Banks in my Mind: LNB Bancorp

Banks in my Mind is a series written for the Complete Growth Investor. LNB Bancorp (LNBB) was the first one in the series and  was published some weeks ago. I want to emphasize the need to update the stock price information to current levels for all the posts in the series. I still have a position in LNBB, but it is not one of the largest. There are some unbelievable opportunities in the sector consequence of the uncertainty on the new bank regulation. Enjoy.

As a consequence of analyzing the prospects of the financial sector, I came across some potentially interesting investments. I’ll mention some of them but, given that banks are complex to analyze, the emphasizes will be on breadth over depth. If they capture your interest, we can go into more detail in a future post. I would appreciate readers’ comments, because local knowledge can be critical when investing in banks.

LNBB is a small bank from Lorain, Ohio with a strong local presence:

It appears that its credit indicators are stabilizing at a very manageable 3.8% non-performing assets to total assets (NPAs), despite high levels of unemployment (above 10%). Even more important:

Total 30- to 90-day delinquency decreased from 1.34% of total loans at December 31, 2008 to 0.75% of total loans at December 31, 2009. 30- to 90-day delinquency as a percent of loan type is under 1% for all loan types.

The 30- to 90-day delinquency is the most-followed indicator of potential future problem loans, and the low levels across all loan types piques an investor’s interest. The bank’s loan portfolio has a low 7.8% of risky construction and development loans (C&D), while the main market concern is probably the 35.6% in commercial real estate (CRE) loans, where the performance is good and improving. It’s worth remembering that CRE loans do not include CRE developments that are considered part of C&D.

Deposits have grown during the last two years from $867M to $981M, and LNBB has been building substantial liquidity, with a very low 82.7% loans over deposits.  The bank is ready to spring into loan generation as soon as the economy allows.

All capital ratios are well above what the FDIC considers well capitalized. But when it comes to banks, I’m very old school, and the bank’s 5% tangible common equity (TCE) over tangible assets (TA) looks a little thin. They have no private preferred listed on their balance sheet, and $25M in TARP, which seems about normal for a bank this size. That means that at some point, they might have the option of issuing privately held preferreds. Considering that they’re profitable ($0.14 per share in Q1 2010), well reserved, and all the credit indicators are improving, I’ll forgive the TCE issue. The probability of a large dilutive capital injection seems low.

It looks like a safe bank, but how cheap is it? Considering that its TCE is $56M, pre-tax, pre-provision earnings in 2009 was a growing $14M. Net interest margin is a very nice 3.7%, and the bank has a commanding market share in its region, $37M market cap looks very cheap indeed.

Did I mention the insider buying? CEO, CFO, HR included?

For further investigation, the bank just filed their shareholders meeting presentation

http://xml.10kwizard.com/filing_raw.php?repo=tenk&ipage=6909843

Disclosure:  Long LNBB

Thinking about investing in insurance companies?

I made a mistake in the last post. How could I possible hide some interesting data in an inconspicuous link at the end of a boring side comment? David Merkel deserves better than this.

These are the historic reserve deficits of some large insurance and reinsurance companies with long tail risk. His main target was teflon Hank Greenberg that has been denying any responsibility in the AIG debacle. Some chutzpah given all the evidence indicating compromised underwriting standards, under-reserving, increased leverage and declining ROA under his reign. AIG Financial Products and its CDSs were the last consequence of Greenberg’s risk taking leadership and his nonnegotiable 15% ROE target: the ultimate yield hog

But that is old history, soon to be forgotten to become the foundations of the next bubble. Much more interesting for our own purposes is David’s heavy lifting in evaluating reserve practices of such interesting companies like Berkshire, Markel, and White Mountains.

I know that David has liked PartnerRe for a long time and now it is at a probably conservative 0.76x book value. Cincinatti Financial is one that I have not analyzed either but it is priced at 0.88x book value. If you are interested, I suggest to check their investment record and current portfolio; if we are taking long tail risk please tell me that at least we are doing something interesting with that float. They do not have the investment reputation of a Berkshire or a Markel but that just might be appearances.

Probably the most surprising chronic under reserving is White Mountains. For those that do not know, White Mountains has been a staple of value investing portfolios and they themselves were early investors and promoters of Michael Burry’s Scion Capital. And as David mentions, conservative accounting is something they talk about. Does anyone have absolutory or confirming evidence?

As a passive investor, I tend to avoid long tail risk insurance companies like the plague. David’s work is rear view, an evaluation of past decisions, but you can not be sure about their current ones in a soft pricing environment. Even risky banking construction and development loans have durations of just a couple of years, so many of the big bad C&D loans are probably behind us. That is not the same with long tail insurance and when things go sour, turning around an insurance ship with long tail inertia is a Titanic work.

I am also a skeptical man, how can I be at ease with an investment based on management’s pedigree when so much is at stake? It is not that I distrust them personally; it is about having seen from the inside that controlling the commercial areas is an almost impossible organizational act. If you want to know more about the gap of what is needed and what we have, you should read about how National Indemnity operates in Buffett’s letters.

Some well respected companies like Fairfax Financial had their share of problems in the early 2000s and an old standing company like Lloyd’s was brought down to its knees by the weight of asbestos claims. Bad underwriting and reserving can bring down even short tail risk companies like Lincoln General: former part of Kingsway Financial situation currently under litigation.

