Major U.S. Banks Have Major Problems; Which Smaller Firms Are Poised to Outperform?
Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Bank of America (NYSE: BAC) and Citigroup (NYSE: C) each reported dismal earnings last week reporting net income of $0.03 and $0.38 while missing analyst expectations that were set several times higher. I don’t know whether these poor results made you laugh or cry, but they got me thinking. Specifically, they made me think about how by its very nature capitalism abhors dead wood. Think of the marketplace like an ever-changing forest, wherein the death of the largest of redwoods creates an opportunity for new saplings. We could be sad about the death of a large tree or rejoice at capitalism’s ability to grow through creative destruction. If Bank of America and Citi are the old trees, it is regional banks and some smaller investment firms that stand ready to take their place by utilizing the new patch left fallow by the larger firms. Is this happening now? The outperformance of the SPDR Regional Banking Index versus the SPDR S&P Banking Index shows that it is.
Figure 1: SPDR Regional Banking Index ETF Versus SPDR S&P Bank ETF
Even though large banks have liquidity coming out of their ears, it is quite difficult to obtain approval for a mortgage. Furthermore, it is also rather difficult to obtain debt or equity financing to start a small business. There are currently interesting investment opportunities in regional banking, but while researching this idea the company that caught my eye was Main Street Capital (NYSE: MAIN).
Main Street has established a niche for itself by serving the lower middle market (LMM) and providing debt and equity financing for companies that have annual revenue between $10 and $100 million. The company is modestly levered and has $871 million in assets under management with $191 million, or 22%, financed though debt. Main Street pays a 5.1% effective rate on this debt with an average maturity of 6.7 years. Through pursuing attractive investment opportunities in the LMM, Main Street has widened its return on invested capital from 6% to over 15%, corresponding to greater than 20% return on equity. 75% of Main Street’s portfolio is debt of smaller companies and 95% of that portion is secured debt yielding on average 12-14%. The remaining 25% is equity ownership in smaller non-public companies and on average the net asset value per share has grown 7% annually over the past five years.
Going through the company’s investments in the most recent 10-K, the portfolio spans a broad number of businesses (Figure 3). There are coffee shops, jewelry shops, along with all other manner of small businesses from drilling companies to engineering firms among others. As the company is headquartered in Texas, there is a bias toward the financing of companies in the West and Southwest (32% and 39% of revenues respectively), but overall the portfolio is quite diverse within the mainland geography of the United States.
Figure 3: Main Street Capital’s Portfolio Weighting by Industry
For sake of comparison, the table below shows Main St., Bank of America, Citigroup, while Wells Fargo (NYSE: WFC) was also added. Wells Fargo is the most attractive among the the major banks, however, its metrics pale in comparison to those of Main Street Capital.
Questioning the investment thesis: What could go wrong?
The largest possible flaw in the investment thesis is that major banks could compete with a small entity, such as Main St. more effectively in the future. It is staggering that this small company has consistently widened its return on invested capital at the same time that major banks have done so poorly. The price/book value of Main Street is discounting continued return on capital in excess of the larger banks, otherwise one would expect it to trade at a similar price/book valuation.
Consider that the current price/book of Main Street is 1.772, which is 45% greater than the average of 1.225 since the company went public in 2007. However, return on equity has increased by a similar amount causing the TTM P/E to trade near its historical minimum at 8.78x. In other words, Main Street is a great investment opportunity if it can maintain its return on equity.
Will larger banks compete more effectively in the near term? I expect that they likely will not for several reasons. First, the small niche that Main Street has found is unlikely to disappear. If financing becomes easier it will not kill the business model, but could force Main Street to move up the risk spectrum in order to find investment opportunities that the large banks are unwilling to finance. While this could squeeze the company it is unlikely to be a huge blow. It is also expected that increasing regulation from the Obama administration and historical liabilities from the financial crisis are likely to keep the large banks from competing effectively for the foreseeable future.
A final consideration is that rock-bottom interest rates due to an activist Federal Reserve are ironically a huge boon for Main Street. Low interest rates have made large banks much more reserved about their lending practices, depressing the M1 money multiplier to an all time low. Thus, while the cost of debt for a company like Main Street is historically very low, ironically the opportunity for lending is historically very high because low rates disfavor bank lending and create opportunities in the niche market that Main Street serves! As a result, I expect that Main Street is poised to continue its outperformance.
There are many things to like about Main Street Capital Corporation. It has excellent earnings and revenue growth, only positive earnings surprises in the past six quarters and very limited analyst coverage. According to Reuters there are only two analysts firms presently covering the stock with an average target price of $26/share. So along with out of date analyst coverage the stock also enjoys low institutional ownership of 34% with a market cap still below $1 billion. Despite recent success, the firm remains almost the definition of an uncrowded trade. The top five holders of the stock are all company insiders or index funds with CEO Vincent Foster currently holding $38 million in stock, a figure representing over 21 times his reported annual compensation.
In sum, it is expected that the niche Main Street Capital presently serves should be able to grow for the foreseeable future. If the return on equity can be maintained the firm is priced to provide a 12.5% return even in the absence of the robust growth that the company has demonstrated over the past several years. In its first five years, Main Street earned a total return of 232% with dividends reinvested, or an 18% CAGR. As margins have expanded considerably it may be difficult to replicate this level of return over the next five years. Still, I expect double-digit returns and outperformance relative to the broad market. If the firm can simply maintain its dividend (~6%) and dividend growth (~7%), it should be priced to return approximately 12% over the long-term.
brenoboyle has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc , and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!