Is There Opportunity In Small-Cap Banks? by Jeremy Javidi, ColumbiaManagement
- As profitability rebounded from the financial crisis and return on assets improved in 2012 and 2013, the banking industry once again began to outperform.
- We continue to see growth in commercial and industrial loans as a positive indication for the economy. These loans also provide the growth of assets for the banks.
- Given their improving profitability, discounted valuation and strong growth, we believe that small-cap banks are an increasingly attractive investment opportunity.
How does one go about assessing investment opportunity in the small-cap banking sector? Let’s start by looking at the historical pattern of the Russell 2000 Value bank constituent’s valuation as measured by price-to-tangible-book value compared to the return on assets, a measure of bank profitability (Exhibit 1). Over time, the two metrics move in a similar fashion. The more profitable an institution is, the more it is worth. As profitability rebounded from the financial crisis and return on assets (ROA) improved in 2012 and 2013, the banking industry once again began to outperform. We believe that this year’s underperformance gives us an opportunity to buy the industry at an attractive price relative to its profitability and growth prospects.
Exhibit 1: Price to tangible book and return on assets for banks of the Russell 2000 Value Index
Source: Bloomberg. Past performance does not guarantee future results. It is not possible to invest directly in an index.
Now, let’s consider the price-to-tangible-book and ROA relationship in an X-Y scatter chart to see the relationship over time (Exhibits 2 and 3). The diamond represents the pre-crisis relationship, with the industry average valuation at over 2.4x price-to-tangible-book, with an average ROA at 1.1%. The red squares show the industry doldrums as profitability suffered from credit losses. Yet the industry averaged 1.5x price-to-tangible-book value despite the low profitability. The recovery phase, depicted by the green triangles, shows that as the industry gained improvements in profitability, its valuation resumed its previous linear relationship.
Exhibit 2: Price to tangible book – Return on assets X-Y scatter for banks in the Russell 2000 Value Index
Source: Bloomberg. Past performance does not guarantee future results. It is not possible to invest directly in an index.
Exhibit 3: Price to tangible book – Return on assets X-Y scatter – excluding the Great Recession credit effect for banks in the Russell 2000 Value Index
Source: Bloomberg. Past performance does not guarantee future results. It is not possible to invest directly in an index.
We believe we are in a unique period because the purple circle represents today’s relationship between ROA and valuation. This data point has the highest ROA of the recovery period, and yet the valuation remains significantly below its historical relationship. We continue to see growth in commercial and industrial loans as a positive indication for the economy (Exhibit 4). These loans also provide the growth of assets for the banks, and given all of these positive attributes (improving profitability, discounted valuation and strong growth), we believe that small-cap banks are an increasingly attractive investment opportunity.
Exhibit 4: C&I loans in the U.S. banking industry
