A Conversaation With Ed Thorp


Alright, let’s get started here. We’re on today with Edward Thorpe, who’s got a brand new book out, “A Man for All Markets.” That’ll be out in January. And as I went through the book, you’re really considered to be one of the fathers of quantitative investing, which brings up a certain picture of a guy with a bunch of computers trading wildly. But as I go through the book, you really have a tremendous Warren Buffet kind of Ben Graham influence on your approach to investing. Can you talk a little bit about that? Because that really surprised me.

ET: Sure. I came at the securities markets without basically any prior knowledge and I educated myself by sitting down and reading for all of two summers, anything I could lay my hands on and began to get oriented and then I discovered how to evaluate warrants, at least in an elementary way, and I decided that was a way that I could apply mathematics and logical thinking and maybe get an edge in the market. So then I focused on it and it turned out to be correct. I was able to use the analysis of warrants to get an edge on other people.

T: Okay, and then, so you weren’t trading like a mad man, like what we think of quants today. You were setting the trades and letting them run, right?

ET: Yes, initially it was slow trading, we’d put on warrant hedges and watch them and every so often, if there was a big move in the underlying stock, we’d change the ratio of warrants to stock. And then that evolved into revertible bond trading and we did pretty much the same thing there. We means my co-author, Sheen Kassouf and I, we wrote a book about it called, “Beat The Market” that came out in 1967, in fact. So, then we both went on to careers managing money. I started a hedge fund in 1969, after meeting and talking with Warren Buffet for a while in 1968. He’d been running a hedge fund for about a dozen years, and he was just shutting down. And turned out that stocks were at manic highs then. Which is why he was shutting down, and for me, it didn’t matter because I was putting on market neutral hedges. Something people hadn’t been doing before.

T: Yes, by the way, please do not ever authorize a re-issue of that book.

ET: Because?

T: I have supplemented my income for the last, I’m gonna say 15 years, by finding copies of that book and Seth Klarman’s book at book sales and used bookstores, buying them for a buck or two and selling them for 50 or 100 times what I paid for them. I’m usually able to pull that off once a year.

ET: I’ve seen prices as high as $2,000 or $3,000.

S1: Yeah, I just saw it on Amazon for like $1,900, which is remarkable. The only other one I’ve seen higher is Seth Klarman’s “Value Investing” book, which is now I think trading at around $4,000 for a copy.

ET: Oh, I probably got one around here, I’d better take good care of it.

T: I had a copy for years, saw what it was selling for, then about $1,200, downloaded a PDF and sold the book.

ET: That’s funny.

T: Speaking of PDFs, I’ve got one around here of the “Mathematics of Gambling.” And every time one of my friends, ’cause a lot of my friends are traders, and they have a propensity to gamble, every time they tell me about their new system I just run off a copy and give it to them.

ET: Oh, that’s nice.

T: I think I’ve saved them some money over the years.

ET: You probably saw in my new book there’s a section about the Blackjack Ball in Las Vegas?

T: Yes, yes.

ET: So the kind of people that you’re talking about gather there once a year and have a really grand time.

T: I can only imagine.

ET: There’s about a hundred people who come, and I think the average net worth in the room is about $10 million.

T: Wow. Every trader I’ve ever known has a thing for gambling, even the most statistically oriented guys will end up at the race track betting the long shot of the day at impossible odds. It’s the craziest thing I’ve ever seen.

ET: Well, that’s kind of how I got into the stock market, because I first got interested in gambling as you know, and there are a lot of things that are similar about the two. The way you manage money for example, and the way you sit down and if you find a system that you’re sure is right, you stick to it. People have trouble learning that, but if you have a training at the blackjack tables to start with, it’s an amazing education to get you ready for the markets.

T: Now, I had this question slated for later, but you brought it up, so I’m going to slip it in here. When you’re sizing trades and managing money, you talk a lot about using the Kelly criteria. Now, in the Kelly criteria, and this is something I’ve always wondered because I don’t have the deep math background of a lot of guys, but in the market, it’s really hard to define the percentage of the edge, but that’s a necessary component of calculating the proper size bet with the Kelly criteria.

ET: That’s correct.

T: How do you do that?

ET: What you have to do is, you have to make your assumptions more conservative to give yourself a margin of safety. And one of the things about the Kelly criteria, if you take the case where you can in fact calculate the odds exactly. In that case, if you were to back off and only bet half as much, you’d grow at about three quarters the rate you’d grow at if you had the full Kelly bet down. So you can give yourself a pretty good margin of safety, by just backing off to let’s say, half the Kelly bet. So, that kind of thinking, if you apply it to uncertain estimations of the odds, you can say to yourself, “Well, if I’m off in calculating the odds by a fair margin, if I back off in the amount that I bet under the Kelly system, one of two things will happen. If I were right in calculating the odds, I’d maybe grow at three quarters of the rate that I would if I put the full Kelly bet down. But if I were wrong, then I might end up having a full Kelly bet down, but the odds would only be half as good, let’s say, or two thirds as good as I thought they were.” So, by backing off to a half Kelly you give yourself a big range of protection, and of course, this isn’t an exact rule, if the uncertainty is very large you might want to back off even further. So you give yourself a margin of safety on top of everything else.

T: Okay, now I’m going to go back and try to recalculate using some of my bank stocks later where I can come within a range on the edge. I’ll shoot you an email, let you know how it comes out. Because that’s always been a huge question for me was, okay, I know I’ve got an edge, but in order to use Kelly to size it, how do I… It’s not a definable edge that much, but okay. In the book you talk a lot…

ET: As far as Kelly itself, for people who are really quantitatively oriented, I edited a book called “The Kelly Capital Growth Criterion” with two other people, Leonard McLean and William Ziemba. That came out in 2010. And it’s 700 pages of academic papers about the Kelly criterion and commentary and explanation that we put in the text. It’s put out by World Scientific, so anybody who really wants to dig, can go get that book.

T: You don’t have to dig, it’s available on Amazon right now.

ET: Yes.

S1: So no digging required.

ET: Do you have it?

S1: I do not have it, but I checked before we started this call to check prices of “Beat the Market” to see where it was today and I did happen to notice the book.

Now, in the book you talk a lot about statistical arbitrage, I know you stopped doing it in about 2002, according to an interview I read.

ET: Yes

T: But it’s a term that’s used a lot. I don’t think anybody really knows what it means that’s not in the business. Could you kind of describe that a little bit?

ET: Sure. As you actually will have seen by reading my new book, “A Man for all Markets”, the idea was discovered by us back at either December 1979 or January 1980. The reason why I’m not sure is because I was on vacation while it was being discovered, I’m not sure whether it was the end of the month or the beginning of the next month. But in any case, the root idea was a researcher discovered that if you took the stocks that had been the worst performers over the last two or three weeks and bet on them, they would tend to outperform over the next two or three weeks and the reverse was true too. The stocks that were the best performers over the last two or three week would underperform over the next two or three weeks. The stocks acted as though they had some unobservable true value that wandered along some unknown curve, and they set a range back and forth around this curve, and followed it. Sometimes demand would push them up too high, for a while. And sometimes supply would push them too low for a while.

ET: And so he ran a simulation where he bet on the 10% that were the most up for the last couple of weeks, and sold them short. And then bought the ones that were the most down for the last couple of weeks, and set up a hedge portfolio. Now you might say, “Where’s the hedge?” Well, if you have a diversified pool of stocks that are kind of randomly chosen, they’ll tend to track the market. So the ones that were up the most, we would short, and that group tended to track the opposite of the market. That is, it would tend to move as though you would short the market. On the other side, we had a pool that were long and they tended to track the market. So when you put them together, the long and the short sides, the market effect was pretty much cancelled out. Now, of course, there were a lot of other effects, all these stocks were traveling around their own random way around their market factor or market component. Well, we got rid of the market part. So we said, “Gee, this is an interesting new source of profit.” And it’s a statistical play, but it’s kind of… It’s really hedging. Arbitrage and hedging tended to become synonymous even though arbitrage originated for situations where you really have a locked-in profit. Whereas hedging describes situations where you had a pretty good expectation of getting rid of a large part of the risk, but it wasn’t certain that you were going to make a profit.

