Big mutual funds may have moved bank stocks for the past three years, but those days are over, says Harry V. Keefe Jr, chairman of Keefe Managers, and a veteran analyst and fund manager.
The game of investing in turnaround bank stocks, which those big funds played, has run its course. Now, the industry's more predictable earnings, dividend growth, and more professional management will attract the sector's traditional investors: insurance companies, foundations, and endowments.
Mr. Keefe, who was a founding partner of Keefe, Bruyette & Woods, believes the market's worries about dilution -- which he feels are misplaced -- and focus on turnarounds has caused it to sell off or undervalue some of the best-run banks. His four favorite sleepers: Banc One Corp., Norwest Corp., Bank of New York Co., and First Fidelity Bancorp.
Mr. Keefe manages $237 million, and invests in bank and thrift securities. His hedge fund is up 29%. He has made a good part of that money by picking takover targets.
Q.: Is there still money to be made in bank stocks?
KEEFE: There's a lot of money to be made in bank stocks, but you are going to make money in a different way now.
Most of the turnarounds are completed. We bought New World, a thrift in New England, in 1991 at $4 when it was losing $4.
It had 50, 60 million [dollars] in problem loans. At the end of June, it had $16 million in problem loans and $28 million in reserves. It will probably be down to $12 million by the end of the year. It's a $1.2 billion company. Those bad loans are nothing. The stock is now $27 and the bank will earn 2.50 next year.
You can make money in the merger game, which is only in its third inning.
But people are are going to buy bank stocks for a different reason. In the long run, what makes you money in a common stock is dividends. Bank stocks are paying good dividends and those dividends are growing.
Q.: What will it take to attract investors interested in common dividends?
KEEFE: Years ago, banks were thought of as a place for conservative investors to buy stocks. No major bank between 1933 and 1974 cut its dividend, with the single exception of Bankers Trust, which cut its dividend when Pearl Harbor happened.
Dividends grew at about 5% a year compounded and the payouts were 45% to 50%. Then in 1974 there was a real estate mess in the Southeast and Southeast bank eliminated its dividend. The relative multiples of banks to industrials declined. Before that, they had been appreciably higher.
Back then the market for bank stocks was dominated not by hedge funds like mine or Fidelity, but by insurance companies and various endowments and foundations looking for a reliable, growing dividend.
So when Citibank, Bank of Boston, and Shawmut cut their dividends, they frightened traditional investors out of the market. Those people went away from bank stocks because the income wasn't predictable.
Q.: And now it is?
KEEFE: Yes, Capital is stronger than it has been in 30 years. Loan problems are gone and I don't see them returning. And I see dividends growing faster than earnings.
I postulate that most commercial loans originate with loan officers in their 30s. Banks are cutting back on people, so if you are a 35-year-old loan officer at Citibank and you know they are going to cut staff, and you have three kids, a five-bedroom house with a big mortgage and two cars on time, you say, what's in it for me to make this loan? You can always think of a reason not to make a loan.
People talk about banking and interest rates all the time. I think this is funny. Everyone in the financial community thinks he is an expert on the outlook for interest rates.
If margins come down, what would cause that? Because the cost of money went up. And why would the cost of money go up if there is a huge liquidity on bank balance sheets? If they start bidding for money and raising rates, it means there is loan demand.
Q.: What else is new about the industry?
KEEFE: Banks are now being run by managers. That's new. I look at Tony Terracciano at First Fidelity, who took over a rotten company.
He has been there for three years. He was a treasurer at the Chase. He wasn't a loan man, he wasn't a lawyer, he didn't go to Harvard, Princeton, or Yale. But he can run a bank.
First Fidelity has more branches in the Northeast than anybody and he says he is going to operate from Baltimore to Boston. He has the biggest bank in New Jersey, which is an attractive state with high incomes and diversified industries.
He is the second largest player in Westchester. Now he is in Port Chester [N.Y.] and southern Connecticut. The banks in Connecticut have never seen anything like him. He plays hardball. The stock isn't moving. [Tuesday, it was trading at $46.125, down 50 cents.]
He is cheap. He got his overhead down. In the past, banks weren't being run by managers. They didn't focus on costs. They focused on their loans being up 10%, deposits up 15%. The way to make money in banking is to get your overhead down. That's what Banc One does.
Q.: But the shares of Fidelity and Banc One and your other two favorites aren't moving. Why not?
KEEFE: I sincerely feel there are too many bank analysts. Analysts are stretching for a new idea a week. Because they are pressed for performance, they say some bank will do a merger and dilute its earnings. They are worried that John McCoy at Banc One is going to do some dumb deal or that Carter Bacot at Bank of New York is going to do something stupid.
Banc One has done 110 mergers and they've increased their earnings per share every year for 25 consecutive years. Where is the evidence that they don't know how to do mergers?
Q.: What about the deal for Valley National?
KEEFE: In 1992, Valley National earned 0.73% on its assets. In 1993, the return is 1.25% -- that's a 71% improvement. Banc One hasn't made a mistake.
I've heard investors say that Banc One blew a gasket when they paid 2.6 times book for Firstier in Omaha. Firstier earned 1.59% on assets in the first quarter. Investors say, what can you do with that? You can go to 2%.
Firstier has a margin of 4.7%. Banc One's is 6.6%. Banc One says, "We will give them product." Banc One's income from annuity sales is up 61%. Income from mutual funds is up 55%. They are the masters of the credit card business and the back office. They will take the margin up to 6.6% at Firstier.
