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Vol. VI, No. 18

TOM BROWN’S BANKING WEEKLY: 5/7/21

Financial Services Insights and Intelligence

FIRST WORD: The ServisFirst recipe for success. ServisFirst Bancshares is a $12.6 billion banking company founded in Birmingham in 2005 that has enjoyed a phenomenal record of success. Last week, CEO Tom Broughton asked me to speak to a group that included his board, the company’s nine regional presidents, and regional board members.  Amy joined me; we arrived the night before the meeting for cocktails and a low-key buffet dinner with the group. The evening event was a very worthwhile experience, as it gave me a chance to talk to holding company board members who have been there the whole time, to long-time employees, and to more recent hires. Every presentation I make gives me a glimpse into the culture of the company I’m speaking to. Most bank cultures are not especially distinctive, but the best performers, like ServisFirst, First Republic, Pinnacle, and many others, have a very strong culture, which becomes apparent with just a few conversations. A strong corporate culture is to a company what strong faith is to individuals: it acts as a governor on behavior and steers decision-making in the right direction. My presentation for the next day discussed the six ingredients for success ServisFirst had identified. The six elements are all important, but it’s the company’s culture that makes them work so well.

When Tom Broughton started ServisFirst in 2005, he knew exactly what type of banking company he wanted to create, and as he lined up the initial $35 million of capital, he told his investors that he expected his strategy would lead to tremendous financial success. Based on some stories I was told, he wasn’t bashful with his targets and he had complete confidence he would be successful. The company came public in 2014, which is when I began to get to know him and appreciate his model and his management style. He is a straight talker and is hard driving. Be honest in your assessments, strive for excellence in corporate performance, lend and spend money like it’s yours, stay humble, constantly work to improve, own stock in the company, and have fun are all elements of the company’s culture. Here are the six ingredients in the company’s recipe for success.

Many bank CEOs might look at this recipe and say, “that’s what we do,” but most don’t do one or all as well as ServisFirst, because their cultures are not as strong.

Strategic Focus. From the very beginning, the company was going to be a commercially focused bank with five lines of business: commercial banking, correspondent banking, cash management, private banking, and consumer banking for professionals. ServisFirst has always operated a branch-lite model, and it has no desire to build a mass-market retail business. Companies with up to $200 million in revenues constitute the company’s target market.  Many other banks operate in such a focused manner, but their commercial focus is on other segments.

Talented and empowered employees. The company operates nine regions, each led by a president who has considerable autonomy. In addition, each region has its own board of directors, whose main purpose is to help maintain existing commercial relationships and develop new ones. The regional presidents and board members are all strongly encouraged to own ServisFirst stock. Each officer of the bank has the autonomy to (and is expected to) deliver the company’s full set of products and services to clients.

Low operating costs. The branch-lite approach and absence of focus on a mass-market retail business are important in helping keep costs down, but the key to the company’s low efficiency ratio is its “spend money like it is yours” mentality. Jimmy Filler, the company’s lead director, was almost bragging to me when he told me how small the offices in the company’s new headquarters are. Filler, with $100 million invested in ServisFirst, said “it’s almost embarrassing, but it’s the right way to manage a public company.”

Strong credit discipline. Broughton’s whole career is as a credit analyst, and he’s installed a strong credit process and culture at ServisFirst. The company has proven adept at balancing centralized risk management without disempowering loan officers. The company has very limited shared national credit exposure and no leveraged loan exposure. Since the company came public, ServisFirst’s annual net chargeoffs have been under 40 basis points. In the most recent quarter, they were just $0.5 million or 3 basis points.

Core deposit funding with few branches. One of the first elements that struck me about the ServisFirst model is that the company’s rapid loan growth was funded with core deposits. I asked Broughton how the company was able to do this, and he simply said, “we tell our lenders to get the operating accounts.” And they do: since 2015, loans have grown at a compound annual rate of 15%, deposits at 19%, and noninterest bearing deposits at 23%. Success driven by culture.

Disciplined loan pricing.  Despite the hypercompetitive environment, the company maintains above-average loan yields, because it has a culture of being firm, and getting paid for the great service it provides. It’s the culture.

The recipe of success, along with the culture, has resulted in outstanding financial results based on profitability and earnings per share growth.

ServisFirst’s financial performance has been rewarded in the equity market. Since the IPO, the stock price has grown at twice the rate of the KBW Bank Stock Index and has grown considerably faster than some other large, well-known successful companies. I have said before that ServisFirst is a great American success story, and I feel more optimistic about the sustainability of its success after spending more time with the people who run the company.