ET: So in any case, we looked at this and found out that it was somewhat riskier than the other things that we had in our portfolio. Even though it was making about 20% annual life. So we put it aside. And then as I tell in, “A Man for All Markets,” somebody at Morgan Stanley came across the same idea about two or three years later. And Morgan Stanley turned it into a very profitable product. And then that person was disaffected by his treatment at Morgan Stanley, he happened to answer an ad that we had put in the newspaper looking for people with good quantitative ideas. I interviewed him. I saw that what he had done was very much like what we had done, only he had improved it a notch because he used groups of stocks in a single industry separately, to set up these long short hedges. So the upshot was we went into business with him, it worked very well. And it did find… Through the crash of 1987, for example, made money during that terrible down day. Then it began to lose some of its power as Morgan Stanley and others spread the idea and also put more money into it. So, we devised a new method that got rid of not only the market factor, but lots of other things, oil factor, interest rate factor, that sort of thing. And that ran just fine.

ET: And then, as I describe in my book, Princeton-Newport partners shut down at the end of 1988, the beginning of 1989. And I took a time off. Then I heard that people who were continuing with the idea of statistical arbitrage, were doing quite well. So, I set up shop here with just two or three people helping me in 1992 and we had 10 good years running it. Then I decided I didn’t need to work that much anymore. So, I retired again. But anyhow, that’s the root idea and it had a huge impact on the markets, because it’s a natural seque into the idea of high frequency trading. The reason it’s a natural seque is because you have computer fees of the stock ticker. So, prices are pouring into the computer continuously, all day long for statistical arbitrage. Then the machines are recalculating what to bet on, and how to modify the portfolio. So, once you have a high speed data feed that you’re processing all day long. You begin to think, “Well, are there other ways to trade to this data feed, besides putting on trades that are on for an average of ten days or so. And you begin to look for patterns that are shorter. So there’s a natural segue then into high frequency trading, you’ve got all the equipment, all the background and so forth. And I think that’s probably how people got into high frequency trading.

T: That makes a lot of sense. Now, you did a lot, as you went past just the warrants. You found a lot of things that you found and revealed and beat the market also worked in the listed options market. Buying an undervalued stock and selling an overvalued option against it. Would that still work today?

ET: I would say yes, but probably the barriers to entry are very high. Probably the spreads are mostly very small, and so you got to have low cost, you’ve got to have computers, you got to have data feeds and so forth. So just seeing what I’m seeing at home looking at things isn’t going to be able to make much headway I don’t think. But somebody in a big hedge fund that could well be a profit center.

T: Now speaking of the guy sitting at home. Is it, and you addressed this in the book, but I think what you had to say was pretty important, so I’ll bring it out, is it worth the extra effort to try to beat the market today?

ET: That depends on the person. That’s an interesting question. I think to myself, “Gee, if I were 25 and I got interested in this, what would I do?” And I’m not sure, but for what I know now, I’d say the Warren Buffett way is a good way if you want to put your whole life into it. I’d probably decide not to want to put my whole life into it. Now Warren loves it so much, that’s all he’s ever done since he was a little kid. And it’s day in day out. So I would say if you wanted to get really rich and you wanted to spend your whole life, trade your whole life for getting really rich, a trade I don’t necessarily recommend, then I’d say that’s the way to go. But if you just want to make lesser amounts of money, I don’t know what to tell a person at this point because you can do so well knowing nothing in the market.

T: Just by indexing.

ET: Yes. Just sitting there passive index investing. Or like I’ve done, buy a big chunk of Berkshire Hathaway and sit and just watch it.

T: I tell people that. I have a column that I write, it’s daily on RealMoney.com and I’ll often say, “I want you to buy this, put it in a drawer and don’t look at the quote again.” And people say, “You’re crazy.” I’m just say “No, I’m not. Reinvest the dividends. Come back in five years. Let’s talk.”

ET: And people say, “Gee, what if your Berkshire goes down?” I say, “Oh, that’s good because now I can buy more.” They say, “But what if it goes up?” I say, “Well, that’s good too because I feel good because I feel suddenly richer.”

ET: So let it go up or let it go down. I don’t care.

T: In the book, you talk about a way to beat the market that you used at Princeton-Newport and that I still use today and that’s buying deeply discounted closed-end funds and allowing the discount to narrow. Have you considered that much in recent years?

ET: I’ve thought about that and I think you can probably make,I don’t know if you’re doing it better than I, but my experience was long ago when there weren’t people tuned into this as much, you could maybe make 15 or 20% a year pretty safely. Well, later it got down to about 10% a year and then I kinda lost interest.

T: Our research shows that if you track an activist right in behind the first 13 day, let him do the activist work. You’re still up at 15% plus mark so. You say it’s widespread and while that’s true among those of us that follow the market more people know about it then back when you were doing it at Princeton, the average guy has no idea. Now, another one of my favorites and I know that as recently as 2014 you were still doing it, but are you still doing the thrift conversions?

ET: Yes. We’ll be doing one in a few days actually.

T: Now you actually do the deposits, don’t you?

ET: Yes.

T: We buy the aftermarket and you still you do a little bit better than us but…

ET: But you have less work. You just wait.

T: I just wait for like the third day trading. There’s still liquidity and I’m still buying it at 75% a book. And then again at the end of the three year period, which is the change of control period. We come back and revisit them again and we look at price to book and as with closed-end funds at that point, we want to know who else owns it.

ET: And what allows you to buy in the after-market and make an excess return are the flippers.

T: Yes.

ET: They sell too soon and they keep the price down for a while.

: I’ve never understood why a guy would go to all the trouble of depositing all that money all over the country and then flip it in three days for 25% when if you hold another three years you’re probably going to double your money.

T: Yes.

T: It’s always been a puzzle, but I love those guys. They make things so easy for me.

ET: That’s true.

T: Alright, just a couple of other things, and these are, by the way, not just market related questions they’re just,If we were having coffee together and had unlimited amount of time these are things that I would probably ask you.

ET: That’d be a lot of fun.

T: The part about, in the book, in the early part of the book, you were such an intellectually, inquisitive child and pulled remarkable stunts. I love the one with the flare in the balloon. That just cracked me up. But as a parent and as an educator over the years, is there a way to bring out that natural intellectual curiosity in a child?

ET: Well, I can tell you what we did with our kids and it seemed to work. We made dinner time a special time, when everybody got together, nobody had any devices, or other activity or distractions. We all sat down, we talked about whatever was on anybody’s mind. So the mean teacher at school, the bully, whether or not there’s a God, whatever came up. The logic behind climate change, or the arguments against it, and so the kids learned to think for themselves. And this power of thinking for yourself is really formidable because it enables you to do many things. Whereas people who don’t do their own thinking kind of have to key off other people to try to figure out what it is that they should be doing. They basically follow the crowd. So that was one thing. The second thing is that we try to give our kids opportunity, so they had choices, but we tried not to steer those choices. So just because I’m a science, math, gambling stock market type guy, doesn’t mean that I try to steer my kids that way. So one kid became a hedge fund manager eventually, one kid became an architect, and one became a district attorney. So they went their separate ways, they’re all smart. So they inherited that outlook, and they treated their kids that way. So their kids have turned out to be amazing. One girl has triplets, they’re all sophomores at MIT.

T: Okay, that’s impressive and also a very large bill.

ET: A very large bill, yes. Luckily, my activities could cover it.

T: Okay, I was kind of curious about that, because I know that, as a parent myself, that’s been one of the challenges, is to get them to be as intellectually active as you know they can be. So I just wanted to hear your thoughts on that.

ET: I was having an email correspondence about this with Paul Wilmott. Do you know who he is?

T: Yes, I do. I read his publications and understand about 25%

ET: Okay, great. Anyhow, he’s a very smart guy, he lives over in a priory in rural England, but he was a PhD in mathematics, and then started this magazine, Wilmott, a finance magazine, for which I occasionally write a piece. We were discussing raising up children because he raised the same question you did. He said, “Well, I and my wife Andrea were left on our own, and we turned out fine. We just explored and taught ourselves like you did. But our kids are pretty busy, and there’s various things that one can schedule them for and they can do them, so I’m wondering whether that is a good thing or a bad thing.” And so I told him, “It works either way.” I was like him, left on my own to explore and figure things out, just because my parents had no time. They were busy working in war industries then. They were sleeping all the time, or working and that was it.

ET: On the other hand, with our kids, we didn’t exactly schedule them, but we gave them opportunity and encouraged them. And then they had a lot more scheduled activities for their kids: Soccer, Chinese, music that sort of thing. So their kids were a lot busier. But it works either way. The important thing I think is not to try to live again through your children, not to try to make them be like you, but let them just be whatever they want to be, and do what they enjoy doing. My experience was if you do what you love and you just follow that, it will work out.

T: You talked about that several times in the book. In fact, I have passages underlined. You attribute a lot of your success as an investor because you did it not just for the money, but for the love of the mathematics behind it. And at one point, you say that you… Hold on, it’s right here. Your discoveries fit in with your life path as a mathematician had seemed much easier. Leaving me largely free to enjoy my family and pursue my career in the academic world. So you weren’t 18 hours a day bent over a screen. You were enjoying your life, because you enjoyed the work. Not because it was finance, because it was math.

ET: That’s exactly right.

T: I love that quote, because that’s something I tell people all the time, and again I get that crossed eye funny look. And I just tell them I say, “I’ll put my returns up against you every day, but I work a fraction of what you work.” And they don’t think that’s possible, and you are a living proof that it is in fact possible. Now 1948, you apparently spent the entire summer sitting on a beach reading 60 novels that you considered to be classics. Did that make a big impact on the way you thought, the way you approached the rest of your life, because it sounds really cool, it’d be a great thing to do .

ET: I would say yes. It gave me… I’d call it maybe more of a philosophical and humanitarian perspective on life. And it made me think about the big world of society, politics, history, geography and so on. And it gave me a framework for putting things in their place.

T: You talk a lot also about the importance of education, and your concerns about the future of education. Can you talk about that a little bit? Because that’s a huge area of concern of mine as well.

29:58 ET: Yes. I think of education as a lot like the seed corn for society. And if people are willing to pay for it, if they’re willing to be taxed and if they’re willing to build a good educational system, then I see that the minds that are generated out of that will apply tremendous leverage to society and society will grow and advance much more rapidly. And many good things will happen and get done. If you had a society that was devoid of education, it would just sit in place and do nothing. It would be the same thing decade after decade, perhaps century after century. It would be like the perhaps inaccurate image that we have of the dark ages where nothing much happens.

ET: So in a place like California, for example, they made a terrible mistake back in 1978. They passed something called Proposition 13, and I mentioned that briefly in my book. What that did was bust the state budget. So the biggest component of the state budget is education. So that of course was going to suffer. And so education has gotten squeezed ever after in California. At both the elementary, the secondary, and the college level. And tuition has gone up enormously. When I went to the University of California, my tuition was $35 a semester. Of course, that was back in 1949, 1950 and you might say, “Well, inflations changed the number quite a bit.” It has maybe 10, 12 times but just add a zero to $35, $350 a semester, but we’re looking at instead of $700 a year, we’re looking at maybe in today’s dollars, we’re looking at maybe $12,000 a year. Something like that for in state, maybe $30,000 for out of state. So what happens is people can’t afford to get as good an education.

ET: They go to school and even if they can pay the tuition, they have to work in large part to supplement to get the money to pay it because it just isn’t available in so many of the families. If you work while you’re going to school, which I did, you don’t do as well in school as you might. You don’t learn as much. I can think back at the courses I took because I was working, I didn’t learn the courses as well. And the rest of my life, I could feel the impact of that lack of knowledge, that I would have had if only I had been able to focus properly on the course I was taking. So anyhow, to make a long story longer, I’ve seen charts of how much is invested in science, engineering, and education in a society, as a fraction of their GMP versus the rate of change of GMP. And it’s quite dramatic. Societies that have a higher investment of education advance the growth in their GMP much more rapidly in societies that don’t. And the obvious example is something like Silicon Valley. If we didn’t have a Silicon Valley or the equivalent, or Redmond, Washington or the equivalent, we wouldn’t have all the computer advancement that we have. Apple would be a giant company in some other place, Japan, Russia, China, something of that sort as opposed to being a giant company in the United States. So anyhow to not spend money in education is a terrible mistake.

ET: And another consequence of that mistake is gambling. There are lottery systems all over, and one of the ways of getting people to accept them is we’re willing to fund education with lottery proceeds. But that’s actually been in California bait and switch. What happens is they have signed a certain fraction of the lottery profits to education, but then they take away money from education with the other hand. So education doesn’t end up getting any more money. California ends up getting more money in the general fund, and ends up with a major gambling problem on top of it.

T: I think that’s the case in every other state that has a lottery that I’ve run across. They all set the lottery intake by pulling back money.

T: If the money actually did go to school, that’d be a fantastic thing. But there’s, I don’t see any real evidence that that’s happening anywhere in the United States.

T: You do talk in the book and I’ve, this intrigued me, I was surprised to see that we agreed on this, but you think a flat tax might be the answer to solve some of the funding problems at all levels of government.

ET: Yes, I do and there’s an obstacle to getting it in, which is that the complicated tax system is one that’s been made that way by politicians who are busy paying off special interests who in return make campaign contributions to elect or re-elect the politicians. So that’s why the tax code degenerates into horrible complexity over and over. Now flat tax would eliminate most of the power of the politicians to extract benefits from the tax code. So they would oppose it. But, you could probably get support from large parts of society if you made the flat, the change to a flat tax neutral. So for instance, suppose you take away the carried interest benefit for hedge funds. Just to explain what that is, carried interest is a scheme which has been disguised by an obscure phrase, carried interest, a scheme to tax money made by hedge fund operators at the capital gains rate rather than at the ordinary income rate. And so they pay far less tax.

ET: They can also defer the payment of the tax for many years, 10 years or more. Let’s say you took that away. You might get another $20 billion in tax collections that way. What to do with it? Well, go to the politically unconnected rich, the ones who don’t have benefits built into the tax code from bribing politicians. Take the top tax rate down. Apply that $15 or $20 billion tax savings that you capture from the changing the carried interest toward their income, apply that to the top rate. So it comes down from 39.6% to maybe 39% or 38.5% or whatever that comes down to. My idea would be that you keep making changes that are revenue neutral and if you brought a flat tax in all at once, that would be a massive change that if were done in a revenue neutral way, would have as many winners as losers, so you’d have a lot of people rooting for it.

T: Yeah. I agree. I’ve always said to the first part of your statement, that taxes are not just about raising income. It’s also a very complex reward and punishment system. And that’s been the biggest reason it’s developed into the nightmare that it is. I was surprised to see you comment on it in bringing it out in the book, happily so, but we’re in complete agreement on that.

ET: Well, one of the reasons I have some, I’ll call them public policy commentary in the book, is that if you have a math and science background like I do and you believe yourself to be a rational thinker, you end up applying it to as many things as you can. And with a large part of my life spent in finance and economics, I naturally ended up applying a lot of this thinking to public policy and other things that I see in society that have a broad impact. That’s where a fair amount of this is coming from. I believe that if people just learned how to think instead of letting other people do the thinking for them, that we could work our way to a considerably better society.

T: Yes, you address a lot of that in the last part of the book, the chapter called “Thoughts” and it’s one of my favorite chapters in the book. Your comparison between the Roman Empire after they defeated Carthage and the United States today given the fall of the Soviet Union, I thought were absolutely spot on. And I love the way that you say one thing to the optimist and one thing to the pessimist. I think that’s fantastic.

T: Alright, I’ve got one last question for you and this is the big one. It’s one that I try to ask everybody I run across. What books are you reading now?

