COLB - Thoughts On Arrow Financial And Bank Investing

2023-04-17 01:10:04 ET

Summary

• I began accumulating Arrow Financial shares in September 2021.
• In December I reduced bank equity holdings in favor of buying no-risk CDs yielding ~4.5%. This decision meant the sale of certain banks, including Arrow (sales price $32/cost ~$34).
• Reasons for exiting Arrow: 1) auto exposure is no longer a positive; 2) unfavorable net interest margin trends; 3) paucity of expected share repurchases.
• Arrow watch items: 1) 10-K reporting; 2) credit quality; 3) funding costs/net interest margin trends. At today's price of ~$23, if I still owned Arrow shares, I would Hold them.
• This post includes high-level thoughts on bank investing as well as a list of banks I sold and bought thus far in 2023.

Background

I began accumulating Arrow Financial Corporation ( AROW ) shares in September 2021 as documented in this Seeking Alpha article .

This low-Beta investment has not worked as planned. Share buybacks have been anemic. And until March 10 when insider made a small buy, insiders have been frequent sellers of a small number of shares over the past six months.

I sold shares in December and January and closed out my position in March. Average sales price ~$32 versus average cost basis ~$34.

Reasons for Buying in September 2021

My reasons for accumulating AROW shares:

• Superior Risk-adjusted Return on Equity.
• Returns on equity that consistently have exceeded cost of capital.
• Superior credit performance.
• Decent valuation relative to history.
• Core deposit strength with reasonable loan-deposit ratio.
• Management and board share ownership.
• Expectation of share buybacks.
• Low beta.
• History of not doing dilutive mergers.
• History as Dividend Champion with moderate Payout ratio.
• Exposure to a part of the country (Northeast corner of NY) in which I had no other bank exposure as well as exposure to auto lending concentration which none of my other bank holdings had at the time.

Watch Items Identified in September 2021 Article

• Auto exposure among highest in industry.
• