest inverted yield curve in 47 years that ended in the third quarter. And banks were not built to thrive in inverted yield curves. And if you think about what was attempting to be done while the curve was inverted was the Fed was trying to slow the economy. The Fed was trying to take liquidity out of the system. The Fed was trying to absorb some of these excess deposits that were created by the 100-year pandemic response. So that period has ended and is behind us. And while the curve is still flattish, at least it's not inverted and the heat on deposits is not as hot as it once was. So I would say that is what really -- that is number one, what really changed. And then number two is I think the market's perception around having a soft landing and not a hard landing after the Fed went on such a strong tighten. I mean, then the pace of tightening was historic. I mean I think that's kind of what led to the 3 bank failures last year. So you add that up. And now as we get that further in the rearview mirror, we're in better shape. And so I think there's more confidence about growth in the economy. There's more confidence that we're not going to get a bad asset quality reaction or event soon. And then there's the election, which I'm sure we'll dig into more. But the prospect of Trump winning and then Trump actually having won, I think that was your question, what was happening pre-election, but the prospect of him winning was starting to be factored into the stock. So -- and you're right, we've had a huge bounce off of last fall that went up into the summer. And then, of course, now it's accelerated after the election. But that's it. So the operating environment has pivoted and that was the change.

Nathan Stovall

Yes. And I want to pick up there a little bit because I really like how you put it there that some of the ways I've been thinking about it, if you think about the overhang of the group and some of the noise we heard and concerns in the investment community, we were, I don't know, doomsday in some cases, exactly the right way, but I had heard you say, I think last January, worst-case scenario kind of being pushed off the table. each passing day we had that these challenges as you had kind of dissipated or at least became kind of manageable, it felt like money just slowly flowed back into the group pre-election even. Do you think that's fair?

Tom Michaud

Yes. Oh, pre-election money was definitely flowing back into the group. And the -- I was out talking about a coiled spring last September, October of last year, so a little bit over a year ago. It seems like at that point, investors had given up on the banks. And you had plenty of banks trading below book value, and there was a perception that we were going to have a credit cycle, and it just didn't feel good. And so yes, there was a rally that had started in these stocks pre-election. And I think it's because after 2 years of declining earnings because of the inverted yield curve, we were about to get relief. And as a matter of fact, we did -- '23 and '24 were down years of earnings per share. We now think the industry is going to grow earnings at 6% in '25, going to 12% in '26 -- and there are a couple of drivers, but the main driver is net interest income troughed in the second quarter of '24. So you can almost look at this on a quarterly basis. And by the way, what we're also leading off out of this is there's been no loan growth. And that has been a factor, too. We're only looking for like 4%-ish loan growth during the next year or two. Personally, I think that's where the surprise may happen. I think loan growth may be higher than 4%. We may have gone from an era of constantly cutting bank estimates and earnings estimates to going into a period where we start increasing bank estimates. And I think the delta surprise could be that growth in this economy is a little bit better than 4% loan growth. And then I didn't even get to investment banking results, which would be the driver for the global SIFIs. And maybe just let me leave a point because it's so substantial. Our firm, we research investment banks just like we research banks. And most estimates, revenue estimates for investment banks have revenues being higher next year than in 2021. 2021 was the high bounce period of the last decade. And if that's what analysts expect, JPMorgan, Goldman Sachs, Citigroup, Bank of America, they're going to see a bounce in those businesses. And so there's a revenue story in the big banks, too, even though the more spread-dependent banks, which are the midsize and the smaller ones, will get the biggest relative benefit from the yield curve no longer being inverted.

Nathan Stovall

Certainly, certainly. And with the big folks, and I know we're going to talk more about bank M&A and capital raising as well. But similarly, dealmaking has been under pressure sort of across the board. And so they -- now that you -- animal spirits is kind of coming back, those numbers look better, and we're hearing better numbers there as well. One thing that I have been hearing more of, and you talked about best deal environment potentially since '21, we're hearing generalist money coming back into the group. Have you seen that? Do you think that marks a pretty big sea change and sort of support we've seen in valuations coming back to where they are?