ET: Right now, I’m reading a book called “The Accidental Superpower” by a guy named Peter Zeihan. And the reason I’m reading it is because one of my friends who I mentioned in the book, Gary Basil, who was a professor of economics and finance over at UCI when I first met him, sent it to me thinking it was going to be interesting, good to read. We had been talking about the election of Donald Trump, what we thought that meant for the country. This book looks at things much differently than I do and I find that if I read things that may not agree with the way I look at the world, than I’m more likely to learn something than if I just read things that keep telling me, “Yes, you’re right” over and over and over. This is a for geopolitics type book, which basically thinks that geography is a major determinant, geography in demographics are major determinants of how things evolve for societies. It’s an interesting historical perspective and it has predictions of how the future’s going to go. I’m enjoying working my way through that and seeing where I agree and where I don’t agree with it and what I’ve learned from it or haven’t. That’s one interesting book that I’ve been reading.

T: Anything else in recent history that stands out as something that folks should consider reading?

ET: No. One I read not too long ago, parts of it, is “Thinking Fast, Thinking Slow” by Daniel Kahneman. But everybody’s “read” that but they really haven’t. They did a study of people who read books, I guess it’s on Kindle or iBooks I’m not sure which, and they can tell from feedback which pages people have been on and what they found was that only about 5% of his book was read by the typical buyer. So anyhow, I read about 20% or 30% of it because a lot of the rest of it I knew. And a lot of the rest of it I wasn’t fascinated by at the time, but the parts that I read, I really liked.

T: Yeah, I think that’s a lot like the book that was out a few years ago that was real popular, “Influence,” and everybody heard of it and knew a couple of quotes, but I don’t think anybody actually read it.

42:08 ET: Yeah. There’s another book like that I read a moderate part of, again, that nobody else read very much of or hardly anybody did. It’s “Capital in the 21st Century” by Thomas Piketty.

T: Oh, yeah. Again, everybody had cherry pick quotes, and I’m with you, I read about 10% and threw it aside. I thought it was a horrible book but…

ET: That, and, “Thinking Fast, Thinking Slow” were the two least read best sellers according to elaborate studies.

REIT, Reading and Rum

a_pirate__s_christmas_by_maiden13I spent some time today talking with Brad Case about the REIT and real estate markets going into the New Year. Brad is a Senior Vice President, Research & Industry Information at the National Association of Real Estate Investors and has become a valuable source of information when it comes to real estate investing. Brad is one of the few upbeat voices on REITs as we enter 2017 and we spent some time talking about his expectations.

First of all, he pointed out that REIT fundamentals are very strong. Occupancy rates and rents are rising right now. New construction is still well below historic lows, and the absorption rate for new properties is very high right now. There are signs that the economy is picking up and higher GDP growth is closely correlated with high returns for commercial real estate and the REUTs that invest in those assets.

Brad also shared with me the results of his recent research in yield spreads and REIT returns that is very bullish for long-term returns for real estate investment trusts. He found that there the relationship between the spread between REITs and the 10-year Treasury yields is highly predictive of how REITs perform over the next five years. The higher the spread better REITs performed. He told me that right now the spread is pretty high and is predicting a five-year average annual total return of over 14%.

To make sure he did not see accidental conclusions he tested the yield spread using other fixed income assets and found that it held true when using different maturities of Treasuries, corporates, and even high yield. All of them worked, and all of them are bullish with the high yield spread being at one of the highest most bullish levels ever.

He shared his data with me, and the relationship is pretty solid. The spread relationship showed that it was a fantastic time to be a buyer of REITS in 203 and 2008 when some of the highest reading ever were recorded. The yield spread went negative in the first six months of 2006 and as we all know that was a terrible time to be a buyer of anything. Spreads were also at very low levels in 1999 preceding a period of very low REIT returns and returned to bullish levels after the internet crash was delivered five years of outstanding average annual returns.

In a recent article on the NAREIT website Brad summarized the relations between Treasury and REIT yields writing “When Equity REIT yield spreads were negative, as they were in 1997 and again around 2006, forward-looking Equity REIT total returns tended to be disappointing: positive on average, but by only 2.68%. When yield spreads were higher, though, forward-looking total returns tended to be higher as well: in fact, when yield spreads averaged 2.0% or more, returns over the next four years averaged an amazing 21.13% per year.”

I am not as unabashedly bullish as Brad Case, but neither am I rushing to sell the majority of my REITs and real estate securities. Most of the bankers I have talked with in recent months are quite happy with the CRE and multifamily markets in their service areas and don’t see any imminent signs of collapse. Occupancy rates are decent, and in the vast majority of US markets, there are no signs of the dramatic overbuilding and excessive risk-taking that usually proceeds a serious setback. If we get a decent stock market pullback anytime soon, I will become a serious buyer of some of the REITs on my shopping list.

This is one of my favorite times of the year. The holiday is part of it(more on that in a moment) but the new release list from publishers is reaching peak levels and it my Kindle reflected the weight of the stuff I have downloaded in the past few days I would need a wheelbarrow to haul it around. Right after Christmas every year we always get new books from WEB Griffin and Jack Higgins, and they both have a new one due this year as well.

As for the Christmas holiday that starts Saturday when we head out to so the shipping for food wine and liquor for the Christmas Eve Open House. MY wife turns several shades of several different colors when she sees how much I spend on this bash every year, but it is a long running Melvin tradition. We open the doors to friends and neighbors and every year we meet some new neighbors that pop in for a few minutes or a long evening. At some point there will be singing, mainly Christmas carols but I have vague memories of my sons belting out a few badly off-key choruses of Sweet Child of Mine around midnight or so. It is a fantastic time and one of my favorite holiday traditions.

Now at last its time for

Banks, Cyber and Black Eyed Peas


As we head into New Year’s weekend, I find myself reading a lot of year in review and next year outlook material. I am a big fan of the overviews and outlooks but try to avoid those prognosticators making specific predictions they insist are actionable right now for the low, low cost of your retirement accounts. I find that by reading a bunch of the overviews, I can begin to develop a picture of potential developments and obstacles an industry or market my face in the New Year. I won’t act on them today but being aware of what might happen allows me to have a game plan ready if the events do unfold in the manner.

I probably spend more time on banking and real estate outlooks than anything else since that is where I focus much of my attention. Of course, I also believe that if you understand what is going on in the banking sector and real estate markets of a given city, town, nation or continent you know everything you need to know about the economy of that locale.

Deloitte, the global audit, consulting, financial advisory, risk management, and tax consulting firm released their Banking and Securities Outlook 2017 this month, and there are some key takeaways for us as investors. The company thinks that post-election may have brightened the outlook for banks and securities firms, but challenges still exist. Banks will face significant technology challenges in 2017 and will probably have to spend some money to build and protect a new model of banking in a Fintech world.

Deloitte is equally confidently caution about the overall economy saying “US gross domestic product (GDP) growth should be higher than in 2016, reflecting a tighter labor market. However, this almost-full employment is far from ideal; a serious skill divide exists alongside too many temporary and underemployed workers. The resulting low productivity growth could lead to a plateau as the year progresses.” I have been saying this for some time as the job creation I see outside the beltways and rivers is not of the kind we need to achieve higher growth rates and I still talk to a lot of people who are incredibly frustrated with their inability to find a meaningful and rewarding job. Better, not good. Perhaps now that a firm as renowned as Deloitte agrees with me, I will finally get the recognition as a brilliant economist that I clearly deserve!

The company also addresses one of my favorite topics, Bank M&A. The report notes that “M&A activity may slow considerably until greater clarity about the coming regulatory landscape emerges, possibly prompting a fundamental rethink of business strategy. Even so, large national banks will likely continue strategic divestitures to hone their business footprint, shedding ancillary businesses that aren’t core to the portfolio of client services and don’t generate sufficient ROI. Large regional banks with assets in excess of $50 billion may continue making strategic acquisitions to better tackle regulatory compliance overhead. Smaller regional banks approaching $50 billion in assets will try to get comfortably above that mark to attain operational and compliance heft that systemically important financial institutions require. However, most M&A activity will take place among banks with assets between $1 billion and $10 billion. “Since we primarily live in the under $10 billion world we are okay with this.

I spoke with Chris Marinac of FIG Partners also had some comments on M& in community banks when I talked with him earlier this week. When I asked him if M&A was coming to an end or was still a secular trend he told me “I think it’s definitely a secular trend. I think M&A is here to stay. I think if anything, M&A accelerates because of higher prices. Currencies really drive M&A. What happens over time is that stock prices tend to have wider dispersion regarding their evaluations. That is beginning to develop, and I think it will continue to occur as 2017 unfolds, and what that means is that there’s a bigger spread on the price-to-tangible-book, and as that happens, the buyers distinguish themselves from the sellers, and more transactions can happen.

