If one of your bank’s strategic goals is to provide an above average return to your shareholders, then equity price management must occupy a certain amount of executive time. Like loans and bonds, every shareholder has a stated, or at least, an implied “life of holdings.” As interest rates and your bank’s value moves up or down, that life either shortens or increases depending on the goals of the shareholders. In this article, we look at better understanding those goals, the life of holdings and how your shareholder base can predict your destiny.
Your Shareholders are Selling Your Bank
As our Executive Chairman always says, “We are a publicly traded bank, our bank is for sale every day.” It is a simple statement with profound meaning – The Bank’s employees control performance and the market passes judgment on that performance. Perform well, and your stock price goes higher to the point that your bank becomes too expensive to buy and you control your destiny. Underperform, and the market makes your stock price so cheap that investors want out and you become an easy takeover target.
Your Shareholder Base Predicts When To Sell The Bank
For privately held banks, the calculus gets a little trickier but works the same way. Private shareholders expect a return. That return comes in two forms – economic and intangible. The economic return expectations are the same as it is for everyone else. Like public investors, private holders have other alternatives for their money and so need a certain return from keep from selling their shares.
However, investors also receive an intangible or an “emotional” return from owning any company’s equity. For a bank, this return comes from the comfort and satisfaction of owning a regulated financial institution that is likely a bedrock business within a community. For legacy, family-owned banks whose equity has been passed down through generations, this return can be substantial. For banks recently started in the last fifteen years, this return may equate to only a couple percentage points.
In addition to a potentially larger intangible return, there is more transaction friction of trading shares that must be overcome. Investors into a private bank must also derive a return that compensates them for this illiquidity. It can take days and often years to sell your holdings in a private bank. This gets factored into a bank’s cost of capital which is why the smaller your bank, the more expensive your capital is likely to be.
This “liquidity premium” of the cost of capital might range between 0.50% for a regional bank to 10% for a small community bank. At present, given current interest rates, a national bank’s cost of capital is approximately 6.25% with the median community bank cost of capital around 11.70%. Thus, if you are a $700mm community bank, you need to produce an economic and intangible return more than 13% to attract more capital and be increasing the expected life of holdings.
The Shortening of Implied Average Life
In other words, if you add economic and intangible return together, it should equal or be higher than other alternative investments. If not, then private shareholders will likely seek ways to exit the bank. Have enough years of sub-performance, and shareholders, even at closely held family-owned banks, will start to question the amount of capital they have invested.
Further, as equity gets passed down from generation to generation and the family members become more removed from the founding family, that intangible premium that is assigned to the investment may become less and less also prompting the need for liquidity.
Size and Shareholder Life
As a rule of thumb, the more closely held a bank is, the more likely the investors derive their return from the intangible side than the economic side. As banks get larger and outside capital comes into the bank, the shareholder base gets diversified, and economic return usually becomes the larger influence.
The implications of this rule of thumb are interesting as analysts can look at a bank’s shareholder base size, the shareholder composition, and the bank’s return and now have a fairly accurate estimation of when a bank might sell.
Public Bank Implications
Publicly traded banks have their own set of implications for shareholder life. Once a bank reaches a certain size in terms of their outstanding equity and float (the number of traded shares) new investors come in. These new investors range from asset managers, retail investors, and activists. Each of these groups has their own objectives and implied life of holdings.
Almost in parallel with a bank’s expansion of float and performance comes the inclusion into an index. A bank might start out in a bank-only index, but then get included in a general market index such as the Russell 3,000. While being in an index creates additional liquidity which increases the average life of holdings it also means new investors will come in with different objectives. These objectives can also influence your shareholder base’s life of holdings.
As a bank’s equity base grows, investors such as short sellers, exchange-traded funds (ETFs) and other vehicles come in that may take a position in the bank either to match or to try to beat a given index. The rise of program trading, or trading by algorithm, over the last ten years has dramatically shifted the lifespan of many bank investors. Now, once a bank deviates too far from index performance, either positive or negative, these investors will buy or sell, often in unison, to create additional volatility. In doing so, the life of holdings also shifts.
By the same token, a bank can be performing to expectations, but the banking sector may be cooling off or heating up. We see this happening when expectations change regarding credit and interest rates, in particular. Investors may buy or sell a bank’s stock just to increase or decrease exposure to that sector. While this has always been done, the difference now is these program trading accounts now do it with greater volume, efficiency and speed so that on any given day, computer traded accounts, like ETFs can make up 50% to 90% of a bank’s tradable volume.
Knowing Your Bank’s Shareholder
Understanding the composition of your shareholder base and their objectives are critical to understanding one of a bank’s major constituencies. Just as a bank keeps information about their customers in a customer relationship management (CRM) system, so to should a board keep information in their CRM regarding each of their major shareholders.
Like everything else in banking, data is critical. A bank can see what type of investors own their stock and what their trading habits are. By charting each investor’s holdings, trade execution, bank performance, and index performance, a bank can now estimate an implied life of holdings and get a feel for if investors and management are aligned. Tracking items like outstanding shares, the average price paid, selling activity, if dividends are reinvested and the type of entity that each major shareholder is can present a fairly accurate profile about their likely future objectives. This analysis is often done once per year either internally (this is a great intern project), by your investment banker, or with a consultant.
Active Shareholder Management
A board of directors and bank management can exert a certain level of influence such as through communication, marketing and equity structure (dividend policy, repurchase plans, equity class, etc.) that will help influence the life of holdings and shareholder composition. The more a board and management are able to exert this influence, the greater the chance for alignment. Making sure you have alignment between your employees, customers, vendors, regulators and shareholder base has been proven to be a hallmark of success for top performing banks.
Managing a bank’s shareholder base should be an active, not passive, effort that should come with intent. Some investors are after growth; some are after dividends, some are after a short-term capital gain, some a combination and others have technical objectives.
A bank has tradeoffs between retail and institutional investors with the former having a longer life of holdings. While more expensive to go after and manage, these retail investors can be a cornerstone in shareholder management while providing an ample customer base. Developing a large retail equity base takes focus effort and is a specific marketing program that some banks evoke. For some, this work can pay off handsomely in the long run as having a long life of holdings, and a high intangible return can allow a bank to have certain liberties in long-term planning.
Regardless, of your objectives, knowing what your shareholders want and how long they will stick around if they don’t get it are important aspects to figure out. While it is absolutely true that if you produce an above average return, you don’t have to spend too much time on managing your shareholders, it is also true that communication and alignment of your bank are critical. Your shareholder base will likely not tell you their life of holdings and may not even tell you their true objectives. While your bank is for sale every day, no management wants to be surprised on that day when that sale date comes.
Submitted by Chris Nichols on October 15, 2018