Not to detract from a beaten sector, but at current prices personally I am preferring other alternatives in the financial sector.

PD: If someone has done or seen similar analysis with Fairfax Financial, Montpellier RE, Greenlight RE, Aspen or others, could you be kind to share it with us mere mortals? Too busy analyzing other financials.

No position

Insurance Sector Price to Book

While reviewing the presentation of a new reinsurance company, I run across some interesting data on historic price to book multiples for insurance companies.

In the context of also low banking multiples, it seems like the financials is one interesting place to look for ideas. There are several P&C insurance companies with good track records below 1x book value. But before getting too excited let me remind you the warnings about investing in banking and in financials in general:

1. Black Box: you will never be 100% sure of its balance sheet quality
2. Leverage: no perfect margin of safety
3. Thin margins: usually no competitive advantage and bad performance pays
4. Macro matters: you just can not ignore it. Deflation, inflation and interest rates have an impact
5. Leadership matters: more than in any other sector, good management is crucial to control risk and allocate capital. This is not Coca Cola that can survive a series of bad CEOs

Part of the reason for the low insurance valuations is the soft pricing environment discussed at length in several articles by the StreetCapitalist and RationalWalk. Insurance is a cyclical business, where commercial pressures drive uneconomic pricing, that destroys capital, leading no the next hard market. As Peter Lynch mentions in his books, one way to invest in the sector is to anticipate these waves. Not an easy thing to do if you are not a card carrying member.

Let me also remind you the critical questions when using book value multiples in financials:

1. How conservative is that book value?
2. Is it improving?
3. How are capital ratios and the need for value destroying new capital or a reorganization?

An excellent blog to read for an inside view of the sector is the now classic David Merkel’s Aleph blog. He posted recently an excellent analysis of reserve practices of several insurance companies that is tightly related to question #1. Very recommended.

More on the Gulf of Mexico

So how dependent is the USA on ultra deepwater production? I ask that question to have a sense on the government’s flexibility for a short term production moratorium and tough new regulation. This scenario is what the market seems to be predicting as an almost certainty. Well, this is how relevant is the Gulf of Mexico crude production:

30% of crude oil production and 19% of its reserves. If you include all liquid fuels the numbers are better but still big, with offshore GOM representing 8% of production and 15% of reserves. If you also consider that ultra deepwater production is not marginal anymore the probability of a production moratorium without real evidence of widespread negligence and corruption is probably low .

Long term, onshore reserves are a real alternative. It  comprises a large percentage of the US crude reserves but it includes secondary recovery techniques like waterflooding that may be more expensive to extract. So expensive regulation of ultra deepwater drilling may be forthcoming.

The outlook for natural gas in the Gulf of Mexico once again surprises. Perhaps counter intuitively, its lower environment impact and less dependency could make it a target for grand standing and short term measures.

Some natural gas GOM E&Ps like McMoRan Exploration have been hit as a consequence of the Macondo blowout and the suspension of exploratory drilling. MMR production is mostly in shallow water but their exploratory efforts are in ultra deep gas.

No position

Gulf of Mexico and Ultra-Deepwater

In that Macondo forgotten even by the birds, where the dust and the heat had become so strong that it was difficult to breathe, secluded by solitude and love and by the solitude of love in a house where it was almost impossible to sleep because of the noise of the red ants, Aureliano, and Amaranta Úrsula were the only happy beings, and the most happy on the face of the earth. -  Gabriel Garcia Marquez, Cien Años de Soledad

I thought it was important to put in context the  numbers of ultra-deep water exploration in the Gulf of Mexico after a possible market overreaction to the Macondo blowout. The market has left no prisoners, not only taking concern for British Petroleum and Transocean, but also all the contract drillers (Noble, Ensco, Atwood Oceanics, Hercules Offshore, Seahawk Drilling) and some exploration and production companies like ATP Oil and Gas and McMoran Exploration. I particularly recommend Toby Shute’s articles on the investment implications of this disaster.

This graph from a recent EIA post(US Energy Information Administration) tells a clear story of dependence on deep water and ultra-deep water production as shallow water production reached its peak in the nineties and began its decline. So drill all you want, but the USA is becoming more dependent on more difficult to find and more costly to produce reserves. And I have not even talked about the cost of potential  new regulation.

This is one more indication that energy prices may fluctuate but there is only one trend: up. And this is the present. If you want a peek into the future, let me introduce the proven reserves in the Gulf of Mexico.

PD: You have probably noticed that the natural gas story is different. Subject for another time

Long ATPG

Charting Banking VII: historic price to book

So where are bank valuations in terms of the credit cycle. The following is a graph from a recent Tom Brown post:

As you can see bank’s are close to the historic 25 year lows valuations. The big questions are

1. Is the book value stabilizing or even improving?
2. Is that good quality book value?
3. Are the banks well capitalized or will they need value destroying new capital or a reorganization?

I hope to have already addressed the first question by showing how the industry profits have rebounded and how the supposedly next shoe to drop have been grossly exaggerated in its impact while the real culprit seems under control. Regarding the second and third questions give me some time. We are only in part seven of the series.

What are the implications for investors? Well you can ask those three same questions for an specific bank. And if you can answer those positively,  you probably have found an opportunity because most banks multiples are at their lows. Here is a small sample with some large banks.

No position at the moment

Huntington Bancshares