“There are still many boards of directors who I would say are tired by the environment. They certainly were scared by what went on during the financial crisis years, and they remember what it felt like. And when they’re given an opportunity to come out at a reasonable price, and particularly when they can take strong currencies from the buyer, I think there are enough banks who will say yes and take that on. I think the decision was made a long time ago that they would like to sell. It was just a question of when they could get a reasonable price. This is still an ego game, and the egos don’t like when they have to take a low price, and something that is seen to be less than a real market bid. Now that pricing has come back, I think egos can very much be massaged into feeling good about a particular M&A transaction, and if the pricing is much better.”

“So I still think the number of M&A deals will be higher at ’17 versus ’16 and ’15, and I think that there are going to be some banks who decide not to sell because they feel a little bit less pressure from the regulations. But honestly, I think there are enough boards who want to get a transaction done because the pricing is better, and that they can get a price that they can be happy with and feel good about. That’s where I think the ego comment is important because I think this is an exercise in human behavior as much as it is finance.”

Both Deloitte and Chris had some comments on cyber security as well. The Deloitte report said that “While core cybersecurity threats remain the same, more sophisticated threat vectors are emerging resulting in greater impact. For example, in addition to distributed denial-of-service (DDoS) attacks, denial-of-system attacks that make enterprise-wide information systems completely inoperable are likely to increase. With cloud adoption accelerating, encryption, identity, and access management are likely to dominate the agenda. Also, regulatory pressure is likely to increase, forcing banks to focus more on regulatory compliance rather than risk mitigation.”

Chris Marinac was in agreement telling me that “the concept of cyber security in the regulatory framework is awfully important. In fact, I would say that cyber might drive certain companies out of business, because the regulators are as serious as a heart attack about banks and boards of directors being all in on cyber. That’s in spending, and it’s also just an attitude commitment that you have to be vigilant 24/7 on cyber security, and you have to be on guard, and if you’re not, that’s going to create regulatory decimation where there’s going to be some of the companies who just can’t take it, and they have to move on. So I feel like the cyber, and the tech spending is still a real topic, and that if anything, companies might be investing savings that they’re getting on taxes. If we get tax reform, or frankly better spreads, which I think are going to happen, you might see companies taking the revenue from a better margin, and perhaps stronger net income because of taxes, and reinvesting some of those profits back into technology spending to not only make sure that they’re in line with the rest of the Jones’ but also that they’re ahead, that they can anticipate the problems. The cyber issues, large and small are still out there. “

Write this down. If we did a remake of Mrs. Robinson today, Mr. McGuire’s one word would be “Cyber.” All the great new things that technologists and pundits see happening are heavily reliant on cyber security. FinTech, EdTech, robotics, driverless cars, virtual reality, the list goes on and on, and every single one of them is hackable and will require a constant and expensive vigilance on cyber security. You need to be aware of the best companies and emerging technologies in cyber security because lacking an EMP blast that takes us back to the stone ages Cyber Security is the going to happen 100 to 1 sector right now. Be patient, buy at a good price but be aware of what is going on in the sector and who is doing it.

Happy Year to you all and best wishes for a happy, safe and prosperous 2017. Will be kicking back at home this year as over the years I have had one too many drinks spilled on my suit, one too many overindulgers puking on my shoes and paid way too much money for high priced poorly prepared “special “ dinners that weren’t. We will break out the bourbon, some good wine and spend a nice, safe evening watching those foolish enough to flock to Times Squarer freeze their butts off and most likely pee their pants to welcome 2017. Of course for New Year’s day we will cook up the pork roast and black eyed peas to greet the year. I am not particularly superstitious, but I do like a tasty tradition.

Flawless Predictions

Originally published on Real Money December 23rd 2016 at Real Money


Originally published on Real Money.com December 23 2016

oday we kick the holiday into high gear around our house. We have a party for Christmas Eve every year, and of course, there is a huge dinner to cook for Sunday, so there is lots of shopping and prep work that begins today. There will be last-minute errands, packages I forgot to wrap and late additions to the bar I need to pick up. It will be a busy few days, but if history is any guide, it will be a good time for all.

The other thing that has kicked into high gear is the prediction machine. I am getting a flood of emails offering to tell me exactly what the market is going to do in 2017. Some are pie in the sky, and some are doom and gloom.

So far, the range is from up 30% to down 70% for the S&P 500 next year. We could have runaway inflation or a disastrous return to severe deflation according to the experts. Oil is either going to $100 a barrel or collapsing to $10 depending which expert you choose to believe. Real estate is probably going to collapse unless it soars as a result of inflation. Interest rates will spike unless they collapse.

The predictions range from very well considered and presented analysis of the possibilities in 2017 to just plain wild-eyed rants. The former are generally from the big Wall Street and mutual fund firms, and the major goal of these pieces seems to be to keep investors in the fold with their cash continuing to earn fees for the company. The general outlook is for decent gains with positive economic activity and the possibility of some increase in what they call volatility. They are as much marketing pieces as anything else.

The latter are marketing ploys. If you make a prediction of epic proportions and it comes anywhere close to coming true, you will be a temporary legend. In spite of all the evidence that such predictions are nothing more than lucky guesses, the suddenly wise prognosticator will be showered with attention and cash from the investing public. It begins to taper off in a year or so when the role of luck becomes more apparent as subsequent forecasts fail to hit the mark, but the lucky fortune teller does not need to return the cash. More than one decent fortune has been made using this technique, so as long as you have little to no conscience, it’s a sensible ploy.

That said, this prediction thing seems like fun, so I think I will get in on the action. I have been making forecasts for a couple decades now, and I humbly can say that I have the best market and economic forecasting track record in history, and I think it is time you folks starting rewarding me with accolades and cash.

In 2017 the stock market will be open most weekdays between 9:30 a.m. and 4:00 p.m. ET. Prices will fluctuate, sometimes wildly. At least one company everyone loves will collapse at some point during the year. At least one company no one has ever heard of will soar to uncharted heights and become a stock market darling in its own right for a period. Millions of lines will be drawn on millions of charts, with no real useful conclusion being drawn from such activity. There will be unanticipated geopolitical situations that roil the markets at some point during 2017. Pundits will predict all sorts of outcomes. Some will be right, most will not. If the world does end before then, NYSE traders will stop what they are doing on the last trading day of 2017 and sing “Wait Till the Sun Shines, Nellie.”

My forecast is far more likely to be correct than most in 2017, thereby extending my record of flawless punditry, and it has about the same chance of making you money during the New Year as all the others. As for me, there are a few macro pieces I read every year and consider, such as the KKR macro outlook and the outlook pieces from large commercial real estate brokers, but these tend to be more informational than predictive in nature.

Make 2017 the year you begin to react to what the market does rather than trying to predict what it might do. I predict you will make more money that way.

Ignoring Warren and Charlie


Originally published on May 2 2016 on Real Money

There will be a few jillion words written on Berkshire Hathaway’s (BRK.B) annual meeting but I am going to add my two cents anyway. After watching some of the live-stream broadcast and reading several commentaries, I came away with several strong impressions.

The first impression is one I get every year after the meeting. There are far too many people running around trying to be Warren Buffett and invest like Warren. You and I will never have the advantage he has enjoyed of free leverage in the form of insurance float, and odds are we will never get the phone calls for special convertible deals on companies such as Bank of America (BAC) and Goldman Sachs (GS) at incredibly advantageous terms.

Buffett has said many times that he is limited in what he can buy because of the sheer size of Berkshire. On Saturday he pointed out that size is the enemy of performance. He has admitted repeatedly that returns would be higher and that Berkshire would do more Graham-like investments if it had a smaller asset size. Even Vice Chairman Charlie Munger has said that would be his approach if he had smaller capital.

