The Man Who Thinks Banking Should 'Look To Europe,' Close Branches And Consolidate

Deep value investor Tim Melvin had the opportunity to speak with Rhino Small-Cap Financial Fund President and CEO John Schneider. Below is a full transcript of their conversation.

Tim Melvin: We're on with John Schneider today, he's the president and chief investment officer of the Rhino Small-Cap Financial Fund, and you guys are up in the Philadelphia area, aren't you?

John Schneider:

Yes we are.

TM: Okay. The fund, obviously, is in small-cap financials. You're primarily targeting small banks, is that correct?JS:

That's correct. A majority of what we do is community banks.

TM: What draws you to that space in particular?JS:

We actually have another product that does broad-based value investing, and about four and a half years ago, we found that more and more of that [fund was] gravitating towards smaller banks, and they were extraordinarily cheap, and saw that [...] things were about to recover, and so we said, "Hey, if we like it enough why don't we set up a second fund just to do small banks?" So that's the genesis of the Rhino Small-Cap Financial Fund.

TM: So you've been open about four and a half years. How have things been going during that time period? It's been a pretty nice time to be a small bank investor.JS:

It's been fantastic. Our fund is up 22.5 percent per annum after all fees, versus, say, a bank index, which would up 12. So, we've done nearly twice as well as the bank index so far over our per annum for our four and a quarter years we've been running.

TM: Okay. Just out of curiosity, how many takeovers have you participated in so far? Because I know that's been big in this space.JS:

Yeah. I think our count is about eight or nine since we started up.

TM: OK. That's a nice number. Most people don't get that in a lifetime, I don't think.JS:

To put it in context, we have about 45 names in the fund. So we probably have on the average about two a year.

TM: Community banks is a pretty large opportunity set, as you called it in your presentation. There's nearly a thousand names there. How do you work that down to find the ones you're really interested in?JS:

I think that is the real opportunity in this space. In the broader stock market, so many people are gravitating towards index funds and ETFs, and there's a lot of evidence that shows it's hard for active management to outperform. But in the space, because there are so many names that either have no or limited Wall Street coverage – and even the coverage they have it sometimes circumspect. So I think there's a great opportunity for a guy to come in it and do original research and come out with an angle like we do and add value, as we have for the four years plus that we've been running our fund.

TM: I talk to people about small banks all the time, and one of the biggest objections is that they're fairly illiquid. Does that bother you at all?JS:

Well, that's why we set it up. Our fund is a hedge fund, and people have to give 60 days' notice and so forth. We set it up so that all our investors are held to be looking out for everybody, looking out for the whole pool. And that's why you don't see mutual funds in the space, because if everybody went towards the exit at the same time, then you have a problem. But we are very aware of the liquidity and are sure that if we need to, we could liquidate in 60 days. We think that that's the thing.

But you're exactly right. That's the opportunity. Why is there an anomaly? Why are these selling at so much of a discount towards relative to the other bigger banks? [It] is because, I guess, either low quality of research, Wall Street, or brand or liquidity. You don't need a long long time. You just need a couple quarters' time horizon, and you can get out.

TM: Absolutely. As an investor, forget redemptions and all that. Does it bother you to hold the illiquid stuff as an investor? I think this is one of the biggest mistakes people make in their personal investments.JS:

I look at it like Warren Buffett does. He says, "Hey, I'm looking at it like I'm buying a slice of each of these banks, and if you like them at price X and the price goes down because some idiot wants to sell them, then that gives you an opportunity to buy more." So, no, I don't have a problem with that at all.

TM: Very good. I'm going to back up a little bit because you have pretty impressive resume before you opened Rhino in 2005. Can you tell us a little bit about your investment background?JS:

Yeah. I've been a value investor for a number of years, worked for a number of different firms in and around the Philadelphia area. And then, I went up to run PIMCO's value effort in 1999, and I ran a fairly large mutual fund called the PIMCOPEA Renaissance Fund [...] The '90s was just tech mania and value hell, and we timed that pretty well, and I had a five-year recordar where my fund outperformed the Russell 1000 value index by 1000 basis points per year for the five years I ran it, so we had a lot of success there. It was a lot of fun.