SEE YOU IN NOVEMBER: Happy May! This is the time of year when I trot out some graphic or other that shows that the old Wall Street adage of “sell in May and go away” really might be on to something. This one, from LPL Financial, seems to do nicely:

COSTLY EARNINGS: This should bring a smile to the faces of the schadenfreude enthusiasts in the audience:

PLENTY STRETCHED: Presumably there’s a limit to how high companies’ profit margins can rise, right?  It’s hard not to get a sense that that point is not so far away.

OPEN THINGS UP: One of the dumbest personnel-related decisions that corporate America has ever made, in my view, has been to insist, as a lot of companies have since the early 1970s, that many of their job categories be open only to applicants with college degrees, while any idiot in the world could see that those very jobs could be done perfectly well by people without degrees. Kudos to Merck CEO Kenneth Frazier, therefore, for seeing that mistake for what it is, and for calling on other CEOs to make more of their employment opportunities open to non-college graduates. The benefits all around should be obvious. If companies are smart, they’ll take Frazier’s advice.

BOTH SIDES: ESG investing is so easy! The FT reports that even as BlackRock, as part of its unceasing effort to make the world a better place, is supporting a proposal put forth by Procter & Gamble shareholders that protests the company’s sourcing of palm oil from the subsidiary of Indonesian conglomerate Astra Agro Lestari over allegations the unit maintains low environmental standards and abuses local farmers—are you following all this?—it turns out that at the same time, BlackRock is Astra Agro Lestari’s third-largest shareholder, with a stake of $350 million. Don’t worry, I’m sure Larry Fink will come up with a way to square this particular circle.

AUTO PARTS SHORTAGE: Can you say “supply-chain problem”? Plus, the problem is more than just a shortage of chips for new cars.

NO HELP: I’m not sure that UBS has quite yet internalized the lessons of the Archegos fiasco. Bloomberg, on Wednesday:

“Transparency”? How would that have helped, exactly? From what I can tell, the Archegos lender that came out in the best shape of all was Goldman Sachs, who sold its Archegos-related positions as fast and un-transparently as it could while supposedly negotiating with the fund’s other lenders on orchestrating an orderly wind-down of the entire portfolio. Sorry, but sometimes “Every man for himself” can be the least-bad of an array of terrible options.

ALWAYS CANDID: Jamie Dimon sure doesn’t send mixed signals. If you work at JPMorgan Chase and want to get ahead there, he indicated this week, you’d better get back to the office, and fast. “[Working from home] doesn’t work for those who want to hustle,” Dimon noted at a conference hosted by the Wall Street Journal this week. “It doesn’t work for spontaneous idea generation. It doesn’t work for culture. We want people back at work. Yes, people don’t like commuting, but so what?” It’s pretty hard to miss that message, I’d say.

VERTICAL: Lumber. Oof.

ALSO VERTICAL: And copper, for that matter.

NOT THE ONLY ALTERNATIVE: Hmm. You likely know this already, but it bears repeating. Homeownership likely isn’t as essential to achieving long-term economic success as its boosters like to say. In fact, the standards of living in developed economies where renting is much more widespread than it is here seem to be pretty darn high, and have been for decades:

My own view is that the best thing residential real estate has going for it as an investment for individuals is that it’s one asset that the owner can lever up substantially and still not have to face those pesky margin calls when prices (as happens from time to time) turn meaningfully south. Trust me, that’s not nothing.

FEELING BETTER: What a surprise! As Americans keep getting showered with billions upon billions of dollars in free money from the federal government, they’re telling pollsters that, why yes, their financial situation has improved quite a bit lately.

UNPLANNED CONSEQUENCES: Then again, people’s senses of financial security can sometimes be fleeting, and have occasionally been known to come at a longer-term cost:

FEELING BETTER: Rising agricultural commodity prices—corn has risen by around 150% over the past eight months or so, for instance—sure do seem to be making farmers happy.

SEEMS USELESS: I’m a bit of a neophyte on the topic, I admit, but am at a loss to understand what the point would be of the digital currencies said to be being planned by various central banks around the world. One of the big advantages of cryptos, after all, is that they’re developed independent of any government issuer and have a hard ceiling on supply, which means that they can’t be systematically debased—as has been known to, ahem, happen—by a meddling governmental entity like a central bank. Put a central bank into that mix, and what’s the advantage? I feel like I’m missing something. If you can explain what is, please let me know.