Tom Michaud

100%, and we're not done yet. So let's look at it as a percentage of the S&P 500, okay? During Trump 1.0, financials were 14% of the S&P 500. In the current administration, they declined. Well, they're back to 14% of the S&P 500 again. Investors are optimistic about what's about to happen. And then the other thing that is important for long-only investors is that the waiting is going up from new ads. So this week, Apollo was added to the S&P 500 in the financials category. That's a $100 billion market cap. And I think there are 2 messages here. One is there weren't enough financials in the index and the next eligible candidate was Apollo. That came in. We think the next one will be Coinbase, which is $100 billion. The other message here is these are really big companies that aren't banks, okay? So they are nonbank financials, which I think is that whole story, which is how are the banks stacking up and what's their prospect relative to the nonbanks. So there are a couple of stories in there. There's another important point is that, look, these stocks have moved a lot. The large-cap banks, the BKX are up 40% year-to-date. The regional banks are up over 20%. The rally started third quarter of last year. So I think what the premise of some of your questions were earlier is, is there more room to go? Where are we? We just wrote a really interesting report, which is what's the right valuation for bank stocks. Given the fact that we've had a big move, is there more to go? And I think the report did a really good job of saying the shape of the yield curve in history has developed what we believe is an appropriate valuation for the group as well as the level of interest rates and why they are where they are. If interest rates are high because the Fed is trying to slow the economy, that doesn't help bank stocks because they might actually slow the economy. So -- but if rates are -- if they're not 0, 0 rates are bad, which is what we had during COVID, that you could add that to the list of what we're talking about earlier. Banks weren't built for inverted yield curves and 0 interest rates, and that's what we had. But higher rates with some shape and rates that are kind of higher and growth is consistent and the Fed is not tightening to stop inflation, that's an environment where valuations can go up.

Nathan Stovall

That's a normal banking environment, right? That's the environment we're supposed to be in kind of, right?

Tom Michaud

In other words, it's called typical or normal.

Nathan Stovall

Right, right.

Tom Michaud

But by the way, unnormal happens when you're fighting a 100-year pandemic and do unusual things. So we're out of that -- and this is another list of things that we can put in the rearview mirror, I hope, with that pandemic. Hopefully, the investors didn't think that banking was a single-digit PE business because I don't think it is. And also, we follow over 200 banks. If you look out through the end of 2026, -- we see lots of capital build. The end of our forecast period at the end of '26 has a tangible common equity to asset ratio of 9.6% for the industry, at least in our research group. That -- if you had said to me 5, 10 years ago, would the banking industry have that ratio, I would have said no. I would have bet the under. The industry is actually generating a lot of capital. Capital won't be the problem for this industry. And I think it just suggests that the industry itself is pretty darn solid. So you're an investor in these stocks, instead of cutting estimates, we're maybe going to be raising them. You've got earnings per share growth instead of declines, and you got a balance sheet that's strengthening itself. The weak length, though, is the industry is over-earning on credit. It's shocking how little net charge-offs there have been. And so are we -- has something changed? I don't see that changing in the near term. And actually, on credit, the commercial real estate blowout for the industry hasn't happened. And my instincts are, if it didn't happen already, it's not going to happen because interest rates are now -- we're getting a steeper curve. Businesses want folks back in the office. The government wants folks back in the office in Washington and the capital markets are getting healthier to be able to restructure some of these things. That doesn't mean we won't have more commercial real estate losses. We will. But will we have the big event that folks are worried about. And I think each day that goes by, it gets less likely. Now we are most worried about the big urban centers on the coast and the big office buildings, but that's not what the typical bank has as exposure. And the banks that are in the big markets like Wells Fargo and Citizens and Bank of America, they have 10.5% reserves against those portfolios due to CECL, and that's more reserving than the global financial crisis. So yes, building capital and big reserves against the areas we're most worried about. That, as an investor, would make me feel better. And then I'm going to -- one other last thing is that you actually did have a question, and your question was generalist portfolio managers. So I just laid out for you what the fundamental case is and the weightings in the index are going up, -- so yes, you're going to be more interested.

Nathan Stovall

Certainly. And picking up on a couple of things there. Your point about, yes, you're worried about certain pockets of CRE. Your point about reserves, it's one we always point out too, not only are they very high, but the underlying assumptions there are pretty terrible, but they haven't moved that much higher. So they're showing some kind of confidence that they've already built for it. The other thing, too, we've seen some nice markers when you look outside of that space in conjunction with some deals where people -- some banks have looked to prune some of the portfolios and the marks that they think they might have to take there are far cries from those numbers you heard a year ago, $0.90 on the dollar kind of things like that and even a portfolio sale from Valley that was close to par recently. If you told somebody that a year ago, they wouldn't have believed you. So to your point about each passing day, I think it's a really good one that we keep seeing good markers that are the complete opposite end of the spectrum of that very scary place that some of the bears out there were pushing on CRE.

