Bank stocks have been under heavy pressure in 2023 as the Federal Reserve’s aggressive rate hikes slowed lending, sent bond prices plunging and encouraged the flight of deposits. Given the leverage in the banking sector and the possibility of a bank’s deposits evaporating within days – see Silicon Valley Bank – it’s understandable that investors might be a little nervous about buying bank stocks.
While mid-sized regional banks received a lot of bad press in the first half of the year, the carnage was broad-based, even hitting the shares of big banks like Bank of America and Wells Fargo. But with the Fed signaling that further rate hikes are on the way, is now the time to buy bank stocks, even if they are trading at low valuations?
“The well-known problems of a number of leading regional banks have caused the entire industry to collapse due to concerns that similar problems will affect other banks,” said David Waters, CFA, president of Alluvial Capital Management. “Yet there are countless banks that operate differently.”
So it could be a good time to buy, say Waters and other professional bank investors. But you will have to choose your spot, as each sofa’s exposure to the environment can vary significantly.
Rapidly rising interest rates have crippled banks
In general, rising interest rates are good for banks. Banks are able to generate higher returns on their money, often keep deposit rates stable or increase them only slowly, and widen the spread on their funds. But the past fifteen months have been anything but typical.
The Fed has implemented one of the fastest rate hikes in history, raising rates from near zero in early 2023 to more than 5 percent in mid-2023. And there may be more to come.
That’s after a period where banks and investors felt quite comfortable with near-zero interest rates over the past two years, as the Fed cut rates to prop up an economy reeling from the COVID 19 pandemic. And it follows a period of more than a decade in which markets became even more comfortable with a favorable interest rate environment in the wake of the global financial crisis.
But now sky-high interest rates have really squeezed banks on a number of fronts, leaving them relatively little time to adjust their balance sheets:
- Rising interest rates have made loans more expensive, which has slowed down lending.
- Rising interest rates have made deposits more expensive as savers look for higher returns or move their money into safer, higher-yielding alternatives such as government bonds.
- Rising interest rates have caused the value of bonds and mortgage-backed securities to fall, affecting banks’ supply of emergency capital.
- For the reasons mentioned above, rising interest rates also stimulated the flight of deposits, resulting in some of the largest bank failures of all time.
And the Fed has all but assured markets that more hikes are on the way, at least as long as inflation remains a problem, according to statements from the June meeting.
The renewed belief that interest rates would rise even further sent a major fund that tracks mid-sized banks – the SPDR S&P Regional Banking ETF (KRE) – into a tailspin. After falling in March, the fund had been on the rise since early May, as the market began to calm down following a number of high-profile bank failures and growing suspicions that interest rates would soon fall.
Of course, not only medium-sized banks were affected. Both the largest banks and small community banks felt the force of investors dumping their bank stocks.
But even with today’s cheaper bank stocks, is it time to buy?
Bank stocks look cheap, but choose carefully
Professional bank investors see opportunity in the rubble, if you are willing to see through it.
“Banks have come to understand how to operate in a higher interest rate environment, and for the most part have realized that rates will not fall anytime soon as many thought,” said Nate Tobik, founder of CompleteBankData.com and author of The Bank. Investor Handbook. “As a result, they have discovered how to adapt to this environment.”
Tobik thinks it’s an attractive time for investors looking to buy bank stocks, but with a caveat.
“The caveat is that there are still many banks that, if you count their mark-to-market losses on securities and allocate their loans to the market, have no equity or negative equity,” he says.
That is, rising interest rates have eroded their bond portfolios and the real value of their loans, leaving them with less capital, even negative capital, when you correct for the declines.
“For now, regulators are taking the position that they can get out of this,” he says. “As an investor, we must remember that there is no M&A savior that can increase the share price. It will be a slow grind.”
Mergers and acquisitions are one of the traditional ways for investors to make profits in the banking sector. The industry has been consolidating for forty years as rivals swallow each other up. Still, investors can make money in the banks now that the climate is normalizing.
“Bank valuations anticipate quite a bit of stress,” says Waters. “But eventually the market will start to look past it. If investors continue to wait for the ‘all clear’ signal of a moderation in interest rates and the dissipation of recession fears, they may miss out on buying opportunities.”