Investor Monish Pabrai wrote about his discussion on this subject with Munger last year at the Huntington Library saying, “I asked Charlie if he would still promote the buy and hold forever notion if he were running a small pool of capital. He said that he’d do it like he did when he ran his partnership, buy at a discount, sell at full price and then go back. With their present situation he said that it makes no sense to do that.”

Despite the above, too many investors are trying to emulate Buffett by buying huge companies with ever-elusive moats that they can hold forever and a day. What is worse is they do it without looking at where we are in the market and are quick to quote Buffett about ignoring day-to-day market prices. While that may be good advice in general, you need to go back and study when Buffett bought his biggest positions.

He started buying the Washington Post in the 1973 stock market collapse. He began building his Coca-Cola (KO) stake after the crash of 1987. His Bank of America and Goldman stakes came in the aftermath of the credit crisis. The big initial buys of Wells Fargo (WFC) were done during the banking and Savings & Loan panic in 1990.

Buffett may not worry about the quote and market conditions after he buys a stock but he is very aware of conditions when he is buying. Both he and Munger are crash buyers in the spirt of Hetty Green and Mr. Womack, which is the real secret of their success. Want to be like Warren? Stockpile cash between crashes and buy stocks during a panic.

If you are buying stocks, Buffett reiterated his suggestion that you should view it as buying the whole business — and you should be comfortable with being unable to get a quote for the next five years. This is probably one of his most ignored pieces of investment wisdom. Investors are far too concerned about liquidity and I believe they often overpay for liquidity.

We know from the Ibbotson studies that illiquid stocks with value characteristics provide the highest returns over time. Still, if you talk to most investors, they own very liquid shares of companies with growth characteristics and higher valuations. These are, of course, the stocks with the lowest long-term returns. If liquidity is a primary concern, you probably should not own stocks.

I hear the liquidity argument all the time when talking about investing in community banks. These little banks can be hard to buy and harder to sell. It can take weeks — even months — to buy a full position in some of them. That scares away many investors from what has easily been the most profitable part of my investment activities for decades now. Now is probably the best environment for buying community banks since the early 1990s, but most investors will miss it because of their ill-advised concerns about liquidity.

I will leave it others to discuss Buffett’s comments on sugar consumption, diversity, hedge funds and politics. The big takeaway for me is since I am not dealing with the issues of a $350 billion enterprise I should be thinking about smaller, less-liquid stocks and focusing on when I buy and what I pay for stocks. I can ignore market gyrations after I own them but they are pretty important when it comes to buying.

Right now, aggressively buying socks when the market is trading at 22x declining earnings strikes me as one of those “stupid games” Buffett was talking about Saturday.

The ABA on Dodd-Frank and Community Banks


Below is the ABA’s answer to the White House Council on Economic Advisors​ suggestion that community banks had no problems with Dodd-Fran Legislation and were better off becaue the bill passed.
It also outlines the reason that bank consolidation will continue and you need to be a member of Banking on Profits. We have al sot fille dall our slots and will be closing the serice to new members very shortly. Click Here to lock in 50% off for the life of your membership and get teh Monthly Communiyt Banks Stock Investor free with your membership. Use coupon code 50OffBoP​.
August 24, 2016

The Honorable Jason Furman President’s Council of Economic Advisors

Eisenhower Executive Office Building Room 360

1650 Pennsylvania Ave

Washington, DC 20504

Dear Dr. Furman:

First, I appreciate the work of the Council to document the consolidation of the banking industry in your recent report entitled “The Performance of Community Banks Over Time.” This report is long overdue as community banks have been urging the Administration, Congress and regulators to address the rapid decline in the industry. Having thoroughly reviewed the report I must admit to being baffled by your findings. You are correct that community banks are resilient and have endeavored to provide the vital financial services critical to the success of their communities. It is also true that consolidation is not a new phenomenon affecting the banking industry. But the notion that the Dodd-Frank Act—and its 24,000 pages of proposed and final rules—has had no impact on community banks is simply untrue.

The report concludes that the decline in the number of banks since Dodd-Frank was enacted—1,708 or 22% of the industry—is not compelling evidence that the Act has had a negative impact. As proof that somehow the loss of a bank every business day since DFA doesn’t matter, the report states that bank branching patterns, lending growth and geographic reach “show that community banks remain strong.”

A conversation with any community banker would dispel this forced conclusion. The thousands of new regulations that have been imposed on community banks is an enormous driver of decisions to sell to a larger bank. The median sized bank in this country has only 42 employees. These are small businesses themselves. There is simply not enough capacity to read and understand what rules apply (especially as rules are modified); implement, train, and test for compliance with those that do; and still have the time and resources to meet with individuals and businesses about their financial needs. According to research by the American Action Forum, “it would take 36,950 employees working full-time (2,000 hours annually) to complete a single year of the law’s paperwork.”

Some banks have stopped offering certain products altogether, such as mortgage and other consumer loans. The October 2015 RESPA/TILA integration rules have raised mortgage costs, delayed closings and have limited access to home loans to many potential new buyers. TRID Survey Results In April 2016, 72 percent of community banks reported that the 2014 rules on ability to repay and qualified mortgages have restricted their ability to extend credit, even after over two years of adjustment and adaptation. Mortgage Survey Results

Moreover, the rules intended for the largest banks are too often considered ‘best practices’ for all banks, compounding the hardship for smaller institutions. Arbitrary size thresholds create disincentives for community banks to grow because of the significant regulation that is added as soon as the threshold is crossed. This limits the services they could provide because of arbitrary rules, not business decisions to meet community needs.

Even more troubling is that strong, well-run community banks are telling the ABA that they have no choice but to sell. Just a few weeks ago, a banker in the Northeast wrote to us and said:

“Unfortunately we became a victim of Dodd-Frank. The effects of Dodd-Frank, including the TILA-RESPA integration, the pending expansion of HMDA, ability to repay, forced-placed hazard insurance requirements, plus other regulatory issues such as the pending overdrafts rules, restrictions on small dollar lending, the military lending rule, the Durbin Amendment, etc… resulted in financial projections showing substantial declines in revenues and increases in compliance costs, reaching the point that in a few short years an otherwise healthy community bank with strong capital and satisfactory earnings could no longer meet a number of financial bench-marks set by the regulators. These conclusions forced the bank to sell now when our shareholders and some of our employees would be less adversely affected.”

In May this bank merged with a much larger bank, resulting in approximately 50% of the employees losing their jobs, all because of the cumulative impact of regulation. Sadly, this is not an isolated case. The Council’s report documents very carefully the fact that community banks are exiting, primarily merging with other community banks. The report shows the decline quite dramatically, particularly among the smallest banks. Does it matter if small banks are merging? The CEA concludes it does not since community banks “remain strong.”

What happens when this trend continues—as it surely will—if nothing is done to stem it? Community bankers are community leaders. They are involved in many local organizations, serve on school and hospital boards, donate thousands of volunteer hours to charities—all in addition to the advice they provide to small businesses, families and individuals, young and old, about their daily financial and banking needs. If this trend continues unabated, there will be fewer financial services in communities and less economic growth. Whether intended or not, the Dodd-Frank Act has added fuel to industry consolidation, reduced flexibility for product offerings, and increased the cost of providing financial services—a cost that is ultimately is borne by customers.

The report also suggests that the increased pace in consolidation since 2010 is due to the lack of de novo banks, not a change in “exit dynamics.” It argues that the lack of de novos is a result of low interest rates. The exceptionally low interest rate environment certainly has had a negative impact on all banks and no doubt has had a role in limiting new bank charters. But new banks have been formed in large numbers through many recessionary times. For example, in 1990—the middle of the so-called “S&L Crisis” and the beginning of a recession—there were 193 new banks chartered. Over the next 10 years, 1,500 new banks were chartered.

Contrast that with the latest cycle: it started similarly with 181 new charters in 2007 (the start of the recession) but fell off very quickly over the next two years. Since the Dodd-Frank Act was enacted in 2010, there have only been 7 de novos with three of those started only to facilitate an acquisition of a failed bank and another for a credit union to convert to a bank. That means only 3 real new banks in the last 5 years. Even more telling is the contrast between the lack of de novo bank formations and the recovery of new business formations across all industries since the recession.