Tom Michaud

Yes. So if you were trying to say, I'm either going to write the script for the half -- glass is half full versus half empty scenario, the glass half full scenario is seeing more events happen rather than half empty.

Nathan Stovall

Right. You mentioned this earlier talking about the BKX rallying so much, larger banks continuing to trade at higher valuations. That wasn't always the case post financial crisis. We used to talk about that sweet spot. You guys had a great report out last year where you're talking about the different sweet spots around different levels of asset thresholds. But the big guys are trading at higher valuations. Do you think that just tells us continuing or continues to tell us that investors continue to price scale...

Tom Michaud

So this scale argument or observation is really interesting. I believe that scale works and scale works because the numbers show it works. If you look at banks by asset size, you will see that as they get larger, they typically get more profitable, unless they are gathering near a key regulatory attachment point, then they go back down before they go back up. We call it a game of shoots and ladders. You gain on $100 billion, you might lose 100 basis points of ROTCE return on capital because you need to afford crossing $100 billion. But once you successfully cross, you get back on the latter part and you go back up again. So it's a -- it's not a straight line, but it's jagged as you go around these regulatory attachment points. So that's number one. Number two is, is it a guarantee? I'm bigger. Am I more profitable? No. No. There are -- I mean, I think Citigroup, we recommend the stock. Citigroup is on a good path, but they don't earn a double-digit return on equity, and they're several trillion dollars in size. So that's an example of one of the big 4 not earning in line with its size at the moment. Now it might -- it's restructuring. And then you could go down and you could look at Lakeland in the Midwest, you can look at a lot of smaller banks that don't have big scale that are more profitable than most of the banks that are bigger than them. So I mean, you can find exceptions to the rule at every asset size. So it's not a rule. It's a general median observation that works for most of the banks. So my view would be it's a good theme to bet on. And then the next question is sort of why? And I think the why is, of course, you need scale to be able to pay for the technology investments for the never-ending regulatory cost that's been thrown at this industry. I also believe you need to be able to afford diversification of what you do. I mean, I think that regulators, the market, they've all spoken. They don't love commercial real estate-focused banks. So if you want to be a C&I lender, you just don't decide that overnight. You have to have the treasury management systems. You have to have the people. You have to have the clients, you have to have the marketing, you have to have all those things, and that costs money. So to be able to diversify, you actually have to have earnings power to afford the investment. And we wrote a research report a while ago, but it basically said, what matters most over a cycle, capital or core profitability. It's core diversified profitability that builds great banks, not just who has the most capital. So you got to have a good business model that's consistent and repeatable. And it looks to me like scale contributes to making that happen.

Nathan Stovall

Well, if you have that business model, to your point of that being more valuable than capital, you can probably attract capital or certainly more easily, I would think, than a lot of your comp.

Tom Michaud

100% 100%.

Nathan Stovall

I want to shift to M&A and somewhat around the election, but also just broadly what you've seen in terms of the firm's M&A pipeline. Everybody coming out of elections is thinking, okay, friendly regulatory environment, less concerns maybe around credit and more investor support as we talked about. That means more deals, pent-up demand, only more deals. On the flip side, if it's a better fundamental environment, maybe do we have fewer sellers. What does it look like to you today? What are the drivers of deals going forward?

