Long-Term Industry Returns

Inspired by the recent Ash Park on Tobacco and Transformation whitepaper, which came to my attention via @JonFell73 on twitter, I decided to take their analysis that global staple stocks have never lost money in any rolling 5 year period (since 1977) and extend the analysis further back in time.

I downloaded the Ken French 12 Industry Portfolio data (monthly), and ran out the analysis since 1926 (first rolling 5y begins in 1931).  Since I was there, I decided to run out some additional industries as well, both on a market value basis and an equal weight basis.  Here are the charts.  Enjoy!

Consumer Nondurables (Staples)

Durable Consumer (Discretionary)

Manufacturing (Industrials)

Energy

Business Equipment (Technology)

Utilities

Healthcare

Finance

Harvest Investor © 2020. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Eastern Bankshares (EBC)

Eastern Bankshares filed an IPO registration on June 18. Here are a few of my notes from reading the S-1.

Eastern is a mutual holding company (never did a first step conversion) that is converting to a full stock form organization. They are targeting an issuance of 175 million shares at $10, for an IPO of $1.75B (can be up or downsized). Will list on the NASDAQ under ticker EBC. Upon completion of the offering, 4% of shares will be donated to the bank's charitable foundation. The plan is to use the IPO proceeds to expand the bank through both organic growth and bolt-on acquisition opportunities.

Eastern is a full service community bank headquartered in Boston. They have over 200 years of history since founding in 1818. They currently have 89 branches throughout eastern Massachusetts and southeast New Hampshire. They have 2.4% ($8.7B) deposit share in Boston, which they say is the greatest market share for any full service bank headquartered in the Boston area (which is a fancy way of saying they're actually #6 in Suffolk county).

Eastern Insurance is a subsidiary that is an independent agent in the Property & Casualty and Life & Health segments for both retail and commercial clients. There are 22 non-branch insurance offices built through a roll-up of 31 independent agencies over the last 16 years. The insurance business contributes 15-19% of total net income, and helps boost the bank's fee income ratio to near 30%.

Selected Financial Conditions
Eastern is a $12B (will be close to $14B after the IPO) community bank. They run a fairly traditional balance sheet with a diversified loan portfolio (see below) funded by core deposits. Loans/Deposits are 87%. Deposit costs (as of 3/31) were 0.23% vs. 0.84% for peers (peer group chosen by management).

Nonperforming assets to assets have come up slightly in recent quarters to 0.4%, but that's still a very healthy level. The jump in NPA from 2018 to 2019 was attributed to a "loan participation, through our ABL [asset backed lending] portfolio, in a SNC [shared national credit] program portfolio that had a balance of $16.3 million as of 3/31/20."

Expect credit ratios to continue jumping higher in coming quarters with COVID related delinquencies. Management used 1Q to boost ALLL to 1.20% of total loans. I would expect more provisions in coming quarters. 

CET1 has been running in the 12% range in recent years, and will be boosted to 26% with the IPO proceeds.

Loans

• Commercial & Industrial make up 19% of the total portfolio. They focus on middle-market companies inside of geographic footprint. They do participate in syndications and Shared National Credit Program. SNC was 26% of C&I loans. Asset Based Lending Portfolio (ABL) was 10% of C&I. Portfolio appears diversified across sectors - see below for concentrations.
• Commercial Real Estate is 39% of total. Diversified portfolio with 19% of CRE in multi-family. Poses a risk due to COVID rent negotiations?
• Commercial Construction is 3% of total.
• Business Banking, which focuses on small businesses (under $1 million) is 8.6% of total.
• Residential real estate is 16%. They seem to be selling half or more of originations to secondary market, and don't retain servicing rights.
• Home Equity is 10%.
• Other Consumer is 4.5%. Of this, 60% are auto. They did discontinue an indirect auto loan program in 2018, so expects some of this portfolio to runoff. They did note they do "auto and AIRCRAFT" loans under "other" - curious why they specifically noted aircraft?

Deposits

Pleasantly surprised by the strength of the deposit portfolio. Focus on Demand and MMKT is what gives them the 0.23% average cost. CD's are a minor part, with $156 million of CDs are over $100k.

Rate Sensitivity
Eastern is asset sensitive, with a projected 5.7% increase in NII for a 200bps shock upward.

Income StatementCan see the drivers of the 30% fee income ratio. Insurance as well as a fairly healthy Trust/Investment department (AUM of $2.7B, implying a revenue rate of 0.73%). Salaries seem a little high to me (but that's often the case when I look at stocks). Bank rents all of its properties, so occupancy expense is higher than some peers. I think (but am a little unclear) that the charitable donations line item should go away after IPO due to donating 4% of stock to foundation (which, although is significant dilution, comes with a nice carryforward tax deduction).

Price to earnings ratio on 2019 numbers and issuing max number of shares at $10 would be: 14.5x.

Management
Management is as expected for a metropolitan community bank - lots of non-profit exposure on their lists. None seem to have big M&A backgrounds, but that's not expected for a community bank of this size. They have led Eastern through some bolt-on acquisitions over the past two decades.

