Listen: Street Talk | Episode 136: An activist's view of the banking industry

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Nathan Stovall

I'm Nathan Stovall, -- and on this episode, we're talking about activist investing in the bank space, the outlook for banking fundamentals, M&A activity and the regulatory landscape. Joining me on the show is John Palmer, Principal and Managing member of PL Capital.

John, thanks for coming on the show.

John Palmer

Thank you. Good morning, Nathan. How are you?

Nathan Stovall

I want to start off at kind of high level. I've known you guys for a while. I've had the pleasure of knowing you for a while. PL is a little bit different than some other bank investors in the space, and it probably makes sense for audience to get a little bit of appreciation for that. And one of the ways you're different is you do from time to time, take an activist position, but the way that I think about it is that your brand of activism might have a different flavor than some of the other activists that we've maybe seen in the banking space historically. How would you describe your investment approach, John, and the companies you target?

Nathan Stovall
John Palmer

So obviously, we've evolved over the 30 years that we've been doing this. We've evolved and the industry has evolved. And what I mean by that is if you go back to when we started in the early 1990s, 1995, 1996, management teams and systems and processes were less sophisticated, less comprehensive than what they are today. So as we've gone through an evolution, we had 12,000 banks back then. We have 4,500 banks today. And it's kind of like when they built a car in 1995, they built a better car today, better, quicker, faster, cheaper. So the industry has gone through kind of a cleansing where extremely weak companies have been eliminated over the years for different reasons through different cycles. And because of that, it's forced us and we've always kind of been more of the -- we want to try to work with the company and improve the company and get its earnings up and have it stand on its own 2 feet because it works for us and it works for the company and it works for all shareholders. But there are those points in time where the company just will not listen, you have entrenched management, you have an uninformed Board, and then we have to be actively involved. And over the course of those years, we've run probably 25 proxy campaigns and won all but one of them. And eventually, we won that after going at it 3 times. So when we show up at a company now, management realizes that if we're there, we're serious. And if we're serious, we've probably counted noses and think that we have enough votes to win a proxy contest if we have to. So it's kind of changed that dynamic of the conversation from running a contest to, okay, what are you guys looking for us to do? How do we improve the company? So that's evolved over time. And that's, again, a reflection of people getting to know us better and also the industry itself improved and getting smarter over the years.

Nathan Stovall

Picking up on that a little bit, it's not as if you come in shooting first necessarily, it's -- you want to have a conversation about where you could see franchise value being created.

John Palmer

Absolutely. We don't go out and buy the stock today and show up tomorrow and say, "Hey, you need to sell the company. We buy the stock today, and we buy it because of value. That's our #1 driver. What's the overall franchise value compared to where the stock is trading today, there's a large enough spread, and we view every investment as somewhere between 3 and 5 years. We don't walk into a company. Let's say, we believe an adequate return on equity is somewhere between 12% and 15%. We go into a company with a 5% return on equity. We don't go and expect you to go from 5% to 15% in 6 months. It's not possible. And if you do, you're going to break something, and that's not going to end well for anybody. So we go in and look for marginal improvement, how do you improve this? How do you improve that? And quite frankly, we're trying to help the company grow and stay independent. -- generally, it's more accepted today than it was 25 years ago. 25 years ago, they put up a wall and just wouldn't want to talk to us. That's when we would have to go to a proxy contest almost immediately. But even the companies that we're on the boards with, you can look at our track record. HFFC, which the last Board I was on before the one I'm on now, I was on the Board for 4 or 5 years. BNCC Bancorp, I'm on the Board of now. I've been on there since 2019, and we're still working to make improvements. Rich Lashley, my partner, he's been on the Board of Banc of California since 2017. And we've done situations where Banc of California actually did a large deal. So we're not -- you have to sell the company. We're about how do you improve the operations, how do you improve the returns to shareholders. That's what we think about every single day, not necessarily just an exit.

Nathan Stovall

And maybe you just even answered this. You definitely take a longer view, but would you -- the point you might have answered is whether or not you have different investment strategies. Maybe it just depends on the different franchise. Do you -- have you always come at it with a single fund thinking about a single way in terms of size of institution? Or is it really just independent on this is where we see value based on our knowledge of the space?

