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What to Expect for Bank Returns

As the banking business changes, the best bank managers will change with it to preserve returns, says FBR's Dave Ellison.

What to Expect for Bank Returns

Ryan Leggio: Even the best managers still have to work under regulatory requirements. The Basel standards are being set as we speak. For larger banks, I think a big question for investors is, what is sustainable return on equities for large banks going forward? Can you give investors an idea of where they were historically and where you see them going forward?

David Ellison: Well, I think that if you go back four or five years ago, everybody was taking the historical number up, so it went from 12 to 13 to 15. I'd argue that when you get to that high, you're taking on too much risk--of course nobody believed that because home prices would never fall and rates would never change, and of course it did.

So I think people assume that what we saw five years ago was normal. I think what's a normal return on equity? Well, it's probably going to be somewhere between 10% and 15%, but again the better companies will manage. Meaning, if they can't make money in a certain business, they're just going to eliminate it. So, they're not going to trap themselves into low ROE/ROA businesses; that's not what capitalism does. So I think the game now is, you're consolidating a lot of businesses, you're rationalizing a lot of businesses, and the better managers are going to earn reasonably good returns, and it's not going to be 50% in equity, and it's not going to be 2% in equity. It's probably going to be like what's it's always been. It's 12% to 15%.

So, I don't think that's going to change very much, because the business while it has changed, the managers will change with it, just like technology changes and health care changes. The companies don't stay in spot. They move and modify their businesses. But all this is good--all the stuff that's happening is good, because we went up this mountain of risk, complexity, and leverage, and now we're being forced to go back down, and that's good for us a shareholders because we're taking the risk out, we're taking the complexity out, and we're taking the leverage. That's good, because when we had it, it didn't work out so well for most people, right?

So to own the equity is where you want to be in a sense, because we're in that continuum, and it's just a matter of, how patient do you want to be, and one would argue "well, it's going to take a long time for housing to come back, and it's going to take a long time for employment to come back." And that's a judgment call--but I think the companies are on the right track. They're doing all the right things to get from ugly to great, and I want to create a portfolio that's going to benefit from that continuum, and hopefully I've done that, and the shareholders will benefit.

Leggio: From a regulatory standpoint, we've seen some op-eds and articles that community banks are worried about the increased regulation etc. Do you think they can compete with the larger banks in terms of earning similar returns on equity, or should investors also reset their expectations?

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Ellison: That's a more complicated thing, because the sample size there is 20 large banks, and there are 600 or 700 small banks. So the sample size is very large. There's a lot of very good managers and a lot of very poor managers. So you have to say to yourself, okay, it gets back to what I've said: you own the better companies that understand and can react to the changes being made, and I think the companies that see that they can't make it are just going to sell.

So, you could see a tremendous amount of consolidation the next four or five years, unlike what you saw that last four or five years, because of these changes, and hopefully that's good, because if I own those companies that do the consolidation well, I should benefit as a shareholder. So I think there's opportunities there. So I don't really worry too much. If the companies aren't performing well, I just don't own them, and hopefully the guy that's doing well will buy that company at an accretive price, and so I will benefit from that.

So, I think all of these things are not necessarily low hanging fruit, but certainly when you have 1,000 companies that are public and you have 6,000 banks in America, there are lots of ways to lose money, and we've seen that the last three years, and I think there are a lot of ways now to make money, and we're going to see that the next five to 10 years.

Leggio: Dave, last question for you in terms of valuation. You run both a small-cap and large-cap financial fund. Can you talk a little bit about the relative valuations between the two and put that into context for investors, if there is a big disparity?

Ellison: Well, I think, historically, the larger banks have traded at a higher valuation if you measured on price-to-book or P/E. Today, that's not the case. The larger banks are cheaper on a price-to-book and P/E basis, and some of that's because the bigger banks have been more sensitive to regulatory, they've been more sensitive to credit, they've been more sensitive to international activities that have not worked out as well, and they're more sensitive to the big regulatory controls that the world's trying to place on the big banks.

The smaller guys, they're operating in decent markets, they don't have these complicated balance sheets. They didn't go up that mountain as much as the other guys did. So, there wasn't as much to get better, and so the stocks didn't go down that much, and they're earning good money. So I think that historically, we're in an upside-down market right now in terms of valuation now. How long that stays that way, I don't know. But again, it's all about profitability and growth and management, and I think right now people don't trust the big bank managements because of what happened in the last four years, right. Who would, right? So that will eventually dissipate, and I think the stocks will reflect that as we go forward.

Leggio: Importantly, you don't think the larger banks, the Citigroups and the Bank of Americas are value traps, that just because they look cheaper on these metrics, you do think from a fundamental and valuation basis that those types of companies should do better than the average small bank over the next few years?

Ellison: Well, I think from a performance point of view, I think you're going to find a lot of small banks do very well, and the large banks are going to basically do well because they're repair themselves, and they repair not only the financial, but also the public image. Because remember, the big banks are not very well liked by a lot of people in the world because they got bailed out, and so I think that will dissipate over time, but it will dissipate because they'll perform, meaning that they'll report earnings.

Again, we need a healthy banking system in this country. We saw what a weakened, shuddered banking system did to the economy two, three years ago, and so we need a strong banking system to provide the liquidity and the loans to the economy to grow, and we need a healthy stock market. We've got a reasonable stock market now. But we do not have a good, healthy banking system.

So we've got one and a half of what we need. The market is not all the way back, but it's not going down every day, and people are starting to trust it again, and that's healthy for wealth creation. We've got a housing market that's awful, and we've got a banking system that is still in the repair mode. So we've got a couple of things that need to get better, and the Fed is going to give us the opportunity to do that, and eventually the banks will be very healthy, and they'll be lending more aggressively, meaning they'll be taking more risk just like people are taking more risk in the stock market, and that will get the economy going, hopefully get employment working, and the whole thing will not go back to where we were, but the world won't come to an end again.

Leggio: Well, Dave, on that note, I want to thank you for joining us today.

Ellison: Good to be here.

Leggio: And thank you for joining us. This is Ryan Leggio for Morningstar.

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