Stock price fluctuations well in excess of changes in a business’ intrinsic value is certainly not a new phenomenon. As value investors, we not only accept the premise that stock prices will often overreact to news, but we are dependent upon it to create misvalued securities. Yet even with these expectations we continue to be surprised at the degree to which the stock prices of financial companies have been so much more volatile than their underlying business fundamentals over the past decade.
Banks are clearly an economically sensitive industry. In periods of strong underlying economic growth banks see faster loan and deposit growth, driving growth in net interest income. Strong economic growth results in fewer loan losses and leads to an increase in market sensitive non-interest revenues. The level of interest rates provides yet another pro-cyclical impact to the business. Given that a bank’s business model is sensitive to economic conditions, it is therefore understandable that as the market changes its view on the direction of the economy it would reflect that change in the prices of bank stocks. However, when we look at the underlying drivers of intrinsic value in the banking sector, we cannot help but conclude that the market frequently overreacts to the modest changes in near term earnings that result from economic slowdowns.
As anyone that has built a discounted cash flow model understands, a single year’s earnings constitutes only a small proportion of a company’s value yet changes to near term earnings seems to be the dominant force affecting bank stock prices. At Hotchkis & Wiley, we focus on the long-term fundamentals of a business to arrive at the best possible estimate of its intrinsic value. This is clearly a very different approach than many in the market take today. A review of the operating results and stock price performance over the past eight years of two of our longer held positions in the financial sector, Citizens Financial and Goldman Sachs, helps illustrate periods when we witnessed a dramatic divergence between stock prices and the fundamentals that drive intrinsic value.
We first invested in Citizens Bank during its initial public offering (IPO) in September 2014 as the bank was spun out of Royal Bank of Scotland. The IPO priced at $21.50, a very attractive level in our view, considering that we estimated that the bank to have normal earnings per share (nEPS) of $2.70 at that time. Since its IPO, Citizens has steadily grown its balance sheet, made several accretive, bolt-on acquisitions, and repurchased nearly 25% of its shares. Chart 1 below shows the bank’s growth in assets, loans, and deposits per share since its public listing. As a result of the steady growth in the primary drivers of its normal earnings power our estimate of nEPS has grown to $4.50, a CAGR of just over 7%, while also paying shareholders a dividend yield that has averaged 3%.
CHART 1: CFG Growth in Key Business Fundamentals
Chart 2 shows the stock price chart for Citizens Financial since its IPO, as well as our evolving estimate of the bank’s nEPS. Since its IPO, Citizens has generated a total annual return of 10.0%, modest outperformance versus the Russell 1000 Value Index’s total annual return of 7.3% over the same period, yet the simple point-to-point measurement misses numerous large swings in its stock price. Since September 2014, Citizen’s stock has suffered four drawdowns of more than 30%, including a 50% drawdown during the early days of Covid. In each case, the drawdown was driven by increased economic fears that, for at least the first three, clearly proved to be excessive.
CHART 2: CFG Change in Price vs. Change in Fundamentals
As noted above, the core drivers of our estimates of nEPS grew on a year-over-year basis for the entire period from 2014-2021, with the only exception being a small year-over-year decline in loans in 2020. Not only did the drivers of our normal earnings power grow steadily throughout this period, reported EPS also grew in the years following the 2015 and 2018 selloffs. And while earnings declined in 2020 versus 2019, the $1.60 year-over-year drop in EPS pales in comparison to the nearly $25 drop in Citizens share price from early 2020 to the low point in the summer of 2020.
Following the first three selloffs Citizen’s stock posted strong recoveries as the market realized that its concerns proved to be overdone as the banks resilient operating results came through. While we will have to wait to see how the most recent recovery plays out, our experience with the prior three drawdown periods, combined with Citizens steady increase in underlying earnings power and the attractive valuation at which it trades today, gives us confidence that the stock is well-positioned to deliver an attractive return from current levels.
Another example of a stock whose price performance has swung significantly more than its intrinsic value over the past eight years is Goldman Sachs. We first invested in Goldman Sachs in the summer of 2014. At the time, the capital markets industry suffered from very weak fixed income trading revenues. This difficult environment weighed on Goldman’s returns and created a relatively depressed valuation in relation to our $18.00 estimate of nEPS. Our normal earnings estimate for Goldman is based on a segment-by-segment estimate of normal mid-cycle revenues and margins. While the results for businesses like investment banking and equity and fixed income trading may demonstrate more variability from year to year than the revenues of a retail and commercial bank, their average or normal level, and the drivers of those estimates (total assets, loans, deposits, market share of trading and advisory fee pools, organic growth in assets under management, etc.) have proven to be far more stable over time as shown in Chart 3.
CHART 3: GS Growth in Key Business Fundamentals
Chart 4 shows a graph of Goldman’s stock price and our evolving estimate of nEPS since June 30th 2014, the quarter during which we first established a position in the company. Over this period, Goldman produced a total annual return of 9.2%, roughly 200 basis points (bps) ahead of the Russell 1000 Value Index, quite similar to Citizens. Also, like Citizens, Goldman has suffered four drawdowns over this period of greater than 30%, even as our estimate of nEPS grew steadily.
CHART 4: GS Change in Price vs. Change in Fundamentals
As noted above, the business of investment banking and trading produce more variable results from year to year, while market share of the leading firms tends to be relatively stable. At the same time, the market grows roughly in line with global GDP, and the returns earned on capital on average over a full cycle are reasonably attractive. Cleary, the market’s tendency to overreact to short-term operating challenges and to extrapolate current results far out into the future produced several opportunities to add to our position in Goldman at a very attractive valuation.
In summary, any sign of economic weakness over the past decade produced significant declines in the price of banks and other financials. We find ourselves in a similar situation today as concern that rising short-term rates will push the economy into recession has led to a 30% drop in the KBW Bank Index from its high earlier this year. While it can be frustrating to watch our bank holdings perform so poorly, even as they continue to produce decent underlying results, we are reminded that we have seen similar drawdowns before. We are optimistic that the fundamentals that drive normal earnings power and intrinsic value will prove to be stable and growing and once again lead to a strong recovery in share prices in the banks we own.