Would you please discuss your thoughts on the banking crisis that unfolded in the first quarter of 2023?
Liquidity issues have been building in the Financials sector for over a year now. Rising rates driven by the Federal Reserve’s desire to fight inflation have reduced prices of securities and loan demand across the whole industry. These price declines reduced functional liquidity as any sale of securities to fund new loan demand required taking losses, thus diminishing capital ratios. Mark-to-market accounting rules implemented in the 1990s have worked in favor of the industry as rates have been falling since the early 1980s. Now, as rates have risen rapidly, this accounting rule is working against bank liquidity and capital ratios.
With regard to the uninsured deposits of Silicon Valley Bank (SVB) and Signature Bank, we believe it was important that the Federal Reserve agreed to insure all the deposits to alleviate concern. However, it is unknown how the government will apply the rule in the event of additional bank failures.
One outcome of these bank failures is that liabilities may be in flux. There are approximately $18 trillion of deposits held by banks and approximately 40% of those deposits are uninsured. An unintended consequence of the rapid expansion of electronic banking is that customers can move money from one bank to another very rapidly. In addition, when money is withdrawn from a bank, those funds are no longer available to become loans. Fewer deposits could curtail lending activity, potentially affecting demand for products and services.
How do withdrawals affect smaller banks in the short run?
We believe smaller banks are more vulnerable as 80% to 100% of their revenue base comes from the net interest margin (NIM), which is the difference between income generated from loans and the cost of funds. For the largest banks, approximately 50% of revenue comes from the NIM while the remainder is generated from other business lines, such as asset and wealth management.
For perspective, looking at data in the two weeks following the collapse of SVB and Signature Bank, large banks had $68 billion of inflows and money market inflows totaled $200 billion while small banks experienced $120 billion in outflows. By comparison in the last year, a trillion dollars had already moved into money markets from banks of all sizes.
We believe this trend has affected a small number of commercial banks. Among the approximately 5,000 banks in the U.S., only a minority of banks have been severely impacted. Many smaller commercial banks have not seen tremendous outflows as they typically have strong relationships with their customers.
How do bank valuations compare to the broader market and historically as of 3/31/23?
Some banks look inexpensive on a price to earnings (P/E) basis. As of 4/26/23, the KBW Bank Index traded at 7.7x 2023 estimated earnings and 7.8x 2024 estimated earnings, approximately 60% lower than the S&P 500’s, which were 18.7x and 17.0x, respectively. The bank index P/E was also well below its 10-year average of 15x. Currently, we are experiencing some of the lowest relative P/E valuations since 1994.
What kind of banks do you seek for the Hennessy Small Cap Financial Funds?
For the Hennessy Small Cap Financial Fund, our investment process for over 25 years has focused on traditional bank models. We seek those smaller banks with high-quality management teams, diversified loan books, core deposits predominantly insured, ample capital, and historical records producing profits through entire business cycles.
Alternatively, we tend to avoid smaller specialty banks with unproven business models.
What is your outlook for the banking sector for 2023?
Earnings in the first quarter of 2023 have generally been in line with Wall Street’s expectations. Major themes include margin declines, muted loan growth, and stable credit conditions. Management guidance for 2Q23 was consistent with trends in the prior quarter. However, growing attention is being paid to credit conditions with a few companies having notable increases in bad loans and/or charge offs. The balance of 2023 looks challenging for the group. Emerging credit costs will be added to ongoing pressure on margins and loan growth.
We expect to remain invested in banks with core deposit franchises and proven track records over credit cycles. We believe opportunities to buy quality banks at favorable prices is ahead of us as they work through the earnings headwinds.