John Palmer

It's both. First of all, it's size. We like to be in the $1 billion to $10 billion type companies typically because their valuations tend to be lower. The companies that are larger, the valuations tend to be higher, and there's a good reason for that. They have a larger asset earning base, which allows them to be more efficient, which gives them a better return on equity, which gives them a better stock price. and allows them a better price to earnings multiple, which allows them to use that currency to acquire the companies that we're involved in. And the companies that we're involved in typically don't have enough scale to get to where they need to be in terms of appropriate shareholder returns. So that's why we're kind of in that space. Our philosophy is a little different for different companies. And what do I mean by that? So if we have a company that's, let's say, $7 billion in assets, and it's returning 6% on equity, it's not going to have an appropriate market multiple. That's one where it needs to improve its earnings and probably sell. If we have that same company earning 15% to 17% on equity, the philosophy there is they should probably be an acquirer. They should probably go out because they can attractively do deals that adds to earnings, that adds to the value of the company. So it's not a one pitch company should sell. It's a how do you create the value, the best way to create value. But again, that's driven by how well the company is run. So our -- when you look at our investment thesis, 80% of our equity are in 10 companies essentially. And then the other 20% are in companies that we think eventually one day will fall into our top 10. Of those top 10 positions today, we're on the Board of 5 of those companies. So 5 of those companies, we think need improvement. 5 of those companies, we don't think need improvement, but can do it on their own or they're doing what we think they should be doing. We actually like it where we have an investment in a company. I'll give you a classic example, Evans Bancorp in Upstate New York, which is interesting, which we'll talk about later, is we filed the Fed to go to 19.9% ownership in that company. We never were on their Board. We didn't feel we needed to on their board. We met with their senior management team. their philosophy and our philosophy was aligned, their view of earnings and where they should get to was aligned. We had a very interactive conversation with management on a continuous basis. We added no value in the boardroom. So we didn't want to use up one of our most precious resources, which is our time. We'd rather spend our time on another Board where we need to push management. We need to push the Board along. That was the situation we did. And you'll note, they announced a transaction in September of last year where they're going to become part of NBT Bank, which we think is a very well-run bank, too. Scott Kingsley there has done a very nice job, came out of CBU. We think it's going to be a very nice franchise.

And in that case, that's -- we saw value there. We like what they're doing. So that's not classic activism at all. But in the other 2 that you talked about, let's start with the one who maybe is performing but hasn't necessarily gotten to the scale you think they could get or you think they should grow.

Nathan Stovall

What does that kind of conversation look like? I know you have history and sort of rich in the deal environment, not only with the banks you work with, but even before PL. Is it talking about what you've seen work? Is it trying to get them comfort with the idea of pursuing an acquisition? Is it talking about parties that you think they should know? Maybe a little bit of all that.

John Palmer

So first of all, it starts off with -- I'll give you a classic example, BNCC Bancorp, I'm on the Board of up in Bismarck, North Dakota. We put a fellow on the Board there by the name of Mike Vekich, and he was making progress, but he needed help. So he asked me to join the Board in 2019 on Board. We immediately started analyzing the company. and realized we had about $400 million of excess deposits that we couldn't loan. We had a 55% loan -- or 45% loan-to-deposit ratio. What we were doing is we're taking in HOA deposits, homeowners association deposits, putting those into securities. And remember, this is 2019, 2020 before rates went up. We started looking into those deposits and realized all in, we -- the company thought they're paying 50 basis points for it. But when we did an all-in analysis and looked at all the expenses associated with it, money was closer to 200 basis points. Fortunately, we got out of those deposit relationships, sold down the securities portfolio, got rid of them just before rates moved up. I'm not going to say we're good. I'm going to say we got lucky there. So that was the first thing we did. Then we started looking at headquarters that we owned. Did we really need an expensive headquarters? So we sold that. We then started looking at some branches that weren't profitable. We closed those down and got rid of those. We then looked at our mortgage company that had done a tremendous job when mortgages were during the '20 and '21 years where mortgages were just booming, but quickly rolled over in '22 when the market rolled over and went from profitability to losses. We genes that sold that. So we've kind of continually stepped to make the company stronger and stronger. We realigned management, changed the Board, changed the Chairman. And now we're at a point in our history of, okay, what do we do next? And that's where we're sitting today. But that's kind of a classic example. And the problem we have is we're $1 billion in assets, same problem every bank in the country has. And we've got more regulatory burden, which there's a change in the regulatory scheme. I see it maybe pulling back a bit, but it's not going to pull back a lot. So the expenses that we have embedded are embedded. It's difficult being a $1 billion bank today. And then on the revenue side, you have the consumer protection agency coming at us, trying to push down all the fees we charge to try to support the regulatory processes that we have to go through. So it's a very challenging situation for us, and it's very difficult to get our efficiency ratio below 70%. And certainly, getting to 60% is a huge leap. I'm not sure we can do it on our own. But that's kind of the way the evolution works. You pull as many new things that you can pull to try to make the company better. And at some point, you're out of things that you can do. And it's time to either find an acquisition if we have appropriate currency price or find a partner if we don't.

