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2018 leaves bank investors bruised, searching for value

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2018 leaves bank investors bruised, searching for value

Bank stocks just recorded their worst annual performance in seven years, and investors looking for cover might be wise to put their money behind strong deposit franchises.

The SNL U.S. Bank and Thrift Index fell close to 20% in 2018 amid geopolitical turmoil and a flattening yield curve that threatened further expansion in net interest margins. In the latest Street Talk podcast, we highlight the Street’s outlook for the banking sector in the aftermath of the selloff and make the case that the best deposit franchises could serve as a port in the storm for investors. After a tough 2018, some analysts believe bank stocks are now undervalued, while others are only recommending select names because they see fewer tailwinds to drive the group higher.

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The mixed outlook is quite a bit different from the beginning of 2018, when banks were expected to benefit from margin expansion, lower taxes and a friendlier regulatory environment, Keefe Bruyette & Woods analyst Chris McGratty noted in a recent episode of his firm's podcast.

"For 2019, it's admittedly more challenging to identify the next phase of obvious catalysts to support the group. Where that leaves us is to search for situations that perhaps are less dependent on the macro," McGratty said on KBW's All Things Financial podcast in mid-December 2018.

The analyst said his firm has identified three names — TCF Financial Corp., IBERIABANK Corp. and Umpqua Holdings Corp. — as top fundamental ideas for 2019 because they see the potential for the banks to meet or potentially exceed earnings estimates through the execution of expense plans or a de-risking strategy coupled with share buybacks.

Whether or not banks meet or exceed estimates, or at least see their earnings grow at this point in the interest rate cycle, will often depend on a given institution's deposit base. In 2017, many bank investors expected the Federal Reserve's normalization of interest rates to benefit net interest margins, and accordingly, result in improved profitability across the sector.

However, Hovde Group analysts noted in a Jan. 2 report that it became apparent around the middle of 2018 that many banks were not as well positioned for the changing environment as many investors had hoped. Joe Fenech, head of research at Hovde, told us around that time that the bank group would be separating into haves and have-nots, largely around institutions' funding bases, resulting in increased bifurcation of how the group trades.

"This is not a throw-a-dart type of environment and whatever bank stock the dart lands on is going to perform well," Fenech said on the Street Talk podcast.

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That has proven to be the case. Banks that reported elevated deposit betas — which measure the percentage of changes in the effective fed funds rate that banks pass on to their depositors — began to see their stock prices come under pressure during second-quarter earnings season. For instance, Bank OZK and Eagle Bancorp Inc. both saw their stocks sell off considerably in the aftermath of second-quarter earnings, when they reported deposit betas of 65% and 85%, respectively, on their interest-bearing deposits. Those levels compared to 37% recorded by the banking industry in aggregate and 25% by community banks during the same period.

Eagle Bancorp's stock performance after its earnings report was particularly noteworthy since its shares fell nearly 5% even though the company's reported margin had held up in the second quarter.

Meanwhile, banks that have shown an ability to report lower deposit betas have been rewarded with higher valuations. This is evident when separating publicly traded banks with more than $500 million in assets into quartiles by the deposit beta recorded in the most recent quarter.

The banks in the first quartile experienced an average beta of 15.9% in the third quarter when compared to year-ago levels — about half the level reported by the industry — and they traded at an average price-to-tangible book value of 173.6% as of the Jan. 3 close. Banks in the second quartile traded at 159.5% of tangible book, while institutions in the fourth quartile traded at 145.5%.

The results are similar when dividing the group into quartiles based on their noninterest-bearing deposit concentration. Noninterest-bearing deposits equated to an average of 37.15% of deposits at first-quartile banks, which traded at an average price-to-tangible book value of 178.4% as of Jan. 3, compared to 128.6% in the bottom quartile, where noninterest-bearing deposits made up only 12.09% of deposits, on average.

Despite the discrepancy in valuation, virtually all bank stocks have come under pressure in recent months. The Hovde bank team believes that the market has thrown the baby out with the bathwater, assuming that the rate cycle will prove challenging for all institutions, but they do not believe that will be the case.

"Some banks undoubtedly will struggle mightily, fundamentals will continue to deteriorate, valuations will languish, and many likely won't survive. But for others, the sky certainly isn't falling, current conditions are very manageable, and as a result, valuations should, and likely will, improve, for some noticeably so," the team wrote in a report.