TM: That is very impressive because, 1999, just as a value investor, one of the worst years I've ever seen. It was just ridiculous.JS:

In order to win the race, you have to survive the race. That's part of the game.

TM: I was a broker at the time, and we were doing okay. We weren't doing the triple-digits returns that some of these other guys were doing, but every day you had somebody coming and going, "You've got to sell all these little thanks and insurance companies. I need some Cisco and some AOL." You just had to look at them and go, Merrill Lynch is 3 blocks down on the left, because I'm out. I can't do it.JS:

And the crazy thing is, you'd think that people would have learned their lesson from the pain after '99 of all that crazy tech investing. And yet, you can see a lot of it has returned again. Some of the names have changed, but it's the same stuff. Look at biotech and some of these crazy— Netflix and Tesla and all these kinds of crazy things. And they're very high value. The overall market is pretty, I would argue, fully valued. And yet, you still see pockets like our small banks, like you did in '99. And like in '00, when the high fliers came crashing down, and the general market came down and value actually – my fund at the time was up and up [...] I think you could see that kind of scenario over the next one, two, three years.

TM: I have to tell you, John, I'm hoping for it, because like you, I split my world into two. I've got my value portfolio, and I've got my bank portfolio. While my banks are fully invested, my value stuff is over half cash, because we just can't find it to buy right now.JS:

I think, overall, the marketplace is somewhere between fully valued and expensive. We are 6 plus years into the economic recovery, and the stock market has come a long, long way from the spring of 09. And yet, power small banks in our funds are selling at one times tangible book. They're giving them no value. And if you ever get interest rates to go up, the banks will actually earn something for their very expensive distribution system called branches.

TM: I was joking on the last fed day that the big noise you heard was the sigh of disappointment from every community banker in the nation. Now, I talk a lot about small banks, it's kind of my thing. People really are concerned about banks. They keep trying to tell me that banks are very complex and sophisticated and hard to analyze. Now, I don't think that's the case with the small community banks. Would you agree with that?JS:

I think you just put the great qualifier on it. I think the large banks are complicated. I think our little banks, they [are] just a very straightforward stuff. They take on deposits, and they make out loans. And if you read all the footnotes, the vast majority of them don't have a lot of contingent liabilities. So, it's pretty straightforward stuff. And also, I think, the capital that the entire banking industry that the United States has is way greater than it was last time, and the regulatory oversight is way higher. So, I think a lot of people try to fight the last battle. And in fact, there much, much stronger than they were last time.

TM: The small bank in particular really isn't at this point. Since I'm exposed to anything that looks like 2008, 2009. Is it? I mean, even if real estate, I think, took a hit, which I don't think will happen, I don't think you'd see the losses this time around.JS:

I agree with you. But we are always sort of pessimistic by nature. We're always looking at the next thing. There are some pockets of things that people are worried about. People focus on energy. We have very very little exposure both directly in the bank loans that the banks are making, and also in the states that are heavily energy dependent, but people are worried about that.

There's some people who are focused on ag[riculture] and how ag prices also come down a lot. So, lending against ag land and things. But there's always something to worry about. It's kind of like the old CEO of Intel said, "The paranoid survive."

TM: Right. Fortunately, if you're as value sensitive as you are, it was almost impossible to get community bank exposure to energy and ag, because they never really bucked down. I mean, Texas banks would have loved to own them. But you couldn't get near them.JS:

Yes. They were very expensive. We were half with our eyes open— that were nervous about it a year ago, even before this all came apart. But secondly, as you say, the kind of banks that were exposed to energy were the ones that were too pricey and not really the ones we were going to own anyway.