Other investors are less optimistic about the current moment, but still see opportunities.
“In general, I think now is a tepid time to buy banks,” said Don Hensel, a private bank investor and retired commercial banker. “While banks trade at a discount to many other sectors, it is difficult to see how they will grow profits.”
Hensel points to declining deposits and rising payroll and technology costs today, compared to “rising bond yields and stronger credit prices [that] will ultimately increase sales.”
What characteristics should investors look for in a bank stock?
“I think it’s a good time to buy some bank stocks,” Waters says, emphasizing the word “some.”
The interesting one? “These have cheap, sticky deposits, well-diversified loan portfolios with high underwriting standards, and they didn’t go crazy buying long-dated securities when interest rates were at rock bottom,” Waters says.
What other characteristics do professionals look for in their bank investments?
- High quality: “Investors should focus on high-quality institutions that have been ravaged by the general stigma surrounding banks, and not on the phonies that have made poor decisions in recent years and are now struggling to course-correct,” Waters says.
- Variable interest loans: “If a bank has part of its loan portfolio floating, it has been able to protect its margins,” says Tobik. “The types of loans that would be ideal here are commercial operating lines that are based on a benchmark interest rate, or commercial real estate that is variable.”
- Growth opportunities: Banks that can increase lending through regional or product expansion could continue to grow profits in this environment, experts say. Banks with business lines such as trust operations or SBA origination that generate fees and are less exposed to the interest rate cycle can also help diversify the business.
- High Insider Ownership: “Insist on high insider ownership,” says Waters. “Why would anyone invest in a bank where the people closest to it don’t? I want management to feel the pain that shareholders feel when a bank is struggling.”
- Stick with proven managers: Management teams that have “seen this movie before” and thrived are a better choice than those experiencing all of this for the first time.
- Attractive custom rating: At a time when banks’ balance sheets are under pressure from rising interest rates, it’s important to adjust valuations to understand exactly what you’re paying. “Look for banks that have an attractive valuation after all mark-to-market losses are taken into account,” says Tobik.
Sofas with several or all of these factors are now available in the market, experts say.
“With so many excellent banks trading cheaply, there is absolutely no reason to go dumpster diving,” says Waters.
Are small banks currently more attractive than large banks?
Small sofas have often been popular for a number of reasons, but the size of the sofa is not necessarily an indication that it is a good buy right now. Small banks can just as easily find themselves in the same trouble as their larger rivals. Size is no protection against stupid decisions.
Still, small banks may be particularly attractive right now as they often trade at discounts to larger banks in normal times and have suffered further declines along with the sector.
“I’ve always been a proponent of small banks,” Waters says. “For their growth potential, for their potential to acquire or be acquired, for their more frequently mispriced shares.”
But the largest banks have something that small banks do not: government protection. Amid the March collapse, many depositors moved money away from banks that were unlikely to enjoy such protection, triggering a run of sorts on some regional banks. But banks seen as ‘too big to fail’ – whose depositors were likely to be restored to health if they failed – were the beneficiaries.
“They benefit from an implicit government guarantee and will likely continue to grow their share of national deposits,” says Waters, who thinks big banks could be attractive here.
Big banks have something else that the little guys don’t have: scale.
“Large banks certainly look attractive in this environment because they have the scale to absorb higher staffing, technology and compliance costs,” says Hensel.
As for the mid-sized regional banks that have been hit hard by the recent turmoil?
“It doesn’t surprise me that the regionals are seriously discounted,” says Hensel. “Under the proposed regulations, they will have to keep 20 percent more capital on the balance sheet. I also believe that there will be associated regulatory burdens – such as stress testing – that will significantly drive up costs.”
Hensel says he is on the hunt for “regional banks where the baby was thrown out with the bathwater.”
Whether small, medium or large, investors should, among other things, assess the bank’s balance sheet and understand interest rate risks before deciding to invest. Those unwilling to put in such work may be best served by buying a bank index fund, which offers the comfort of diversification to reduce risk.
In short
Investors looking to get into bank stocks after the stock market declines in 2023 and 2023 should look at their investments from a longer-term perspective, especially with more risk potentially on the horizon in the form of higher interest rates. Still, an industry-wide decline makes it an especially good time to sift through the sector and find the good players and stocks that have been unfairly punished.
