Adult Swim Continues


Last month KKR & Co. (KKR) celebrated its 40th year of existence. In that time the firm has grown from a three-way partnership of Henry Kravis, George Roberts and Jerome Kohlberg with $120,000 of total capital to a private equity and alternative asset management behemoth with over $120 billion in assets.

Bloomberg recently had an excellent interview with Henry Kravis and looked back over the past 40 years. In the interview, Kravis said that over the years the firm made some mistakes by not paying any attention to macro developments.

While valuation is still the overriding factor when KKR makes an investment, Kravis believes the firm needed to be aware of the macro situation, too. “About five years ago we set up a macro asset and allocation group, which has been invaluable and made a huge difference in how we think,” Kravis said.

This can help us frame how we think as well.

Henry H. McVey is the Head of Global Macro & Asset Allocation for KKR and his outlook is regularly published on the firm’s website. Back in January we looked at KKR’s forecast for 2016 and it was pretty accurate predicting slower global GDP growth, so I was anxious to read the firm’s recently released report, Adult Swim Only: 2016 Mid-year Update.

KKR remains cautious saying, “At the risk of being labeled Master of the Obvious, today’s macro backdrop, which includes high P/E ratios on stocks and low yields on bonds, appears an extremely challenging one for investors looking for outsized returns in public markets.”

The firm doesn’t see much potential ahead for returns in the stock market. McVey notes P/E ratios are very high, and that the broader market’s ratio has increased 51% since the market bottom in 2009. He is also not upbeat about the potential for earnings growth and suggests we may see multiples contract on stagnant earnings.

The report observes that valuation measures such as P/E, price-to-EBITDA and price-to-sales are in the 90th percentile of their historical ranges and the market is fully, if not over valued at current levels.

Streaks of seven or more years of positive S&P 500 returns are extremely rare and we are probably overdue for a bad year in stocks, according to McVey.

KKR continues to favor credit over equity in the current environment. “Within Liquid Credit, we generally favor Levered Loans over High Yield, though we acknowledge one must be flexible in the current environment of heightened volatility. We also like the flexibility we have through our new five percent position in Actively Managed Opportunistic Credit to pursue periodic dislocations and/or niche areas that might be overlooked by traditional benchmark seeking mandates.”

This bodes well for business development companies and levered loan closed-end funds in the second half of the year. It also makes Blackstone/GSO Strategic Credit Fund (BGB), long a favorite of Real Money Pro’s Doug Kass, a solid choice.

KKR likes real estate assets with the potential for yield and growth, especially non-core assets with the potential for improvements. It favors those situations with a flexible capital structure as well. As individual investors, we can capture those types of situations with Apollo Commercial Real Estate Finance (ARI), Colony Capital (CLNY) and Brookfield Property Partners (BPY).

McVey does not expect to see a major global correctional as much as a period of low returns. He looks for the economy to muddle along until late 2017, early 2018 when he expects a mild global recession. The biggest market risk right now, according to McVey, comes from the potential for excessive debt creation in Europe or China as well as “mounting geopolitical risks.” He notes that we are seeing unprecedented “splintering of political harmony” around the world, which presents some risk to the global economy and markets.

As you can tell, this is not an upbeat outlook. McVey believes simplicity is overvalued right now and that remaining opportunities lie in complex and idiosyncratic situations. He thinks that, barring any shock, the global economy will just continue along at a very slow pace, which is very much in line with my “better, not good” outlook on the economy.

McVey suggests that more volatility is likely in the future and that public market valuations are full and returns on capital have probably peaked.

In his conclusion McVey writes “…Are we being too cautious? We do not think so; some selectivity seems required after 84 months of economic expansion amidst rising geopolitical tensions. Maybe more, though, is our view that the investment community now better understands that lower rates and more stimulus suggest slowing nominal growth and low returns now lie ahead.”

KKR is one of the most successful investment and private equity firms in history. It has a very cautious view of the world right now and investors would be wise to follow their lead in these turbulent times.

Banking Done Right


Originally Published on

As I was doing my “ready for the weekend pizza and vino” run last Friday, I got a ring and checked my phone to find a very interesting email. John Allison, CEO of Home Bancorp (HOMB), let me know that he thought I was unfair to his company when I suggested the stock was too rich to buy at current levels. He is the founder and largest shareholder of the bank and he reminded me that it has been the fastest-growing community bank since 1996. Allison is one of the best bankers on the planet if you measure his performance by return on assets, efficiency ratio and growth rates, so I agreed to talk to him the next day and hear his side of the story.

It’s a really good story. Allison got his start in banking when he was appointed to the board of a small local bank, First National Bank of Conway, in the 1980s. Shortly after joining the board, he teamed up with some fellow shareholders and bought the bank and was named chairman. A few weeks later, the bank got a memorandum of understanding from Federal Deposit Insurance Corp. (FDIC) regulators for poor policies and credit issues. He told me that he rolled up his sleeves and dove in head-first to fix the issues and it was the best thing that ever happened to him. He learned the ins and outs of the banking business in the process, and the rest, as they say, is history. In 1985 the bank was sold to First Commercial at a decent profit and he joined the board at the new bank.

