Merger and acquisition (M&A) activity in the banking sector has been an important driver of returns for the financial services sector. Would you update us on recent M&A trends?
Overall, the M&A environment appears strong. An important deregulation measure was passed in May 2018 that reduced the number of banks subject to strict supervision and costly annual testing by raising the asset threshold from $50 billion to $250 billion. We believe a less restrictive regulatory environment could help drive a higher level of M&A activity by mid-sized banks that are no longer subject to the annual review.
In fact, due in part to this adjustment, M&A activity is currently moving at a faster pace compared to the same time period last year. Almost 170 transactions have been announced year-to-date through July 2018 among public and non-public banks and thrifts, accounting for about $21.4 billion in deal value. By comparison, 267 transactions were announced in all of 2017 totaling $26.6 billion in deal value.
Importantly, we believe prices paid for acquisitions remain reasonable. Acquiring companies are paying on average about 1.7x on a price to book (P/B) basis and 26x on a price to earnings (PE) basis for their acquisitions. While on a PE basis average acquisition prices are near their previous peak, on a P/B basis, (the more important measure of the two in our opinion), they are significantly lower than the extreme multiples paid at the peak of the last cycle in 2007 of approximately 4x.
The Large Cap Financial Fund has been adding more exposure to diversified service and transaction-oriented financial companies. Why?
We believe financial companies outside the banking industry can offer compelling opportunities for growth and high returns. Secular trends, such as the rise of electronic payment systems, are driving growth for many Large Cap Financial Fund holdings such as Visa, Inc. and Global Payments, Inc. Similar shifts in the investment arena, boosting demand for index providers, as well as banks offering custodial, operations outsourcing and stock lending services, are behind the growth for companies such as
MSCI, Inc. and State Street Corporation.
Moreover, these diversified service and transaction-oriented financial companies tend to be less sensitive than banks to cyclical factors including the level of interest rates, credit quality, and economic growth. By holding fee-based electronic service providers as well as mid-size and large banks in a concentrated portfolio (currently 27 holdings), we seek to generate outperformance over time relative to the Russell 1000 Financial Services Index.
What do you believe will be the revenue and earnings growth drivers for companies in the Small Cap Financial Fund going forward?
We believe there are three main factors driving growth:
1. Core Business Expansion. Many smaller banks with traditional lending operations are growing as a result of the expansion of their loan book, an extension of their deposit base, and improvements in customer service.
2. Strategic Acquisitions. M&A is a potential growth opportunity for smaller banks. We believe growth by acquisition is a positive, long-term strategy for smaller banks looking to extend their franchise and diversify geographically. Currently, the Fund is focused on owning banks that have had a successful track record of buying other banks.
3. Regulatory Easing. The regulatory environment for acquisitions is likely to remain favorable. The Federal Reserve recognizes that larger organizations are better able to withstand economic downturns, and the sentiment favoring industry consolidation has improved.
Banks have been rewarding shareholders with higher dividends and share buybacks. How do these methods of returning capital to shareholders affect growth in earnings per share (EPS) and book value per share?
In recent years, banks have returned a significant percentage of earnings to shareholders.
In the past few years, the largest U.S. banks have historically paid out, on average, over 80% of their earnings in dividends and buybacks. The Comprehensive Capital Analysis and Review (CCAR) projected estimates for total payouts for the full year 2018 have risen to 94%, with a 33% payout for dividends and 61% for buybacks.
At lower valuations (for stocks trading at or below book value), buybacks increase the growth of EPS and book value per share. At current valuations, buybacks are beneficial to EPS growth but are slowing book value per share growth—although book value growth is still positive. In addition, buybacks often indicate that management views their own shares as an attractive investment.
Dividends, while they do tend to slow growth in EPS and book value per share, may be preferred over buybacks in times where valuations are higher.