Big Opportunities in Small Banks: Finding Value in the New High Rates Regime

David started by introducing Drago and shared a brief update on recent developments in the financial markets and banking sector.

First Involvement with Community Banks

When asked about how he and Petiole first got involved with community banks, Drago said that he started managing money for The Family Office and its affiliate company Petiole in 2011, when the U.S. economy was coming out of the global financial crisis. Loan losses had wiped out the capital of many banks, and regulators were asking them to raise equity to replenish capital levels. Regulators were sending urgent letters to the board members of banks, telling them they had 5-6 months to raise capital, and if they didn’t succeed, board members would be liable for the failure with their personal assets. Big and well-known names were able to access the capital markets, but small community banks had a tougher time. Petiole saw an opportunity there and started calling hundreds of small banks, and ended up investing in about 30 of them at very attractive valuations. By the time Petiole exited that portfolio, it earned a 21% annual return for its investors.

Distinguishing the Role of Community Banks

When asked how he can distinguish the role of community banks, Drago answered that by the 19th century, all major European countries had established their central banks. However, in the U.S., several attempts to organize a central bank failed, and for many decades there was no authority in the U.S. to issue national banking licenses. As a result, the U.S. ended up with one of the most fragmented banking systems in the world. When the Federal Reserve was established in 1913, there were about 30,000 banks, and the number has dwindled over time, but there are still many independent small banks whose business model is to focus on their local communities. Community banks are the smallest banks in the country with assets of less than $10 billion. In the U.S., there are 4,700 community banks, and of those, about 700 have a ticker, meaning that they can be bought on an exchange or over-the-counter. This is where very interesting investment opportunities can be found today.

Competitive Advantages and Services Offered by Community Banks

Answering a question about the competitive advantages and services that community banks offer today as opposed to larger banks, Drago responded that community banks are very unique in the U.S. economy. They are deeply embedded in their local communities and have extremely strong and stable relationships with their customers.

Community Banks: Strategic Advantage of the U.S.

Community banks are one of the biggest competitive advantages of the U.S. economy, because the more competition you have, the better the outcome for the client. With customers being mostly small businesses, they are much better off when they are banked by a multitude of smaller lenders with a local presence and personal touch, rather than by big institutions. This dynamic lowers the cost of financing for small businesses and promotes economic growth.

Outlook on Recent Bank Collapses

Regarding recent bank collapses, Drago described them as idiosyncratic rather than systematic. He added that many people have become armchair bank analysts over the past couple of weeks and there has been a lot of noise. This is not a run on the entire banking system, it’s normalization of balance sheets that had swelled with excess deposits from the pandemic stimulus. For the system as a whole, it’s not an issue. He also said that the unwind started in the middle of last year, with deposits in U.S. banks gradually declining, which was not an issue. However, it has become an issue for a few select banks, because liquidity in the pandemic didn’t flow evenly, and the banks that experienced huge deposit inflows are now the ones experiencing huge outflows, because they assumed the money was theirs to keep. The liquidity planning tools that Silicon Valley and Signature Bank used did not reflect the reality of their balance sheets.

Thoughts on the Response of the Government

Drago thinks that the U.S. government is very good at fighting problems that have already surfaced, but not necessarily at anticipating and preventing issues. The lightning-fast deposit runs on Silicon Valley and Signature bank surprised regulators because they occurred at a pace never before seen in history. However, the repo facility the Fed put in place last week provides quick and sufficient liquidity backstop for banks facing deposit outflows. He does not believe there will be any more failures driven by liquidity issues because the government just addressed this with the new liquidity facility and instead, there will be orderly and controlled balance sheet restructurings of banks facing funding issues.

Effect of the New Regime on the Economy

When asked about how this new regime will affect the economy, Drago answered that in the immediate term, liquidity is going to reign supreme and banks are going to slow down their lending. When credit is tight, a recession usually follows, and it might start soon. Community bank stocks, however, lead on the way down, but also on the way up. He also added that they might turn around earlier than the rest of the market, possibly in the next 4-5 months.

Investment Selection

In response to how he selects investments for his portfolio, Drago said that when you construct a portfolio for the new interest rate environment, it is going to be exactly the opposite of what worked for the past decade. When rates are high, you want to own the lenders rather than the borrowers and buy value stocks, not growth stocks. Small cap stocks also tend to outperform large cap stocks in such environment. Community banks are in the perfect intersection of these themes.

Valuations and Investor Positioning

Drago noted that because of their sticky customer relationships and deposits, community banks will not be particularly affected by the recent turmoil and deposit flight. Yet, investors are reluctant to own the sector and are very underweight relative to their benchmarks, the most since the Global Financial Crisis. As a result, community banks stocks trade at 7x earnings, compared to 14-15x in the past. Because community bank stocks are currently trading around book value, which for banks represents their liquidation value, the downside is quite limited. But the upside, if trading multiples re-rate to past averages, is more than 100%. This is a very attractive risk-reward profile, even if earnings decline in the near term.  

Financial Technology and Traditional Banking

Drago does not believe that FinTech companies will be competitors to banks, but rather partners.  Recent events demonstrated the value of sticky deposits and FinTech companies don’t have ways to generate such deposits. He expects that many FinTech businesses will evolve and partner with banks and provide them with technology solutions that will save cost and time, and make banks more efficient.

Community Banks and Petiole

When asked about how community banks' investment strategy fits with the philosophy of Petiole, Drago said that the mandate of the company is to protect its clients’ wealth and to find investments in which the highest risk-adjusted returns are achieved. Community banks fit this profile, and they tend to have significantly lower volatility on the downside than larger public banks. Petiole has a big focus on private investments and doesn’t mind giving up some liquidity in the portfolios of small cap community banks, when in return it receives private equity, like returns, with a much smaller drawdown than the public market.