TM: Now, when you are evaluating all of these universal banks, what specific things are you looking for that says, okay, that one gets on to my shortlist?JS:

The types of things that we think you want to be exposed to, you know are, one: We talked about how eventually, someday –and I don't need to figure out the month the Fed starts to raise rates – but eventually, the Fed is going to raise rates. And when they do, you want to own an asset sensitive bank. Our banks are asset sensitive; and I might say, we had pretty good performance this year even with our asset sensitive heavy banks. But whenever that happens, that's the place you want to be. We have what we call operating leverage banks, so smaller banks are growing loans twice as fast as the larger banks, something like 8 percent versus 4 percent.

And so, if you can grow loans, eat and you can keep your expenses in check, you can get operating leverage. So we're always looking for that. We're looking for guys that are able to take some of their retained earnings and give it back to shareholders, preferably with our stocks being at 1x book, that they can buy back their stock. We're seeing a little bit of that.

So, not only is net income going up, but ETF, earnings per share a growing up. Because they're buying back the number of shares. So they're going out even a little bit more. Those are sort of the things. And then, of course, as you talked about earlier, hopefully we get a little bit of lightning strikes, and we have one or two of our banks shell out in a given year.

TM: There is a lot of talk, and I talk about it constantly, because I talk to a lot of bankers doing these interviews, and just in a normal course as I travel around. Regulatory costs are ridiculous. Rising like crazy. At the FIP conference, where I met your associate James Bell, everybody was complaining about it. All the speakers. In the bars. I mean, they were not happy about the costs. And several brought up that the new rising cost is going to be cybersecurity. Given all of that, a lot of these little guys can't make it as an independent, can they?

JS:

I agree with you completely. And looking at your letter from earlier this month, I think you're right. It used to be that people would say, 500 million dollar asset banks were too small. And I think now, with all the regulatory stuff that's going on— but that's probably now 750 or a billion. And so, banks that are below a billion dollars really need to sell themselves out, merge themselves, whatever, to get to something that's bigger so they can take their compliance costs and spread it over a bigger base.

TM: How about the credit outlook? Do you see anything developing there at all?JS:

I would say that we've gone through a huge recovery. Little thanks. Four years ago when we launched. How our fund— it was ugly and people were like, "Why do you want to buy banks and all this credit stuff?" And that's the thing. You want to buy them when things look bad. And then, as they recover, and then you benefit from that, back to 22 percent per annum recovery that we've had in performance, a lot of it was driven by that. As you're standing here today, the problem is, in some of the bigger banks, they have negative provisioning. So, you can't sustain negative provisioning for very long.

Our little banks, a lot of them have essentially zero provisioning. If you asked me, "Do I see anything on the immediate horizon?" I'd say no. But something will come along. So, when we build our modeling for companies, we're always assuming some sort of normal provisioning. Thirty (30), 40 basis points of normal provision; we think that's what you need in the long run. So guys that have less than that— we assume that eventually they're going to have to provision a little higher.

TM: Which well, of course, hit earnings a little bit. Interestingly, one of the bankers at the FIP conference last month was talking, he said, "Everything looks great right now, but we're gonna mess up. We are bankers. It's what we do."JS:

Yep, exactly. People worried about energy; I'm not so sure. But eventually, something will hit. And the sooner they catch it, the better.

TM: People keep talking about energy in the banks, but I have had a chance to talk to quite a few Houston bankers and folks down in the area. My wife is from Texas, so we have a lot of friends down there. And I'm not talking to even the Houston area banks. They don't have a lot of exposure. Post-crisis, a lot of the riskier loans were forced out into private equity and business development company land. I don't feel like the Houston area banks have a huge risk.JS:

Well, all I know is Citi reported earlier this week; they said they have 21 billion dollars of energy loans, and I was surprised to hear that they now have 640 million dollars of non-performing energy loans. That's 3 percent. Three (3) percent is not the end of the world, but up from essentially zero. So, I don't know what they're doing, but they've run into some stuff.