Nathan Stovall

Yes. And if you find a deal, if you do an acquisition, the idea of shared fixed cost, you both have it, you can take out 25%, 30% is what we always see. And suddenly, the numbers start to get closer, right?

John Palmer

Yes. What's really interesting is you can take almost any bank, especially in the $1 billion to $10 billion price range or asset size range. The cost saves coming out of a transaction are typically equal to or more than the ongoing earnings of banks. So in other words, if you have a bank making $1 a share and it's involved in a -- it's acquired by a good acquirer, typically, you're going to get at least another $1 of earnings out of that company. And if you go back to the early '90s when Rich and I were doing investment banking work, if we could get 20% to 25% of the expense base, the target, that was pretty good. Today, it's typically 35% or even more, and we've seen some of our companies acquired companies and take out 60%. Now they're in-market deals. You've got a lot of branch consolidation. But I've seen 60% cost saves. It's huge. And if you simply think about it, if you and I and Curt could sit here and buy all 4,500 banks in the country and put them together, we'd be the richest 3 people in the world because we're going to take out 4,500 HR departments, 4,500 data processing departments, Boards of Directors, CEOs on and on and on, the cost savings are just huge.

Nathan Stovall

I want to go to the flip side. So that was the -- we see them as an independent operator. We've got ways to improve them. Their earnings profile is there. But then you talk about the other where maybe the return profile is lower and you think you can come in and really help that. What does that conversation look like? -- where do you start? I know it's going to be specific to the institution, but what are some of the things you often run into?

John Palmer

So probably the most interesting thing we run into is directors who have supported the management team and are okay with a 4% return on equity. And our job is to educate them and say, listen, 4% return on equity is not appropriate for a publicly traded security, lack of liquidity that we have. So it's typically a smaller company. Our return should be 12% to 15%. And what we have to -- and then we boil it down to return on assets, probably doing 45, 50 basis points on return on assets versus that should be doing 100 plus -- and we start to educate that Board of Directors and bring in information. We'll do runs of here's where our peers are, here's where the national market is. Here's every bank in the state and slowly bring them along and all of a sudden, they start to ask questions. So it's very often you get on these boards. And the directors aren't working against you. They're just uneducated. They might be one of the realtors in town, very, very good realtor. They might be the local pharmacists. They might be the person in town that owns the car dealerships. They don't understand returns. They don't understand where the market is and where they should be. So we spend a lot of our time educating them. And once you get them educated, they become advocates with you. I've seen it time and time again where it's happened. We had a situation once where I brought in a run of the top 100 trips in this market area, and we were #99 out of 100. And the directors looked at me and said, well, wait a minute. The CEO told us we were the #1 bank in this market -- in this city. I go, well, he's right because we're the only one in the city. But when you look at -- you look nationally, you look at the county, you look at the state, we were at the bottom of the list. And it really woke them up. And at the same time, they also went, wow, we've kind of been misled. We've kind of been told that we're this great company, and we didn't realize we really weren't. And that's repeated itself again and again.

Nathan Stovall

Education and sharing your experience and being able to show peer comps and what works, they kind of get there. I mean as you said, they're good business people, but they're not necessarily banking people.

John Palmer

Exactly. That's like if you put me into a manufacturing environment or put me into a tech company, I have no value. I don't want to go there because I don't know what I'm doing.

Nathan Stovall

Right. So I want to shift a little bit broader with the idea of where valuations are. And I know that you look at specific entities or specific banks. So we'll have to come back there. But you guys have talked about in your shareholder letter in the summer about opportunities and catalysts we see for the group, whether it's steeper yield curve friendly regulatory environment, et cetera. We've seen a lot of that come in the past. We've seen the group rip quite a bit, and there's a lot of optimism now. How do you feel about valuations today? And maybe even phrase that a little bit differently, the 3 kind of scenarios we talked about, the good one I want to ride with and get bigger, the good one who I just let do what they do or the one who needs more of my help who's underperforming, how does the valuation picture set up any of those 3? Does it change the way you think about any of those 3? Where do you see the most opportunities now?

