2 Attractive Ideas In The Bank Sector

2 Attractive Ideas In The Bank Sector

2020 has been a rough period for the banking sector. The XLF (Financial Select Sector SPDR ETF) has declined 18% year to date. Headwinds include record-low interest rates and a coronavirus-fueled economic slowdown, which has hindered loan growth and clouded visibility on credit risk.

Despite the near-term challenges, Warren Buffett saw opportunity this summer, aggressively acquiring more shares of Bank of America (BAC). With an investment of over $2 billion, Berkshire (NYSE:BRK.A)(NYSE:BRK.B) now owns approximately 12% of the bank. And BAC is now Berkshire’s second largest holding worth over $20 billion.

As contrarians, this bet looks smart to us. With the stock down almost 25% in 2020, BAC trades below book value, an attractive entry point for such a high-quality franchise.

With over $2 trillion in assets, BAC is one of the largest financial institutions in the U.S. BAC’s scale provides access to some of the lowest-cost capital in banking, paying less than 15 basis points on interest-bearing deposits which it lends at significantly higher rates.

This competitive advantage not only provides downside protection in the current environment, but also material upside once rates recover. Further, as one of the most interest-sensitive banks, BAC should be among the first to benefit once rates begin to rise.

In the meantime, shareholders are in good hands with a quality management team who is focused on tight cost controls and an attractive, secure dividend yield of 2.8%.

Toward the end of last week, Deutsche Bank analyst Matthew O’Connor jumped aboard, upgrading BAC to Buy from Hold, given:

more confidence in a continued macro recovery, the massive lag in bank stocks vs. the overall market, attractive absolute valuations of bank stocks, likely solid pre-provision net revenue trends in both 3Q and 4Q of this year, and arguably lower credit risk than we feared a couple months ago.”

At ~$25, BAC appears to be a solid, long-term investment idea, especially for large investors, looking to put significant dollars to work.

However, for more nimble investors, our favorite bank is a relatively anonymous firm called Hilltop Holdings (HTH).

Headquartered in Dallas, TX, HTH is a financial holding company built through a series of strategic acquisitions. Since 2005, when Gerald Ford invested in the business and joined the Board of Directors, HTH has been an aggressive acquirer, with five successful transactions – pushing the share price 2.5x from ~$8 per share to ~$20 today.

The firm’s primary line of business is to provide traditional commercial and consumer banking services through PlainsCapital Bank and its wholly owned subsidiary, PrimeLending. Also, HTH’s broker-dealer subsidiaries (Hilltop Securities Inc. and Hilltop Securities Independent Network Inc.) provide a full complement of securities brokerage, institutional, and investment banking services, as well as, clearing services and retail financial advisory.

As we described in a recent article (Hilltop Holdings: Our Top Idea – Inexpensive, Tangible Catalysts, And Elite Leadership), HTH trades at a fraction of tangible book value with a rock-solid balance sheet. We believe this envious position will lead to share appreciation in one of two ways.

The mostly likely path is accretive M&A. The company’s chairman and largest shareholder, Gerald Ford, a legendary bank acquirer, has been patiently waiting for a more challenging banking environment to be offensive with the company’s sizable war chest.

Ford has a long, proven track record of building value in times of distress. With bank valuations currently looking more attractive (XLF is down ~20% YTD), Ford is on the prowl again, ready to drive HTH’s inorganic growth via opportunistic acquisitions.

However, if Ford and the team are unable to find their diamond in the rough, we still see upside in HTH. Prior to suspending the share repurchase program, the company repurchased 700,901 shares at a weighted average price of $21.32 during 1Q20.

Given the firm’s strong recent performance and cheap valuation, it is likely the share repurchase program will be reinstated. At today’s price of ~$20, shares continue to trade below the company’s average 1Q20 buyback price and, more importantly, TBV.

Conclusion

The challenging environment has created several pockets of value in the banking sector. For large cap focused investors, BAC appears to be a smart bet. For those willing to venture into the small cap arena, we favor HTH, an underfollowed, but compelling opportunity for patient, long-term investors.

Disclosure: I am/we are long HTH, BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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