Sadly, the forces that have acted to stop new bank charters are the same ones that have led to the dramatic consolidation of the banking industry—excessive, and complex regulations that are not tailored to the risks of specific institutions. Beyond Dodd-Frank, there are new capital hurdles, unreasonable regulatory expectations on directors, funding constraints, an inflexible regulatory infrastructure, and tax-favored competition from credit unions and the Farm Credit System that weigh on community banks. These—not the local economic conditions—are often the tipping point that drives small banks to merge with banks typically many times larger and is a barrier to entry for new banks.

The question that the CEA should be asking is how prudent regulatory relief will contribute to economic growth. Stemming the tide of consolidation in the industry will help preserve the unique banking system that has led to the strongest economic country in the world. If we continue to watch the industry shrink by one bank every business day, the availability of financial services will decline, particularly in the thousands of smaller communities where the bank is the only financial institution serving the area.

Each and every bank in this country helps fuel the U.S. economy. Each has a direct impact on job creation, economic growth and prosperity. Community banks have always prided themselves on being flexible in order to meet the unique circumstances of each customer. These institutions are working hard to drive economic activity in America’s cities and hometowns, but the regulatory environment is holding them back.

Comprehensive regulatory relief is long overdue for community banks. This is why it is imperative that the Administration and Congress take steps to ensure and enhance the banking industry’s capacity to serve their customers, thereby facilitating job creation and economic growth. And each day another community bank leaves the field, it makes that community—and our economy—poorer.

Banking on Business


Originally published as a series on Rel Money

CNBC’s annual “Top States for Business” list came out this week, and it occurred to me that if a state is a great place for business, then it’s probably also a fantastic place for banks. So, let’s use my next two columns to look at promising bank stocks in the five highest-ranked states — Utah, Texas, Colorado, Minnesota and North Carolina.

I’ll look today at some good publicly traded banks in Utah, Texas and Colorado, and use a future column to run down promising financial firms in Minnesota and North Carolina.

Utah only has two publicly traded banks, and I like Peoples Utah Bancorp (PUB) , which is based in the booming community of American Fork.

PUB has 19 branches around the state and about $1.5 billion in assets. It’s a well-run little bank, with a better-than-average efficiency ratio of 0.56 and an above-average return on assets of 1.44%. The firm’s loan portfolio also skews heavily towards industrial and commercial-real-estate loans, which is a big plus for a bank that’s located the country’s most business-friendly state.

Unfortunately, PUB isn’t cheap at a 1.48x current book value. But if you value earnings, the stock’s P/E ratio is just 15. That’s eminently reasonable for a well-run, high-growth community bank.

Now, I’m not personally capable of chasing a stock higher. But PUB could make a strong addition to my long-term portfolio the next time the bank’s stock price pulls back.

Picking a good Texas bank to invest in is easy, as I’m a big fan of Green Bancorp (GNBC) , which I’ve already been buying over the past month.

GNBC operates in the major Texas metro areas of Houston, Dallas and Austin, but has recently exited energy lending and is disposing of all energy-related loans. In their place, the bank’s portfolio heavily favors commercial real estate and commercial and industrial loans. This should be a huge positive for the firm.

CEO Manny Mehos founded, expanded and sold a different bank in the past, creating outsized gains for his shareholders — and I expect this scenario will eventually play out again at Green Bancorp. Private-equity investors own a little more than 13% of GNBC’s shares, and they probably have their eye on a future sale of the bank as well.

There’s only a very small handful of publicly traded banks in the Centennial State, and National Bank Holdings (NBHC) is my pick.

The bank has 99 branches and some $4.6 billion in assets, with 1.73% of that considered nonperforming. NBHC has also done a smart job of growing by acquisition, and has also been aggressive with stock buybacks. Since 2013, the firm has repurchased 45% of its shares outstanding at a $19.87 weighted average price (the stock currently trades at around $21).

Commercial-real-estate and and commercial/industrial loans make up about 50% of the firm’s loan portfolio, while single-family mortgages account for another 22%. That’s good news in a state that CNBC’s study found had America’s No. 1 workforce.

Another potential plus for Colorado banks is the state’s legalization of marijuana sales, which currently contradicts federal law. Colorado’s legal pot shops generally can’t use the traditional banking system right now, but I believe that will change if and when the U.S. government inevitably takes marijuana off the federal illegal-drug list.

Colorado retailers legally sold almost $1 billion of marijuana last year, and that doesn’t even include smoking supplies and accessories. The second that the federal government legalizes their business, banks will want to serve the industry — and I expect a bit of a “gold rush” to get into the state’s banking market.

National Bank Holdings would make a perfect target for a larger regional bank that’s looking to move into the state. The bank currently trades at a modest 1.15x book value, but any transaction would undoubtedly occur at a much higher multiple.

On the downside, NBHC does have about $132 million of energy exposure on its books. It also earns just a 0.14% return on assets — much lower than its peer-group average of 1.03%.

It just makes sense that if a state is a good place to be in business, it’s a good place to own a bank. Choices were limited in Utah and Colorado as there simply are not that many publicly traded banks, but we came up with one in each state that should be an outstanding long-term holding. There were a lot more choices in Texas, but most of them are trading at premiums and many have a high level of exposure to the oil and gas industry. I picked my most recent bank purchase, Green Bancorp (GNBC) , as it has eliminated its energy exposure and the stock trades below book value. Today I want to look for banks in the two remaining top five states for business.

I never really thought of Minnesota as a big pro-business state, but not only is it fourth this year in the CNBC report, but it ranks seventh over the last decade. The state scores high for infrastructure, education, technology and quality of life, and the combination has kept it in the top tier of the ranking. There are not a lot of publicly traded banks in Minnesota, but there are two banks worth considering for your long-term portfolio.

TCF Financial (TCB) is a bank with $21 billion in assets and a strong, diversified loan portfolio. In addition to traditional consumer and commercial portfolios, TCB has divisions that do auto lending, inventory financing and equipment leasing. These are higher-yielding businesses and TCB does a fantastic job of underwriting the loans as its nonperforming assets are just .14% of total assets. The bank has 399 branches across the Midwest and conducts its financing operation all over the United States. The bank trades at about 120% of tangible book value but is cheap when valued on earnings, with a price/earnings ratio of just 11. The stock pays a 2.34% yield, so you do collect some income while waiting for the favorable business climate to help lift the shares over time.

North Carolina does come to mind when I think of business-friendly states. The state has strong financial, agricultural and manufacturing sectors and the presence of major universities in the research triangle of Raleigh, Durham and Chapel Hill has spurred growth in biotechnology and high-tech industries. Here we have a lot more choices to consider.

I am a big fan of Asheville, North Carolina-based HomeTrust Bancshares (HTBI) . The bank has been in growth mode since completing its conversion from a mutual thrift to a shareholder-owned bank. Since then, HomeTrust has added five markets and grown assets from $1.6 billion to more than $2.7 billion. It also has been active buying back stock and has repurchased about 25% of its shares outstanding since it was allowed to begin buybacks in 2013.

HomeTrust management is focused on growing the bank in its home market of North Carolina as well as in eastern Tennessee, South Carolina and Virginia. The stock is trading at book value and is in solid financial condition, with an equity-to-assets ratio of 11.77 and nonperforming assets that are just 1.08% of total assets. HomeTrust either is going to continue to grow and drive earnings and its stock price higher or someone is going to decide it is too attractive of a franchise and make an offer for it. Either would be a huge win for investors.

Also based in Asheville is ASB Bancorp (ASBB) . This bank has been under fire from activists, and one noted bank activist, Lawrence Seidman, currently has a representative on the board. The stock is trading at tangible book value and I would not be shocked to see the bank sold at a decent premium to a larger competitor. ASB has about $786 million in assets and is in good financial shape, with an equity-to-assets ratio of more than 11 and nonperforming assets that are just 1% of total assets. The loan portfolio is a nice mix of residential real estate and commercial real estate loans with limited exposure to commercial and industrial loans or construction loans.

After last week’s madness, it was nice to have a quiet weekend before the great rebuild begins this week. A Dumpster is being dropped off this morning and I am looking forward to lots of noise and clutter.