Compensation seems high to me, but a lot will be tied to new stock offering going forward, so properly incentivized.

Board of Directors seems weighted toward health care / elder care. That didn't show up in their loan portfolio.

Officer and Director participation in the IPO: they max out at 200k shares. Glad to see a few maxing out their allocation (specifically CEO Rivers), but would have liked a little better uptake. Wish CFO Fitzgerald had maxed out allocation.

Valuation / Outlook
At a $10 price, EBC will IPO at a P/TBV of 0.65. This compares with its hand selected peer group average of 1.05.

However, EBC will be running a capital ratio 23% after IPO. I would love for them to turn around and immediately start buying back shares at 0.6x book, but I don't think that will happen.

I see EBC over time approaching peer group valuation, but the crux will be how well and how quickly they put excess capital to work. Acquisition target banks are cheap right now, so that's a tailwind. 

As of today, I really like EBC and their prospects. A high quality community bank converting at a good time. We will have to watch closely as the IPO approaches and see how the stock responds in early trading.

 

Harvest Investor © 2020. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Thrift Conversions

Thrift conversions are considered by some the ultimate value investment. A mutual bank, which is communally owned by the depositors, decides to convert to stock ownership. When you buy a share in the new institution, there is no selling shareholder and no shareholder dilution. Your capital is added to the existing capital base, all of which you (the new shareholder) now own. It's akin to buying a house, but when you walk into your new home, your purchase cash is lined up neatly on the kitchen counter, ready to be put to work on new home improvement projects.

Conversions have a long and storied history on Wall Street. Seth Klarman in his famous book, Margin of Safety, outlined their attractive economics ("as long as the preconversion thrift has a positive value"). Peter Lynch did likewise in Beating the Street. Yet since you're often dealing with small- and micro-cap names, they remain a cult investment.

I have historically dabbled in this market with some successes and a few not so successes. Finding a good, repeatable, strategy when it comes to Thrifts has, however, alluded me. Strategies that I have seen recommended by other investors include:

• Buy the whole complex (i.e. buy every new Thrift IPO).
• Lingering questions: how long do I hold these positions? What causes me to sell? How to I manage portfolio allocations? 
• Focus on the takeover candidates. 
• Lingering questions: Do I wait until the IPOs are seasoned for three years (regulatory rules usually prohibit acquisitions for 3 years)? How long do we wait for an acquisition? What key criteria are acquirers looking for? 
• Follow the activists (Stilwell, Seidman, etc.). 
• Lingering questions: What are their criteria for ownership? Is coat tailing sustainable, or will I panic at an inopportune time since it's not "my" idea? 

While the answers to most of the above lingering questions is old fashioned, in the trenches, due diligence, I still feel I need some quantitative backing to get my hands around a strategy that better fits my investing personality.

For that reason, I went back and looked at every single mutual bank IPO (as listed on bankinvestor.com) from 2005 to today. I then looked at those banks performance in the first three years after IPO, years 3-5, and an overall performance (IPO to 5yr). I also looked at how many were acquired, how long it took for them to be acquired, and their performance.

A few caveats: this is an "in bulk" analysis - glossing over the vast differences between all of these banks. It also ignores the differences between 1st step conversions (to a Mutual Holding Company structure) and 2nd step conversions (from MHC to stock company). Also, there is some survivorship bias. I wasn't able to get price data on every single bank (the farther bank you go, the worse my data capture became).

For ease of comparison, I grouped them by year - creating Thrift IPO vintages. See the following table.

A few takeaways:

• From 2005 to the end of May 2020, the S&P 500 total return was 8.4% per year. Thrift IPOs (assuming you held for 5 years and kept rolling your portfolio into new names) returned 6.7% per year [in fairness, this is a price only return - dividends may have added to the performance]. Right off the bat, we're behind just buying an index fund.
• Thrifts, like most all of the market, are subject to cycles. Buying vintages 2005-2009 (IPO'd into or during the Financial Crisis) did very poorly. Vintages 2010-2014 did very well. 
• Whether by cause or effect, the 2010-2014 vintages had very high acquisition rates. In a strong economy acquirers were looking for solid deposit bases and growth opportunities. 
• In recent years (vintages 2014-2016), you would have done better buying new IPOs and holding for three years. Historically, however, that trend reverses, and you would have done (marginally) better buying seasoned banks three years after IPO (opening the acquisition window). 
• There is some (limited) evidence that buying seasoned banks after a drawdown may have merit. The 2007 & 2008 vintages recovered nicely from the Financial Crisis in years 3-5 of their lives. 
• 37% of all thrift IPOs are eventually acquired, but the average time from IPO to acquisition was 6.9 years (or 3.9 years from when the acquisition window opened). 
• If you can identify the acquisition targets (a very big IF), their average return from year 3 to acquisition was 17.5% annually for an average of 3.9 years. 