Tom Michaud

So I think that the trend of bank consolidation since the mid-'80s when the laws were changed is absolutely underway. The direction of the number of banks where we're headed remains consistent, which is we're going to have fewer banks. The question is what's the pace, okay? And I think the power of economies of scale are alive and as well. And I think the demand -- now we should add to the list of things that banks have to deal with is the nonbanks, okay? So they need to prepare for that competition. So I think the need for scale is strong. I think there's pent-up demand. Now look, the current administration, President Biden in July of 2021, wrote a very broad executive order to his team. We all read it. It said, I would like everybody who works for me in this government to do a study on the benefits of M&A as well as what policy adjustments need to be made, and let's also make sure we focus on financial services, okay? And the reaction to that was an attempt to slow it down. So now we can look at the math of bank consolidation. It took 40% longer to get an answer on a merger application from the current government than the one before it. Same application. It just took 40% longer. So it was basically, I think, an effort to slow it down. I mean it's kind of hard to think it was otherwise. And there were even instances of -- I think there are 4 or 5 FDIC deals that took more than a year. When you drag it out like that, you increase uncertainty, which raises the table stakes for management teams to consider consolidating. And so that was, I think, an effort to slow it all down. I think in the new administration, you may end up with a policy that's not as focused on just M&A is bad. Now by the way, let's talk about some of the public benefits of M&A. And I'm not an expert on the airline industry, but I think it's important. So JetBlue was going to buy Spirit Airlines because JetBlue was in better shape than Spirit. The government sued to stop it. Deal didn't happen. Spirit went bankrupt. Are we in a better place as a nation, as an industry because that happened? If the public markets or private markets, the capital markets were going to support JetBlue and trying to fix the airline and maybe even help themselves in the process, I think the capital markets probably would have supported that deal. But I'm not an expert. I don't know for sure, but that's my observation. Same thing in the banking industry. One of the things I am most shocked by last year is how much money the FDIC lost when a bank failed. Even a few weeks ago, this bank in Oklahoma, $110 million in assets, I think the FDIC said they were going to lose like $30 million on it. Like really -- if you knew that bank was going to fail, it would be better to have a healthy competitor buy that bank if there was one and possibly save the fund, the $30 million. That's what business and capitalism is all about. The well-organized, well-positioned companies self-heal the industry they're in by acquiring the weaker one.

Nathan Stovall

Well, not even on that dire of a situation, but a point I've heard you make many times along the same line is regional champions to compete with the big 4, right? Same kind of idea. The idea of let's create more competition and to get away from a sort of too big to fail sort of marker or something like that, not just even in the most dire cases.

Tom Michaud

Here's the fact. We need consolidation so we have more competition. The victory is not by how many banks we have. The victory is how many competitive banks do we have. If you were to freeze in time and say no more bank mergers, just not having them. That means the big 4 banks will gobble market share to the point that nobody else has a chance in the sense that, look, they've got 40% market share. Wells Fargo has legally been unable to grow and Citigroup is executing a shrink strategy. At some point, Wells Fargo will be able to grow. And at some point, Citigroup will stop shrinking. Then what happened? So in other words, they have 40% market share and 2 of them are sort of kind of in a time out. When they're not in a time out, they'll be even more competitive. And so my view would be create competition by allowing other banks to challenge them. And then while the banking industry is going through this dynamic, you've got the nonbanks that are as well positioned as they've ever been. And you've got Apollo with a $100 billion market cap. When KKR was added to the S&P 500, it replaced Comerica. Comerica, I think, is a terrific bank, but it had a $7.5 billion market cap. Comerica -- I mean, I'm sorry, KKR has $122 billion market cap, okay? Don't forget this nonbank competition. And this new administration, I think, is going to have to review digital assets, crypto and blockchain. The current administration on some of those things had a no-fly zone basically. It was -- we don't want you touching it. Now I'm not saying to be all in, but I also think that if some of these technologies and businesses evolve, you got to have the banking industry involved in some manner. It needs to be safe and sound. But just to say no means you're making a bet. If in 10 or 15 years, these other payment mechanisms are what the world and the country wants, then you're basically pushing the banks in the back seat. I think you need to develop these policies with the whole financial system in mind. And you just got to be willing to develop the safe and sound procedures and laws that keep it safe because nobody wants an accident.

Nathan Stovall

And there's something to be said for pushing some risk out of the system. But to your point, you don't want it all to go out of the system because then you can't control it.

Tom Michaud

Exactly. And also, I'm in a unique spot because of my personal history a little bit in that I think the Bank Secrecy Act is very important. Well, remember, the Patriot Act is a national security bill. It was signed by President George W. Bush, and it was strengthened after 9/11. And basically, the banks play by the rules. And I think the nation is safer because of those laws and nonbanks don't have to do it. So the more the banks touch payments and payments come in and out of the banking system, it means more that you know the Bank Secrecy Act and know your customer and anti-money laundering is in play and that there are laws and rules that are being followed, which I think keeps the nation safer. So I think it's a national security priority, too, myself from my seat.

Nathan Stovall

I remember many regulatory attorneys telling me for years that banks were fighting the war on terror by having SARS reports out for the FBI to follow and various agencies. So totally appreciate that comment. In closing, I want to talk just a little bit about capital. We've mentioned capital several times, one, that the industry is generating a lot of capital that you've got money coming back in the group, broad generalist money coming back. We've seen capital raising kind of pick up, but it feels like a lot of it is waiting on the sidelines and trying to be put to work. And it seems like it's been really supportive of a wide variety of strategies, whereas 6 to 12 months ago, it was very specific whereas now for the right issuer, it seems like if it's growth or if it's maybe even franchise changing, it's there. What's your view of the capital markets right now? And what kind of capital raising activity you think we see in the next few quarters?