John Palmer

Yes. So let's start off with what do we see as a catalyst for the industry as we go forward. And you mentioned many of them. First of all, the yield curve, first time we have a positive yield curve in quite some time, which banks need positive yield curves. Obviously, they borrow short, lend long, you need steepness in the yield curve, and we're getting that. I think that continues irregardless of the Fed cutting or the Fed not cutting. And I think we're seeing that, and I think we'll continue to see that. The second thing is a back off on the regulatory and more specifically, regulations around M&A. There's been a lack of M&A over the last 4-plus years, and we had the COVID years, that slowed down M&A then started to pick up again. Then we had a new administration that slowed down M&A, and we're starting to see it pick up again. And I can tell you that we're seeing it, and we're aware of a lot of discussions going on in the marketplace. So I think you're going to see a boom in M&A. And I think you're going to see too, the rule was if you had 1 deal in the pipe, you couldn't have 2. So you take a Wintrust, a very good acquirer. If they bought a $1 billion bank somewhere, even though they're $50 billion, they couldn't have another $500 million bank, which is silly. They're capable of walking and chewing gum at the same time. So I think you're going to see a change in that. You're seeing their stock prices start to go up, too, which gives them a better currency to allow them to go down market and to buy too. So I think there's a lot of catalysts for value. And then -- and to top that off, we are seeing and hearing pipelines growing significantly. I think people are getting more and more confidence in their businesses, willing to take more of a chance. I think there's some noise in the media over tariffs and where that's going to all shake out. But I think as that gets defined, I can absolutely tell you that the banks were involved in the loan pipelines started jumping in November, like I've never seen them jump before. Specifically, the Board I'm on, we have the biggest pipeline we've ever had. So I think that all bodes well for the industry. When I sit back and look at valuations, there's one big issue out there, which is the AOCI, which is the discount on securities portfolios in the available-for-sale portfolio. So when you look at our portfolio today, round numbers trading 120% tangible book. But when you factor in that AOCI, it's closer to 110% of tangible book. And we have to be careful, and we've had this discussion internally, where people tend to take the last 6 months of their life and extrapolate it to the forever future. So if you go back 6, 9, 12 months ago, we were buying positions at 80%, 90% of tangible book. Today, those positions are 100%, 105% of tangible book, and we're going, oh my goodness, we can't buy anymore. And we're trying to get over that mindset because if you look back historically, typically that we're trading in the 150% to 170% of tangible book range. And we'll probably get -- may not get all the way back there, but we're going to get a good ways back there. If you look at it on a relative basis, the industry is trading at 53% of the S&P, where historically, it's been somewhere between 60% and 100%. So call it 80% of the S&P. We're significantly below where we've been. And then as we talked earlier, as you go up in market cap and you go up in return on equity, the multiples get bigger. So if you go to the regional banks, they're trading around 180% of tangible book. The money center is 185% of tangible book. And we're still down here in the community banks trading basically at book and with good earnings growth coming and trading at like 9x earnings, which we're still at. We're not at the lowest we've been -- but if you took out the last 2 years, we're trading at bottom valuations. And what's really interesting is we've gone back and looked at this, you tend to have a crisis and you'll have a 2-, 3-year period of negative returns on stock prices in the banking industry. And then that's followed by a 6- to 8-year upward movement in stock valuation. So 2- or 3-year pullback and then you get 6 to 8 years of upward movement. We've seen it happen again and again, again, you go back to the great financial crisis. You can go back to when the Fed spiked rates, you go back to the dot-com era, it tends to repeat itself. So we think there's a runway here for another 6 to 7 years of upward movement in stock prices.

Nathan Stovall

And some of that is certainly broad money coming back to the group. We're hearing talk about that. You're hearing more optimism. You're hearing more generalist funds look. But one of the things you kind of spoke to, but I want to put a finer point on is community banks historically have had acquisition premiums built into them, at least good names. We haven't really seen that, right? And so if we see that picking up, is that part of the thesis here that maybe that valuation gap between the smaller and the big guys narrows?

John Palmer

Absolutely. There's no acquisition premiums built in at all. I mentioned Evans Bank earlier. So if you went back and look at Evans Bank in June of this past year, you could have bought every share you wanted for $25. They announced a deal at $45 in September. So 3 months later, almost a double in where you could buy it. The stock is now around $41, $42 and change. I suspect when that closes, that will go up to because the earnings will start to come through. So you essentially almost had a double in 3 months. And I can tell you the acquisition premiums are not built into any of our companies. We're getting close to another transaction, and it's going to be interesting how it's perceived by the market. It's going to be a huge premium to where people thought the company was worth.

Nathan Stovall

One of the things we've been talking about with M&A activity broadly, and I saw somebody make this point yesterday, it's a good one. If we did see a material shift post election, and we will see one in the regulatory environment, but in sentiment and just confidence in terms of pursuing a deal, shouldn't we -- even though we feel great about where it's going to go, shouldn't we all take a step back and realize these things take time before we sort of blow the whistle and go, where is it? Because we haven't seen a huge pickup yet, but you've got a date for a while, so to speak. So it's maybe a second half of the year of '25 event more so than, okay, we should be off the races right out of the gate. Do you think that's fair?