Bottom line:

• Understand the banking cycle. There is a delay between when the banking cycle turns up, and outperformance in Thrift IPOs (due to them being acquisition targets). This is evidenced in the vintage 2010-2013 IPOs. They saw their best performance in the calendar years 2013-2016 as acquirers sought them out. Put another way, momentum for the whole community bank complex matters.
• Valuation and fundamental analysis are important. Buying the whole complex may work in certain instances, but it needs to be paired with attractive valuations and strong fundamentals. You need to understand the bank, its geographic region, and management incentives. 
• Perhaps the biggest takeaway is that each of the strategies listed above: buy them all, focus on takeover candidates, follow the activists, etc., may each work at different points in the cycle. Be adaptable and disciplined enough to adjust for economic circumstances. Be willing to walk away from the sector when the stars don't align (and conversely, be willing to build positions when they do). 
• I think there is value in going back and studying each of the banks that have been bought out over the last 15 years - I will add that to my research list. 

If you have any other historical or quantitative evidence on thrift conversions and trading strategies, I would be happy to discuss. Thanks!



Harvest Investor © 2020. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Bayer: Forget about Monsanto

In 2012 (using the year ended 6/30/12 data), Microsoft was trading at 12.5x trailing earnings of $2.00. And this didn't account for the $7.16/share in net cash they had on the balance sheet. Net that out*, and shares were trading at 8.9x earnings.

The concern at that time had to do with the Windows segment. iPhones, Apple in general, and Androids were all chipping away at the once dominant Windows operating system. Would people even be using desktops in the future?

To account for this, I decided to net out the Windows segment from operating earnings - pretend it didn't exist. So I took full year operating income of $21.7B and subtracted off $11.9B to get $9.8B in ex-Windows income. Adjust income taxes (proportionally), and you're left with $7.9B in net income, and EPS of $0.93.

Without Windows, Microsoft was trading at 27x earnings. Adjusted for cash*, the company was trading at 19x earnings, which wasn't bad considering the growth potential of Servers / Cloud. I was very confident that Windows was worth more than $0 to the operating income line, so this analysis gave me the confidence to continue holding my MSFT shares (which I had bought in mid-2009 and was becoming disgusted with by 2012).

While this type of analysis - looking at a company's weak point and leaving it for dead - is just a form of semantics, it helps me get my hands around the fundamentals, and is also a way to make sure it really is an attractive valuation.

Today, I'm seeing a similar situation in Bayer (BAYN.DE, or the ADR in the US BAYRY). Bayer closed on the acquisition of Monsanto in the summer of 2018. Almost immediately, they walked into the glyphosate (Roundup) buzz saw when, in August 2018, a California jury awarded $289 million in a single cancer lawsuit.

To say this has weighed on Bayer's share price is an understatement. Since summer 2018, shares are down -40%. The market cap of the entire company is now 62B euros ($68B), which is roughly what they paid for Monsanto.

So here is my thesis on Bayer: remove the crop science unit (mostly Monsanto) - assume it goes to $0 EBITDA. 2019 EBITDA was 11.5B euros. Crop Science was 4.8B euros, so net (Pharma and Consumer health) EBITDA was 6.7B euros.

Enterprise value is 97.5B euros (61.6B market cap, debt of 39.1B, cash of 3.2B).

This is an EV/EBITDA (netting out the companies larges division - Crop Science) of 14.6x. Compare that to another health care company with three large divisions: Johnson & Johnson (Pharma, Consumer, Medical Devices), which is trading at an EV/EBITDA multiple of 14.0x today (Glaxosmithkline is at 11.6x, while Novartis is at 13x)

Today we can buy legacy Bayer for the same value as Johnson & Johnson, and get Monsanto for free.

While Bayer has been cheap for a while, what really got me interested was the announcement recently that they are in talks to settle 40-70% of the outstanding 125,000 glyphosate lawsuits. I think this is a major step forward for the company.

Also, anecdotally, none of the farmers I talk to are overly concerned about the cancer risk of glyphosate. Most view it as a chemical used to kill living organisms (plants), so of course you need to use precautions. But on the whole they continue to use it as a primary weed control device. Their biggest complaint isn't the cancer risk, but the fact that they've used so much glyphosate over the years that weeds have built up an immunity to it, and they're being forced to use other, more dangerous chemicals (like Paraquat).

Caveats:

• I don't view Bayer as on par with JNJ. JNJ's Consumer division has better brands that Bayer does. It may not be the best comparable stock.
• Bayer is a pharmaceutical stock. I've read up on their patents, pipeline, and portfolio. Most seem to think it has good potential, but let's be honest - I have no idea what I'm talking about on the pharma potential. 
• The company will have major litigation expense going forward. Maybe Monsanto is worth less than $0? That's a risk I'm willing to take. 

Bottomline, I think Bayer is trading at too steep a discount for the quality of their underlying assets and earnings potential. Happy to hear feedback.



*I'm not a big fan of doing net of cash valuations as, in my experience, $1 cash is rarely worth $1 of share price, but I'll break my own rule in this example.



Harvest Investor © 2020. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.