TM: At the risk of getting myself in trouble, if a mistake is going to be made, it gets made first at Citibank, and then Bank of America will come along and magnify it.JS:

Well, I don't know. I'm just saying I was surprised. And they have reserved 280 million dollars to date in energy loans. So, for them, none of these numbers are big numbers, but directionally, it's not the greatest thing. All I can say is, we, fortunately, have avoided it. As you said, in the small-cap bank world, in total, there's not a lot of exposure to energy. But investing in banks, you always have to worry. Worry, but as I say, in the stock prices, selling at 1x book, it's insanely overdone in what's going to actually happen.

TM: Marty Whitman once said that if he could find a sound bank trading below book value, it was hard for him to imagine a way to lose money. And I think that does hold very much true. Now, we are in the sweet spot. I think we're probably in the second, maybe third inning of the takeover consolidation wave. How long do you think this stays this good?JS:

You know what it really is? It's arbitrage. Basically, if you're a midsize regional bank and your stock is selling at one and a half, 1.7, 2x book, and you have very limited loan growth – for what all the banks have reported so far, literally 1, 2, 3 percent, kind of, loan growth, so your earnings are pretty anemic. Then it's really easy math to go out and buy one of our little banks. They're selling for 1x book and you pay a 40 or 50 percent premium, and you pay 1.5x, 1.6x book. And then you eliminate the corporate overhead; you eliminate some branches. And it's additive. So, I think it's not a matter of "are the mid-size banks eager?" It's, "how many little banks are willing?"

TM: I think it goes a little further than that, because most of the little banks at this point are figuring out there's no rescue from the Fed. And regulatory relief is not going to take the form that they might have hoped. So, I think they're coming to the realization that they have to sell. Somebody said to me the other day, "Well, there's never going to be a premium, because everybody knows they have to sell." But, in this economy with no growth, for every bank that has to sell, there's four that need to buy.JS:

I agree with you. It's not in the stock price, because, our portfolio is selling at 1x book, and they will not be sold at 1x book. There's nothing inherently wrong with these banks. If they're willing to say they can find, as you said, four buyers all paying 1.5 to 1.7, maybe now you're seeing deals inch up to 1.8 or 1.9x tangible book.

You've seen this phenomena for 30, 40 years, depending on how far back you want to go. The number of banks in this country is going to slowly shrink. Compare our banking system to any bank in – pick a place – Europe. We got many too many banks. When I was a kid, you'd go to an intersection and you used to have four gas stations on all four corners. Now you go to that intersection, you got four banks in all four corners. We do not need anywhere near the number of branches we have right now. We don't need as many banks as we have. People aren't even going. Visits are way down. We just need to close branches; we need to consolidate banking.

TM: Absolutely. Somebody asked me the other day, "How long can this go on?" And I said, "Until we get below 1000 banks."JS:

Yeah. In Europe, there's not even 1000; there's handfuls. Go to Spain or France or Germany, pick a country, I don't think there's 100 banks in these places. We need way, way fewer banks.

TM: We were one of the only nations in the world that had the— if you remember, up until the late '80s, interstate banking was illegal. You had to have a correspondent relationship with Chase Manhattan or somebody in New York to do any international business. It was a very sloppy system.JS:

Yes. It's still a holdover from that era.

TM: One of the things that I talked about a lot, and you're probably talking to as many, if not more, bankers than I am, in the small banks space. I point to something that I call exhausted bored syndrome. I think this has just been a tough five years to be a banker, and a lot of these guys, if they get anywhere near their original investments back, they're quite willing to sell at this point.JS:

Yeah. Well, I think different people have different rationales, but clearly, some of the value of the variables that go into that are, the age of management, and a lot of people have a certain price in mind, and if they can't get their price, then they'll sell. It's just a matter of time.