Tom Michaud

So one of the most impressive capital raises I've seen in my career was Monday of this week. On over the weekend, A.J. Gallagher, which is one of the leading insurance brokers, acquired from private equity, another insurance broker for $13.5 billion. On Monday, it did a 1-day following -- follow-on offering for $10 billion, including the green shoe. And it was more than 10% of its market cap and it was done near market.

Nathan Stovall

Wow...

Tom Michaud

You want to see -- and I know that because we were on that deal, we were a co-manager on that deal, but we have a relationship, so we were on that deal. You want to know confidence and depth of capital markets. And I know it's not a bank, but it is a financial. And I think it just sends the signal, and we were involved, so I had a seat at the table there. I was overwhelmed with how successful that deal was. And it says a lot about how the market is thinking right now and is willing to reward companies that the market believes are doing smart things. There's money there to do that. So it's the same thing with the banks. You mentioned earlier, the bank stocks have been reacting well to consolidation. And more than 50% of the M&A of late has included a capital raise that's either debt or equity. And even though it's our view that capital is going to build for 2 years, and that's mainly because earnings are growing faster than the balance sheet, number one. And it also is because of AOCI adjustments going down because -- by the way, book values are going to grow double digit because of bond amortization. We're still burning off these losses, and that's going to grow book values. That's another valuation plus. But even though they're doing it organically, banks are looking to really strengthen their balance sheets at the moment. And they are well capitalized, I believe, now and even more so with some of these recent actions. It seems like the common equity Tier 1 ratio seems to be closer to 10% for many companies. And then for those crossing -- approaching $100 billion, even seems like $11 billion. So the industry is choosing to do that. which I think means the industry is going to have a lot of capacity to meet loan growth if it goes forward. I believe the biggest constraint at the moment is not capital, it's core deposits. And I think what will determine a bank size in the future is its core deposits more than its capital. The capital is available. And look, we're going to be a part of multiple bank offerings just this week ourselves. We've already ourselves have priced a few deals, and we've got a few more coming. And so we can tell you that these deals have been really well supported in the marketplace. And I think many of the themes I talked about are what investors are thinking.

Nathan Stovall

And that creates optionality even beyond growth, right? I mean, whether it's restructuring, whether or not it's looking to do a deal or anything like that. But I wanted to pick up on that core deposit comment because that's an interesting one. And I think it's one -- you didn't say this, but perhaps that's a lesson of this rate cycle, right? We've reminded that's the true value of a franchise. And maybe that's what should govern our growth and the idea of is this truly core stable funding in terms of the size of the balance sheet kind of going forward?

Tom Michaud

I kind of believe my lessons learned from last year are core funding. I mean, I started as a bank credit analyst. Core funding matters. The market -- and by the market, I mean, investors don't like it when banks have more than 100% loan-to-deposit ratio. I think they also aren't going to like it if they have too many uninsured deposits and that, that's a really big factor. And I think banks that have good solid core deposits are going to be able to be more competitive and to grow more. And I also believe even though nonbank competition is real for assets, whoever controls the corporate deposit treasury relationship is the senior most institution in the room, in my opinion, because there are lots of firms that will provide credit, but being a trusted treasury management bank might be where the real, real value is going to be. And so I respect the banks that are leaning in heavily on that. And then I should not -- as you know, I'm a big proponent for deposit -- FDIC deposit modernization. I think that is the piece of leftover work to do from last year's bank cycle crisis is we do need to modernize. And I think one of the best proposed bills I had seen was the one that Senator J.D. Vance introduced last year. I would encourage folks to look at that bill. I thought that bill -- I think he called it the Payroll Protection Guarantee Act. And I think that would go a long way to make sure that America doesn't pick its bank based on its size during moments of stress.

Nathan Stovall

Well, that's the backbone of the industry trust that the money is safe. And as you've said to me in the past, we haven't updated those limits even for inflation, much less other considerations. So it probably is long overdue. Well, I think that's a great place for us to leave it. Exciting times in the space. It sounds like you agree, more tailwind, more energy focused on the banking space in some time. So we're looking forward to an exciting '25. But Tom, thanks for coming on and sharing your thoughts about this as always.

Tom Michaud

Nathan, great to be with you, and I wish everybody a happy holiday.