While at the First Commercial, he led a team that worked to buy Texas banks and assets during the late 1980s oil bust. They were very successful in working with the Resolution Trust Corporation to do profitable deals and they grew the bank by hundreds of millions of dollars. First Commercial eventually was sold to Regions Bank in 1998 for a staggering 4.11x book value. Later that year he joined with Robert H. “Bunny” Adcock, Jr., to buy a bank in the booming metropolis of Holly Grove, Arkansas, that had about $25 million in assets. They moved the charter to Conway, Arkansas, and today the bank now known has Home Bancorp is a $9.6 billion banking organization.

Mr. Allison explained the process to me. He said he was not looking to buy healthy banks as they expanded. They wanted to buy broken or poorly performing banks and fix them. The opportunity to make big money, he said, was in buying bank with a 0.5 return on assets and getting it up to a 1.5% or 1.75% ROA. He will not and has never done a dilutive deal. If a deal does not have the potential to significantly move his earnings-per-share needle, he simply won’t do it. If the target bank won’t do the deal on his terms, he moves onto the next one. He is openly scornful of banks that do dilutive deals and overpay for target banks.

As we talked it occurred to me that John Allison and I were doing he exact same thing with community banks. We are looking for underperforming banks that really need to sell and then invest in them in hopes of a high rate of return. I am looking to get there first and then hopefully sell them to Allison and other acquisitive bankers, but out approach is basically the same.

Then he said something eye-opening. Allison said as banks move up to and over the $5-billion asset mark, the price-to-earnings ratio and EPS growth rates are far more important than price to tangible book value. I can tell you that I really wish he hadn’t said that because John Allison is a very successful banker and knows more about banking than I ever will. I can’t just dismiss his remarks out of hand and cling to my “book value only” beliefs. I am going to have to clear some time on my schedule and test banks of a certain size based on growth rates and P/E ratios. I suspect that I will find he is right and I need to adjust how I look at the larger banks in the future.

He then rattled off a long list of banks that trade at higher P/E ratios than his but have much lower ROAs and higher efficiency ratios. Based on that list he thinks his shares are undervalued relative to the rest of the industry. He backed his opinion up with cash, as his earlier this year he exercised his option on more than 100,000 shares and simply kept the stock.

He thinks the future remains bright. His company is looking to do more deals in Florida and he says he has a team on the ground there ready to go when he finds a new acquisition and comes to terms. He told me his ROA right now is about 1.7% and he sees no reason he cannot work that up to 2% before too much longer. The already-efficient operation is looking to improve further and he is targeting a 35% efficiency ratio compared to the industry average of right around 60%. He told me that everything he does will be in shareholders’ best interest and I believe him, because he and his family own 11 million shares of Home Bancshares and are the largest shareholder.

Did he convert me? Almost, but not entirely. I would break out in hives if I paid 3.8x and 18.9x earnings for a bank. However, his bank is priced at a discount to peers that do not perform as well as his does and could be considered cheap compared to similar institutions. I also think his size and valuation argument makes a lot of sense, and if we see a sector and/or market decline that brings the stock to a P/E of 15 or so I might get hives if I don’t buy it at that level.

After speaking with Mr. Allison I knew I had a bunch of spreadsheet time ahead of me. His suggestion — that as a bank moved up in asset level, its price-to-earnings ratio and performance became much better valuation factors than price to book — made sense to me at some level.

I have never really thought about the idea, as I have always done just fine buying smaller, underperforming banks and then selling them to the high performers for a lot more than I paid. However, when you have been around as long as I have, you know there is more than one way to skin a cat — and Allison has made a lot of money in banking, so I needed to test the idea.

The data suggests that he is correct. Buying a portfolio of higher-performing banks, as measured by return on assets, that have strong, recent earnings growth, does indeed beat the market. I looked at banks with 15% earnings growth and returns on assets over 1.5%, with P/E ratios less than 20. You outperform very nicely over the 15-year period, and crush it over the last five years.

Looking at a 10-year period, you lag the market a little, because you really get killed in 2007 and 2008 before rebounding very strongly in 2009. From 2011 fonward, this approach outperforms the market by 60%. Buying the highest-performing banks does offer market-beating returns over time, but it can be a bouncy ride.

We can markedly improve results by “Timming-up” the approach, a little. I took the top-performing banks with strong earnings growth and then limited my purchases to just those with a P/E ratio of 15 or less, and a price-to-tangible-book-value ratio of less than 2. Returns improve dramatically, and they do so in my favorite fashion. The portfolio does much better in 2007 and 2008, and this improved defence allows the model to outperform over the five-, 10- and 15-year timeframes. Over the past five, the model has outperformed the S&P 500 by about 70%, as banks have recovered from the credit crisis.