TM: Now, we're in a very slow growth economic environment, and I don't really see that changing anytime soon. There's pockets of strength around the country, but we are just kind of trawling along here. In this environment, can the community banks continue to grow assets, loans and earnings?JS:

Well, I think this quarter we're in is a perfect example. The S&P earnings are expected to be down 5 or 6 percent EPF year-over-year. A lot of that's driven by energy. So, X energy, the S&P is supposed to be up 1 or 2 percent. Banks, large-cap, regional banks, are supposed to grow a little bit more than that. Our little regional banks, we think we're going to grow near 10 percent. It doesn't take rocket science. All it takes is: They've got access capital, they can grow.

The big three or four banks, JPMorgan, Bank of America, Citibank— look at their earnings. Look at literally Citibank's assets over the last five years; it's essentially flat. They've had no growth for the last five years. So, what's happening is, those guys are not allowed to make any acquisitions. They're sissy banks, so they're not allowed. The regulators don't want them to grow. So, basically, what's happening is, little banks are filling in for the lack of growth of the bigger boys, so they are growing. This is FDIC data. As I said, come out. The little things are growing 8 percent loans, and the big banks – and I'm not talking about the mega ones, I'm talking about the retail ones – are growing like 4 percent. So, they are still able to grow earnings. And I think, at some point, people will recognize that growth.

TM: I feel like since the first time since the crisis ended, the little things have gotten themselves together, pulled their shoulders back and said, "We're going after the big guys." Because, when I was talking to bankers in 2010 and '11, they were like, oh no no, we're not going to market against those guys. But at the conference, again, a lot of people were saying— one banker called the big banks his marketing department.JS:

Yeah. Well, what happens also is, not only is it the marketing department, its employment. All those guys that work in those banks are tired of, for five years, all the bureaucracy and compliance and regulations. And so, they find it very refreshing to quit and work for a smaller bank where they can have a little bit more freedom. So it's their HR department.

TM: Do you have any favorite regions of the country that you're investing in? That you seem more attracted to?JS:

We try to have a pretty diversified portfolio. We don't have any particular region that we want to overemphasize. If you look back at it, I guess four years ago, we did own a fair amount of what I would call Rustbelt banks, because they were extraordinarily cheap – selling at about half of book, because people were fearful of places look Ohio and Indiana, [even] when they worked really well. And then, we maybe had a slight overweight in places like North Carolina, because their unemployment lagged, and now they're doing well.

We do own one area that's a little controversial; we do own some Puerto Rico banks. People are worried about the government there, and we are too, but we think the banks themselves— their exposure is limited and the stocks are extraordinarily cheap. It's one of the only places you can buy banks still close to half of book value. So we like Puerto Rico. But we've got a very diversified portfolio in terms of geography.

TM: In terms of Puerto Rico, are there any one of the banks there that you would say, "Oh no. We're not doing that!"?JS:

I would have said that, because they had, I think, they had 10 banks, and now we're down to three that are based in Puerto Rico. You've seen the bad banks already got wiped out. The banks that are left are very strong capital. They literally have TCE ratios of 12+ percent. So, they're very strong capital. They have really worked down their non-performers. I think now you've gotten to where – and that's why we are interested now – you've gotten where things are starting to bottom out there.

TM: As we look out into world or community banks, what are one or two ideas that you could share with everybody?JS:

Sure. One that we like is Colony. It's CBAN; it's based in Georgia. It's kind of a rural bank. Still very cheap; selling just a little bit about book value. They had credit issues that they've now all resolved. They are now starting to pay off their tarp. We think they'll have that resolved in the next six or so months. And then, we think, here's a bank that selling at $9 that we think they can earn well north of a buck, so selling it something like a 9x one year out earnings.

TM: What's the price to book on that one?JS:

I'd say, a little over 1x.

TM: Ah. They've really shrunk non-performing assets here.JS:

Yeah. The tangible book value is just south of 9, and the stock is 9. So essentially 1x tangible book.

TM: Which part of Georgia are they in?JS:

They're in Fitzgerald, which is sort of in the farm growing region, just south of Atlanta.