OPEN SEASON: On the other hand, I‘d say it’s a fair bet that not all cryptos, even those created without the connivance of some central bank or other, will end up being bastions of long-term value.

STRONG HOUSING MARKET, NOT A BUBBLE: The strength of the housing market is unusual, but in the current environment, is hardly surprising. Existing home sale prices hit a record high in March, at $329,000, up 11% from a year ago, according to CoreLogic. This is the biggest year-on-year increase in 15 years. Strong demand, favorable financing rates, and record-low supply have all contributed. However, the increase in price is having the impact on demand you would expect, as witnessed by the decline in mortgage applications in eight of the last nine weeks, and in 13 of the 18 weeks this year. Just about everything points to the strong housing market continuing, including a favorable market for homebuilders.

READY TO ROLL: It’s hard not to get a sense that financial services firms are set to stampede back into the office. From Tuesday alone:

 THEY’D RATHER STAY PUT: And these new moves to get workers back on-site should proceed smoothly, right? Not so fast! Bloomberg, on Tuesday:

An Accenture Plc survey of 400 North American financial-services executives found that almost 80% prefer for workers to spend four to five days in the office when the pandemic is over. The majority say remote work is making it difficult to train younger people and is hurting company culture.

There’s just one problem: Many employees want to maintain flexibility after proving they can stay productive from home, Accenture executives say. [Emphasis added.]

It turns out, Accenture has found, that now that so many mid-level bank employees have shown that they can maintain their productivity while working from home—and in an environment in which they helped generate record bank profits, don’t forget—a lot of them aren’t so eager to resume commuting five days a week. Who could have expected that? Employees are especially reluctant to return, I suspect, because in many cases the work environments they’ll be going back to are being reconfigured into downsized, low-cost open-plan office dystopias. Have you ever worked in places like that? I think I’d prefer to stay away, too, to tell you the truth.

INFLATION IS HERE, WHAT’S NEXT?: Over the last several weeks, my discussions with bankers and investors have shifted from concerns about inflation rising in the future to signs of inflation showing up in government reports. Suring the inflation-related portion of my presentation to ServisFirst last week, for instance, I was stopped in mid-sentence by a board member who loudly declared: “inflation is here!”  Wolfe Research strategist Chris Senyek nicely sums up what all this could mean for the equity market.

Mere increases in commodity prices are unlikely to raise the structural level of inflation, but persistently higher wage rates might. Entry level labor is tight and wages are rising, but this can be offset by increases in productivity, on which front we received some good news this week.

TEDDY BEAR MARKETS: If a bear market is defined as one where stock prices decline more than 20% from its peak, there have been 26 bear markets over the last 90 years. The one last year, which saw the market fall 34% from their peak, set a record for the fastest bear market in history. On average, it has taken three years from the end of a bear market for the market to return to its previous high. Last year was the fastest bear market recovery, with just 126 trading days between the market’s low and a new high. Is this a secular change caused by the shift in investor attitudes to buy the dip? I am not so sure. Vanguard surveyed 2,000 of its investors. These investors are 60 years old, on average, have $225,000 invested with Vanguard, of which 70% is invested in stock funds. In February last year, only 4% of these investors thought the market could decline 30%. Then in April, after the market had just gone down by over 30%, only 8% thought the equity market could go down another 30%. By December, after the market’s recovery, only 5% thought the equity market could go down 30%. There is a lot of optimism, and not many historians who recognize that the market can trade sideways for an entire decade.

A U.S. BANCORP UPDATE FROM CEO ANDY CECERE.  When Andy Cecere became CEO of U.S. Bancorp in 2017, I remember having mixed feelings for him. On the one hand, he was inheriting a strong, well-run institution—and, having known him when he was CFO and even before then, I knew he was more than capable. On the other hand, in following the legendary Richard Davis, he had big shoes to fill. Since taking over as CEO, though, and even in a tough environment, Cecere has indeed built his own record of success. Here’s are some highlights from a discussion I had with Cecere this week.

Status of Minneapolis and returning to work. Every day since the verdict in the Chauvin trial, the conditions in downtown seem to get a little better. The boards around the buildings are being removed, and more people seem to be returning to their offices. About 75% of U.S. Bank’s employees continue to work from home, but Cecere is spending a lot of time discussing plans to have employees gradually return to the office over the summer. The company will adopt a pretty standard, tiered approach, with some full-time people returning to the office, and some part-timers and a small group only working remotely. Employees are being encouraged to get a vaccine, but he does not anticipate a vaccine requirement at this point.