Banc One bought American Fletcher in Indianapolis in the mid-1980s, when it was earning 85 basis points on assets. In the first quarter, Banc One in Indiana earned 2.09% on assets.
But the stock acts like death. [It traded at $41.625, off 25 cents late Tuesday.] I can't own it in my fund, because I have to report monthly performance. But I own it personally.
Remember what I said about dividends being the reason to own common stock. In the last 20 years, Banc One's dividend has grown 13.9% per year compounded. The S&P 500's has grown 6.8%.
In the last 10 years, Banc One's dividend grew 14.6% per year compounded, and the S&P 500's. 5.3%. In the last five years, it's been 15.3% and 5.2%. In the last 12 months, they have raised their dividend twice.
Q.: Why aren't people buying Bank of New York?
KEEFE: Bank of New York was selling at $62 in the first quarter. Now it's around $56. At the end of the first quarter, State Street Boston announced problems in the mutual-fund clearing business, which all these analysts imputed to Bank of New York. It wasn't the same. State Street's computer capacity had run out. Bank of New York, because they bought Irving, has computer capacity for the next two centuries.
But investors started selling Bank of New York. Here's a company in which half the income is fee income. They are the biggest guy in ADRs, the biggest in government bond clearing, the second largest in mutual funds. They have a wonderful credit card business. All these fee income businesses are growing somewhere between 10% and 20% a year, compounded.
Bank of New York earned 1.20% on assets in the first quarter and their target for 1995 is 1.40 to 1.50. And the stock sells at eight times earnings.
Why? Because some analysts say that when Carter Bacot bought National Community in New Jersey, he paid a big price. They think he will do another merger in New Jersey and dilute.
There is no evidence that Carter Bacot has ever diluted. Before the feathers hit the fan in New Jersey, National Community was growing at 25% a year compounded and earning 25% return on equity. That merger won't be dilutive.
Historically, the bank pays out 30 to 35 of earnings in dividends. I'm using $6.50 for earnings next year. So 35% is $2.75. On a $52 stock, a 4.4 yield. That's pretty good.
Q.: What's the story on Norwest?
KEEFE: I was going to give a talk to analysts in San Francisco and Los Angeles in April when the markets were acting awful, and I thought I should have something constructive to talk about.
So I asked some industrial analysts at Shearson to value a company with the following performance: in the past five years, the earnings per share grew 100%, dividends grew 120%, the lowest return on equity was 18.5%, and it was currently earning 20%. Earnings per share will grow 100% in the next five years. They said it should sell at 24 to 27 times earnings.
I asked the industrial analysts who attended my talk how they would value the company and they said it would sell at over 20 times earnings. Then I gave them the dirty four-letter word: It is a bank. It's name is Norwest. And it is selling at 11 times earnings [The shares traded at $26.875 Wednesday afternoon, down 50 cents]. The S&P sells at 16.9. That lacks logic.
Norwest is in all 50 states and every province in Canada. Only 5% of their loans are commercial loans. It's the biggest originator of home mortgages. Its finance company earns 22% on equity. And the stock acts lousy.
Q.: You've said a good part of your fund's appreciation comes from picking takeover names. What's your strategy?
KEEFE: Analysts follow 30 stocks. We follow 500. If you follow 30 or 40 banks, you aren't looking at the takeover candidates. That's the difference.
For example, Mid-State Federal Savings Bank had agreed to a merger with First Florida and the government wouldn't let it go through because they thought that First Florida was weak. That tells me that Charlie Harris, who is running Mid-State, wants out.
Charlie Harris is an attorney. He used to be general counsel for Sun Banks in Orlando when I was their investment banker. He doesn't want to run a bank. He is a deal doer. He has an office in Orlando and the company is in Ocala. After the stock sold off on the news about First Florida, we bought 9.9% of the company.
We bought Fortune Bancorp. John Torell, from Manufacturers Hanover, was running it. By coincidence, the first house I ever bought I bought from his father. I've known John for years. He is a good banker. The company was a mess and he was cleaning it up. But he is living in New York, running a thrift in Clearwater, Fla. That tells you something.
[Amsouth recently signed agreements to purchase Fortune and Mid-State.]
Q.: Who's likely to be taken over?
KEEFE: Germantown Savings in Bala Cynwyd, Pa., just outside Philadelphia, looks good. It has a strong market position. It has a book value of $31.50. The stock sells around $37.50. We think it will earn $4.20 next year, so that's less than nine times earnings. It's nonperforming assets are less than 30 basis points. It has a reserve of 500%, so it is way overreserved.
Germantown won't speak to analysts, so no one pays attention to it.
Is it a merger candidate? Not according to the chairman. But it is quality bank, selling at a modest price, with no problem loans in a good strategic position, surrounded by CoreStates, Meridian, First Fidelity, PNC, and Mellon. The law of averages says some day, someone will buy Germantown.
Baltimore Bancorp is a turnaround story that has turned around. It has a franchise in Maryland. It sells at 1.2 times book. It will be sold at 1.6 to 1.8 times book.
Cumberland in Louisville, Ky., is another one. It has $1.2 bilion in assets. The book value is $31.70 and it sells at $36. It will earn $4.30 next year -- that's 8.4 times earnings.
PNC bought Citizens in Louisville, National City bought First Kentucky. Banc One bought a small bank in Lexington. So you have three acquirers and NBD is in Indiana, right nearby.
One more we like is the Cooperative Bank in Massachusetts. It is in Middlesex County, which is a place for eggheads working in high tech. Other than Bay-Banks, the bigger Boston banks don't have a position there. It is selling just over book value at eight times earnings, and they have loan demand because it is a prosperous area.