TM: Okay, because that's an area where there's been a lot of activity, is banks from Southeast and Southwest Georgia, trying to buy their way all the way up into the Atlanta market. I just saw a nice presentation— JS: Atlanta, people have forgotten, but when you have the credit crisis, Atlanta was a bad boy area. They had a lot of problems there [...] now resolved themselves for the most part. So now, I think, you're starting to see some of the guys that are growing there continue to grow.
Related Link: The Future Of The Small Bank Industry
TM: I've seen presentations and talked to a couple bankers in the southern part of the state where they're really trying to grow up into the Atlanta area, because that's where most of the economic activity in the state of Georgia is right now. JS: And we've seen that in a lot of our more rural banks. They're rural; they have very low cost deposits. And then they might open a branch Or, we would prefer to just have them open a loan production office in a bigger city that's nearby. And then they can take their low cost deposits and grow loans in some place that's close enough that they aren't getting out of market. And we think that's a very successful model. TM: OK. Now, not to put you on the spot, but talking about Puerto Rico, since these are larger and liquid and I don't think we can move them with our conversation, can you give us a favorite name in Puerto Rico? JS: I like OFT, used to be called Oriental. Sells for literally 60 percent of tangible book. Let me pull up a thing here and get updates on the specifics. Basically, it's a seven million dollar at that bank. The stock is selling for south of $9. It's got a tangible book value of almost 15. And as I said earlier about the capital, these guys have a tier 1 leverage worth of 10, and tier 1 common of north of 12. Pretty strong capital base. And they really don't have— it's got a little bit of exposure to the government, which we think is going to be resolved. We think, if things start to recover, it can only be a buck and a half. Under $9 stock. Pretty inexpensive. Whatever that is, six or seven times earnings. TM: I just pulled your track record up here, and it really is impressive: 22 percent since you came in. I don't think anybody's doing that out there. It sounds like you guys are really committed to the space, that you're in this for the long run. JS: Yeah. As I said, we had the fund for four and a quarter years, and we've been following small banks for the length of our original funds, which is now 10-years old. And I've been following banking since I've been in the business, which goes back to the eighties. So, we know this space. We like the space. We think we have established our little niche here. We're having fun investing our money alongside our clients. TM: Very good. It's always good when the managers have skin in the game, that's one of my favorite concepts of investing. I like to invest with people who are doing the same thing I am. JS: Buffett says, "Eight-year-old cooking". TM: Now, you guys are a hedge fund so you can go short. Have you found any shorts in the community bank space? JS: We don't do too much on that side. We like the long side more. The fund is now roughly 70, 75 percent long and 5 percent short. So, it would just be the exceptions that we stumble upon that we short. TM: Stand the criteria on the head and look for those with poor loan portfolios and poor earning recovery potential? JS: You got it. It's the reverse of everything we've been talking about. Expensive stocks. They're doing very aggressive lending that are letting their expenses grow way out of control. And you're just racing for that cliff. We don't do a lot of research looking for them; it's looking on the long side. And, occasionally, we trip over these crazy banks and short them along the way. TM: Wrap it up here, do you have any final thoughts on the Rhino Small-Cap Financial Fund and the community bank space? JS: I just think, as you said – this has been a great interview. You know this space. I've enjoyed it. I think the opportunity is, I think, for individuals who find this space attractive like you and I do, there's this selling inexpensively 1x book as opposed to the historical average of north of twice that. Earning a decent return on equity and return on assets and improving margins as opposed to contracting margins for the general broad market. And where you can see the catalysts of the smaller banks gaining from the larger banks, and all banking improving when interest rates go up.
And I guess my pitch would be, if you find this all interesting, I think it's very— as you said, there's literally nearly thousands of banks to buy from. It's pretty hard for an individual to do that. If I were them, I would go out and try to find somebody to do it for me. There are no ETFs that I'm aware of that do small banks. And so, I would find somebody with a good track record to do it for me, which is what we're doing.
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