Strategic focus. Beyond his near-term focus on managing the timing and mix of where employees are going to be working, Cecere says he spends the bulk of his strategy-related thinking on the company’s continued digital transformation. I asked Cecere if something had changed at the company, because I had a sense that around three years ago, the company seemed to have moved from being a digital follower to being a digital leader. He said there was no clear demarcation line, but that in recent years the company has been able to devote a higher percentage of the $2.5 billion it spends annually on technology on “offense” rather than defense. Recall that U.S. Bank was operating under a consent order, because of compliance issues. The stronger offensive effort at U.S. Bank has resulted in 80% of customer transactions being done digitally. Similarly, 60% of its loan originations are now done digitally.

Push to personalize. One of the areas where U.S. Bank has shown itself to be a leader is the evolution to personalization in its retail banking effort. The company has found a great partner in Personetics in this effort.

Scale and acquisitions. On the company’s first quarter earnings call, Cecere made a comment that really caught my attention. “I do think the value and the importance of scale is even more important than it was twelve months ago or 24 months ago,” he said. Does this mean U.S. Bank would like to make an acquisition?  My read is that Cecere does, but he is far from desperate. He did make it clear that, given the disruption that an acquisition causes, it would have to be meaningful to “move the needle.” My interpretation is a bank acquisition would have to have at least $50 billion in assets, and preferably over $100 billion. If I were back playing investment banker, I would say Citizens Bancorp., Regions Financial, or Zions Bancorp would fit his description the best.

CECL in hindsight. Given his past as a CFO, I asked Cecere what he thought in hindsight about the CECL reserve accounting change. First, he joked that it obviously couldn’t have come at a more significant economic time. Second, the biggest lesson we have learned so far is how much earnings volatility the new rules have added, particularly to large consumer lenders. U.S. Bank increased its loan loss reserve by $1.9 billion in the first half of 2020, and in the first quarter it reduced its reserve by $1 billion.  Who is well-served by this new accounting practice? Just the ones we thought when we discussed its proposed adoption earlier: accounting firms and regulators.

Real-time processing. Cecere has been leading the company’s push into real-time processing, in large part because of the increased security and information it can provide users around payments. However, U.S. Bank is working closely with clients on developing multiple cases, since users can’t just be satisfied with automating an existing process, they must be willing to redesign processes that was built for a paper-based system.

Economic activity.  Given the breadth of the company’s geographic footprint, I asked Cecere if there were noticeable differences in regional economic activity. He said the differences were most noticeable by industry rather than geography, with the manufacturing and transportation industries doing exceptionally well while anything linked to corporate travel and entertainment was still way below pre-pandemic levels. Overall, corporate credit line utilization remains at an all-time low.

NEXT WEEK: On Tuesday, the National Federation of Independent Business will release its Small-Business Optimism Index for April. The consensus looks for 101.0 vs 98.2 in March.

THE LAST WORD: Like most everyone else’s, my Mother’s Day celebrations have evolved over the years. Mother’s Day is often derided as a “Hallmark” holiday, but the day does provide a chance for us to express our appreciation and love for the mothers in our lives in our own way. When I was young, my approach could be somewhat lackadaisical. One year stands out. I was probably five, my sister eight, and my brother, ten. My mother, Marge, raided her trove of S&H Green Stamps, which she had been saving over the last few years. She gave us an equal number of books of stamps and drove us to the redemption store. My bossy sister convinced me to “team up” with her and combine our books so we could buy one nice gift. After much looking, we decided to get Marge a foot stool so she could put her feet up at night. We didn’t tell my brother what we got, and he didn’t tell us his present. The next morning after church, we got together in the living room to open Mother’s Day cards and gifts. Marge opened our gift first, and my memory is she was as thrilled as anyone could be who just received a foot stool as a present. Then she opened up my brother’s gift. It was a bow and arrow set. We were all momentarily stunned, but Marge didn’t harp on the self-serving nature of the gift, which would later be used to put holes in our garbage cans. My father took us out to the garage to show Marge his gift which was . . .  a lawn mower. He would go on to give my mother an indoor or outdoor appliance for the next 20 or so Mother’s Days. So a tradition was set in the Brown household with respect to the giving of presents on Hallmark holidays. This year I am giving Amy a handle of Mount Gay rum and a case of tonic water. Happy Mother’s Day to all, and enjoy whatever is your family’s tradition.

Edited by Matt Stichnoth.

Copyright © 2021, Second Curve Capital LLC

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