John Palmer

Yes, I think that's completely fair. I can tell you there's a lot of conversation going on, and I think that continues. But for the first time, I'm seeing people get off the beach and having conversations to actually getting in the water. They're not all the way in, but they're getting in the water again and starting to go for a swim. So it's absolutely coming. And the thing you have to remember about M&A is if you're an acquirer and there is a target that you desire, it's the #1 target on your list. If another company comes and buys it, it's gone. because the odds are that combination of those 2 companies is too large for your company to make an acquisition of the combined unit. So once it's gone, it's gone. So you better be the first one in the queue if you really want that target to be there and be on top of it because it's going to happen once it happens, it's over. You can't outbid it, you can't get back to it.

Nathan Stovall

The FOMO M&A trade that I've heard it called.

John Palmer

It's not even just the FOMO, but you think about it, you've got a company that is close adjacent to your market area. You have some overlap. You've got some branches you can consolidate. If another acquirer comes in and takes that company out, you now probably have a stronger competitor to it. So it's not just missing out on the opportunity. Now you've got even more competition coming at you because the bigger company probably has more product services, can probably deliver better, quicker, faster. So now you have a double problem.

Nathan Stovall

Do you think -- historically, 90% of the deals are banks under $1 billion in terms of sellers. Do you expect to see more regional activity? And not only is that just something we're, of course, interested in, but the idea that if there is that opportunity, then maybe there's double dips out there. And so that could even kind of feed more deals coming. Do you expect to see more there? And if so, what are we talking about? Are we talking about the $20 billion regionals? Or are you talking way bigger than that?

John Palmer

I think you're talking all of them. I think you're going to see a lot more deals. There's been a rumor that Comerica, they may be in play. That would not surprise me at all. I think it could be a good fit for a lot of people. I know there's rumors about some other large banks. There was this threshold of wow, we can't go over $100 billion. I think that's going to go by the wayside. I think there's going to be deals up in that size. And quite frankly, it probably serves everybody better because you have better run company, you'll have more availability in terms of locations. You'll have better service to your customers. You have more products, more sophistication within it, better risk controls, and it makes a lot of sense. And I do think, too, the regulators are pro consolidation. And the reason for that is you're able to take smaller companies that can't afford as sophisticated and complex risk and compliance processes. You're able to get that accomplished by going to a larger bank, having a larger asset base to fund that. So there's actually a benefit and makes the business less risky generally by having larger organizations.

Nathan Stovall

In closing, you talked -- we talked about regulation a good bit, talked about thresholds and how regulators look at it. You mentioned earlier the position in Evans and going up to 19.9%. What do you think there in terms of the regulatory environment and looking at positions at banks? Do you think we could see a change there where investors could acquire larger stakes in banks?

John Palmer

So in 2019, the Fed proposed changes to their -- the rules at the holding company and the amount of ownership levels, and they finally approved and then finally codified it in 2020. So it's only been just coming up on 5 years that we've been able to do that. And what they did was they essentially allowed you to go to 24.9% with some caveats. The biggest caveats are you can't be Chairman of the Board and you can't control more than 25% of the Board, which we never really want to be Chairman, and we never really want to control 25% of the Board. So in effect, today, we can go to 24.9%. I think we were one of the first. We went out and we filed for a 14.5% stake in a company called Old Point Financial in Virginia, which we got approval on. And then we filed for a 19.9% stake in Evans. And in the future, we'll probably file for more. But with 24/9, we're okay at that level. We're not looking to go to 30% or 40%. We can do all we want to do at 24.9%, which we think is very, very effective. And it allows us to kind of to your point, if we have a smaller market cap company, it allows us to put enough of our funds into it to make it worthwhile for us to spend time and to help improve that company versus if we're only putting in a small amount of our investors' equity, we can't afford to take the time and make that a full-time effort.

Nathan Stovall

Right. And if you think about the value PL offers, it is that interaction. And if you're talking about smaller institutions, suddenly, that number isn't just going to be big enough.

John Palmer

Exactly. Exactly. Yes, that's our value added. Again, we're concentrated. We spent a lot of time with our companies. We know them intimately. We know the management teams. We know the Boards, and we push them to their strengths or we push them to their weaknesses to correct them.

Nathan Stovall

Well, terrific. Thanks so much for coming on the show. I think it's a great place to leave it. Appreciate the insight into the space and the optimism as well.

John Palmer

Yes. Appreciate your time. Good to see you again.