Street Talk – Episode 74: Investor sees legs in strong credit performance, US bank stock rally

Bank stocks have surged in recent months as the outlook for credit quality and the broader economy has improved, but community bank valuations might have even more room to run, according to one investor.

The SNL U.S. Bank & Thrift Index is up nearly 90% from March 2020 lows and more than 45% since news of an effective COVID-19 vaccine surfaced. The investment community had feared that banks could sustain credit losses comparable to the hits taken during the Great Recession, but bank stocks have rallied as the worst-case scenario moved off the table and credit quality has shown few signs of deteriorating, at least through the fourth quarter of 2020.

Still, Joe Fenech, chief investment officer at GenOpp Capital Management, said in the latest Street Talk podcast that many bank stocks, particularly the securities of smaller banks, which have underperformed their larger counterparts, have greater upside. He believes that will materialize as credit quality continues to exceed expectations, M&A activity rebounds and generalist investors eventually return to the bank group.

"I still don't think people are fully grasping the magnitude of what the Fed and Congress has done here," Fenech said, noting that government stimulus and actions taken by the Federal Reserve in response to the pandemic have been several times larger than the relief efforts enacted in the aftermath of the Great Recession. Those actions have supported borrowers by flooding the markets with liquidity but in turn have also put pressure on banks' net interest margins.

"What's happened here is we've effectively traded credit risk for margin. Essentially, on the one hand, all of the stimulus and liquidity has effectively either pushed out or entirely removed credit risk from the equation in this cycle," Fenech said. "The corollary to that, on the other side of the coin, is we think the cost of that is going to be borne in margin."

Fenech said he and other investors would not worry about lackluster margins when banks are still trading below tangible book value, since that level suggests there are concerns about the value of a bank's assets.

The SNL U.S. Bank & Thrift Index currently trades at 175% of tangible book value, up substantially from approximately 100% of tangible book value at the lows in March 2020 and 135% at beginning of November 2020, roughly a week before the news of an effective COVID-19 vaccine hit the market. Small-cap bank stocks, however, have significantly lagged their peers, with the SNL Small Cap U.S. Bank and Thrift Index currently trading at just over 130% of tangible book value.

Fenech does not believe that current performance is reflected in many bank stock valuations and expects analysts' earnings estimates to increase in the near term as credit quality continues to outperform expectations.

"The question I'm getting most often these days after the rally we've had is, do you think I missed the bank recovery trade? My opinion is absolutely not," Fenech said.

Fenech believes that small banks trading near tangible book value today will eventually rally to 120% to 140% of tangible book value or even higher for a variety of reasons, including stronger-than-previously-expected credit performance. He also noted that several funds focused on small banks wound down in 2020, and new capital has not returned to the group to replace them, but he does expect new money to come back to smaller banks over time.

He further noted that the upcoming reconstitution of the Russell 3000 Index could create buying opportunities for some small banks. The index rebalances every June based on the market capitalization of the 3,000 largest exchange-traded stocks. When the index rebalances, the market-cap minimum is expected to be $200 million or more, roughly double the level in 2020, he said.

At that level, close to 70 banks could be pushed out of the index, and the pending change has not gone unnoticed. Fenech said banks with market caps under $200 million have severely underperformed other stocks in 2021, leaving many of them trading at discounts to tangible book value. That could set up "an incredible opportunity" on the other side of the reconstitution, he said, given the expectation for improvements in the broader economy.

Fenech also believes that M&A activity will return in force to the bank space, with a wave of deals kicking off this year after bankers see continued seasoning of loan portfolios and additional progress administering the COVID-19 vaccine. Deals could come with considerable upside for sellers, but Fenech noted that the return of healthy M&A activity likely would restore takeout premiums in a number of bank stocks.

"The math for M&A is going to be really favorable because you have larger, more liquid banks with a multiple buying smaller banks where the stocks have lagged, so I still think the best is yet to come in terms of the bull case on the sector," Fenech said.