It was not a quiet weekend in the news with failed coups, police shootings and vice-presidential madness dominating the airwaves. For a political junkie like me, the GOP convention is going to be high theater and I expect lots of low comedy as well before the week is over. With all the madness swirling around this week, I am just going to keep my head down as the week starts and look for more banks to buy in the nation’s most business-friendly states.

Washington comes in as the sixth most business friendly state, thanks in large part to high scores for technology and innovation as well as a strong economy and easy access to capital. It has been a long time since I was out in Washington, but I do have some great friends out there and have become a fan of the Gonzaga basketball team as a result. I also own a few banks based in the state that should continue to benefit from the business-friendly atmosphere.

First Northwest Bancorp (FNWB) operates 10 branches with just shy of $1 billion in assets in northern Washington. First Federal underwent its conversion from a mutual thrift to a stockholder-owned institution in January 2015 and has been a favorite holding since the offering was completed. It still has most of the cash and the equity to assets ratio is over 13. Nonperforming assets are just 0.4% of total assets, so the loan portfolio is in solid condition. The bank services the north Olympic Peninsula region of Washington and is the only community bank headquartered in the region. The loan portfolio is heavily tilted toward residential loans but it does have a decent amount of commercial real estate and multifamily loans on the books as well.

First Northwest has a shareholder list that looks a lot like a bank investors hall of fame. PL Capital, Joseph Stilwell, EJF Capital, Michael Price, Seizert Capital and Wellington all have a position in the bank’s shares. That could eventually lead to some pressure to deploy capital to benefit shareholders by buying back additional stock or initiating a dividend payout. Either would be fantastic for us as long-term shareholders of the bank. The stock is trading at just 90% of tangible book value, so it’s a great buy for patient investors at the current price.

I also own Anchor Bancorp (ANCB) in southern Washington state. This bank has 20 branches and a little over $400 million in assets. It is also in great financial shape with an equity to assets ratio of almost 14 and nonperforming assets that are just 0.73% of total assets. The loan portfolio is tilted toward commercial real estate and multifamily housing and about 20% of it is in single-family housing to residents of the business-friendly region. The stock trades at 96% of book value, so it is cheap at the current price.

At least one investor thinks the stock is too cheap. Activist Stilwell owns 9.8% of the bank and thinks it should be sold to maximize shareholder value. In a 13d filed last week, he revealed his latest letter to the board. He wrote: “This letter serves to formalize our June 15 meeting and to re-emphasize our belief that Anchor should be sold. When we met with you two years ago, your plans to work diligently and improve bank operations sounded reasonable to us. We believed you when you promised you were making sincere efforts to position Anchor to maximize shareholder value. We understand that you have done your very best. However, continued poor performance highlights the reality that Anchor should now be sold. At our June meeting, your statements on further improvement to Anchor’s return on equity by the end of 2018 sounded unrealistic to us. In our view, it is not in shareholders’ best interests for management and the board to work 2½ more years toward a marginally better, but still inadequate, ROE. Now is the time for Anchor to find a suitable merger partner.”

Stilwell has had a great deal of success over the years in pushing back into a sale, so I will not be surprised to see Anchor Bancorp announce a merger in the months ahead. A deal could be worth something on the order of $33-$35 a share based on recent deal multiples.

let’s look at interesting banks in Georgia, which came in eighth place on CNBC’s list.

The Peach State has a vibrant economy and has recovered nicely from the credit crunch’s messy aftermath. Financial services have boomed in Atlanta, and the state has a strong defense-and-aerospace industry as well.

Agriculture likewise remains strong, with thriving production of soybeans, peanuts, cotton, blueberries and broiler chickens. All told, the state got great scores from CNBC for infrastructure and workforce quality, but the network found that Georgia could do a little better on education and quality of life.

As for banks, Georgia hosts some of the better growth names, like Ameris Bancorp (ABCB) , United Community Bancorp (UCBA) and a bunch of little banks that look vulnerable to takeover offers. But to me, there’s really only one Georgia bank to consider: Charter Financial (CHFN) .

Charter has been a favorite pick of mine for some time now, and I’m excited about the bank’s future and its current stock price.

Charter is what I call a “bubble bank.” Its recent purchase of CBS Financial means that CHFN now has $1.4 billion in total assets, passing the magic $1 billion mark. The firm now also has a total of 19 branches in west-central Georgia, east-central Alabama and the Florida Gulf Coast.

Charter is committed to using both M&A and opportunistic organic growth to expand into the strong Metropolitan Atlanta region. For example, the bank plans to open a new location in Atlanta’s upscale Buckhead area later this summer.

CHFN has also done a great job of transforming its loan book from that of a thrift to a commercial bank since the firm completed its conversion from a mutual thrift to a stockholder-owned institution.

For example, the firm has done well increasing commercial exposure. Commercial-real-estate loans currently make up about 40% of CHFN’s total portfolio, with residential real estate accounting for about 29%.

Charter has also been on a buyback binge since 2014, purchasing a little more than 35% of its shares outstanding. However, that’s going to slow because CHFN shares are currently trading at about 1.05x tangible book value.

CEO Robert Johnson recently told shareholders: “We are pleased with the results of our stock repurchases over the past 10 quarters, but with our stock consistently trading above book value, we intend to focus our efforts on enhancing shareholder value through leveraging our expense structure, improving our noninterest income and realizing the anticipated growth in earnings as a result of our recent and pending Atlanta expansion.”

If management can execute its growth plans, Charter should maintain a double-digit rate of book-value growth that will drive the stock price higher. Shares could also trade at a higher multiple if the bank can maintain or grow its current 1x return on assets.

However, we can’t rule out Charter catching the eye of a larger bank that wants to expand into the bank’s growing, business-friendly region. I think any takeover would have to price the bank at 1.4x book value to succeed. That’s around $19 a share vs. CHFN’s current price of around $13.

Either outcome — a buyout or continued organic growth — should be good news for shareholders. I think you can buy the stock at current levels and add to your stake if the market is kind enough to give us a sell-off.

Owning banks in business-friendly states is just common sense. Locations where businesses can thrive have low unemployment rates and lots of people buying homes and cars. There will be stable deposit bases and good loan demand. Commercial and residential real estate markets will be strong. When we can find reasonably priced banks in these areas, long-term ownership should be very rewarding.

Note that I am planning to close Banking in Profts ot new member soon. You do have to act now to join. Because we deal with a lot of smaller stocks we have decided to limit the number of members to make it easier for all of our member to buy these little banks and share in the outsized profits. We are going to accept 38 new members and then close this product to addional members.

Those that join now will get 50% off the usual price as I want to get this done and closed so I can focus on picking stocks and not marketing. That’s 50% off for the life of your subscription not just the first year. You also get the monthly Community Bank Stock Investor every month free with your Banking on Profits membership.

The money will be made in community bank stocks as M&A picks up. The only question for you is are you going to join us on this profit rich adventure in community bank stocks? Click here to join Banking on Profits at 50% off for life and a free subscription to The Community Bank Stock Investor. Use coupon code 50OffBoP.

I look forward to a long and profitable relationship!

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 RealMoney.com

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.

Just the Numbers


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Because it will help you make money! Each issue has the information and ideas you need to make money investing in the Trade of the Decade.
Banking on Profits May 2015 bonus picks are up 15.02% vs SPY -2.29.

2-15 BOP we covered 7 banks with insider buying below book value. 6 of 7 are up , avg gain 27.21% vs SPY -.82%​

2-15 BOP we found 3 stocks with recent 13d Filings. All 3 are up. Avg gain 21,76% vs SPY -.82 ​

Banking on Profits Monthly added bonus picks last April. That months picks are up an average of 16.66% vs SPY -1.36​

4-15 BOP covered 4 13d filings. All 4 are higher with avg gain of 14.01& compared to -1.41 for spy​

In May 2015 BOP found 8 stocks insider buying at book value or less. 7 of 8 are up avg +12.25 vs -2.35 for SPY

In the March 2015 issue of BOP Monthly we covered 4 13D filings. All 4 are higher.average is 16.26%​

n 3-15 edition of BOP Monthly we found 20 stocks with insiders buying at or below book value. 16 of 20 are higher, total return 15.11%​

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