The current screen of reasonably valued, high-performing banks has some interesting names on it. BankUnited (BKU) has done a nice job of growing earnings and share price since it was recapitalized during the credit crisis. At 1.43x book value, the stock would not usually show up on my radar screen, but with an ROA of 1.15% and 30% earnings growth over the past year, the stock makes the grade under this approach. The P/E ratio is just 13, so the stock passes the growth bargain test.

I am bullish on Florida banks in general, and BankUnited has been one of the best-performing banks in the Sunshine State over the past few years. You get paid to wait for growth with this stock, as BankUnited shares yield 2.66% at the current price.

Porterville, CA-based Sierra Bancorp (BSRR) makes the grade as a growth bargain bank, as well. The bank has been making whole bank and branch acquisitions lately, and it is paying off for them. Earnings have grown by about 17% annually for the past five years, and are up 23% this year.

The bank is reasonably priced — at 120% of book value and 12.5x earnings. The bank is earning a ROA of 105%, right now. You get a decent dividend with this stocks as well, as the shares yield 2.79% right now.

I was delighted to see that Hoquiam, WA-based Timberland Bancorp (TSBK) made the list. I originally bought this bank as a book-value bargain, and have been delighted to see than management has grown book value – and the book-value multiple has been increasing.

Earnings are up 45% this year, and have grown by more than 30% on average over the past five years. The return on assets is 1.23%, so they are performing much better than many of their small-bank competitors. In spite of the excellent performance, the shares trade with a P/E of just 11, and are at 1.3x tangible book value.

Allison is correct that you can pay a higher multiple of book value for banks that are top performers with strong earnings growth and high ROAs. While his bank didn’t make the current list, a little digging showed that Home Bancshares was a growth bargain right before the shares took off on a strong run — which has seen the share price almost quadruple.

The biggest takeaway from myconversation with Mr.Allison was that his approach to growing his Arkansas-based bank is a total validation of my process in picking small-bank stocks.

Allison told me that the way to make money was to buy the broken and underperforming banks, fix them up and increase their profitability. That’s almost exactly what we are trying to do as investors.

We are looking for underperforming banks trading at bargain prices with the intent of profiting when they begin to grow assets and earnings, or as is often the case, throw in the towel and sell to a larger financial institution. Both outcomes are profitable for us as outside investors, and we try to tip the odds further in our favor by focusing on those names that have activist investors pushing for profit and stock price increases or a sale of the bank.

When I look at this approach and crunch the numbers it is by far the most effective method for individual investors to use when investing in bank stocks. Buying banks with a lower-than-average return on assets (ROA) when the shares trade below book value outperforms the market over the five-, 10- and 15-year periods.

During the credit crisis this approach outperformed by being primarily in cash. At the end of 2007 there were almost no banks trading below book value. Bank deals were taking place above 2.5x book value, credit conditions were deteriorating and any bank investor with an ounce of prudence, caution and common sense was in cash. Since the crisis returns have accelerated and I expect that trend to continue as the pressure to grow or sell becomes even more intense.

When I ran a screen looking for banks with below-average ROAs that trade below book value, there are still plenty of candidates for a “trade of the decade” portfolio. My most recent purchase, Green Bancorp (GNBC), has bumped up a little in price but still remains attractive. The Houston-based bank has an ROA of just 0.43% and the shares are trading at just 95% of tangible book value. Green has private equity ownership of 13% and I can promise you that the three firms that control that 13% are looking to get paid off with a much higher stock price over time. CEO Manny Mehos has started, grown and sold a bank before and I suspect that is his eventual end game for Green as well.

I have owned Eastern Virginia Bancshares (EVBS) for a while and been pretty pleased with the results. It hasn’t been spectacular, but EVBS has provided a solid return and it has done a nice job of expanding its presence in both the Tidewater and Richmond markets. The bank has made some smart acquisitions and is working to get asset levels to the point it can achieve the scale needed to increase profitability. And EVBS has plenty of incentive to keep growing or consider selling as Wellington, FJ Capital, Castle Creek Partners and PL Capital are all significant shareholders.

The bank is making solid progress. In its most recent earnings release CEO Joe A. Shearin pointed out that “For the first quarter of 2016, as compared to the same period of 2015, we are reporting an increase in net income available to common shareholders of 60.3%, an increase in annualized return on average assets of 22 basis points to 0.70%, and an increase in annualized return on average common shareholders’ equity of 271 basis points to 8.34%.” The stock is still a bargain at just 91% of tangible book value.

When I ran this screen I came up with 123 candidates. But only 20 of them have market caps of more than $100 million. To participate in the big gains I see developing in community bank stocks you have to think small. It is the smaller banks that will sell out at a profit, so you need to give up any high-tech dreams and medical miracle expectations you might have when trading larger-cap stocks in order to participate in the trade of the decade ( I may need to change this to trade of the half-century).

There are no sure things in investing but buying a small bank in sound financial condition with a lower-than-average ROA and at least one activist shareholder is about as close as I think we will ever get.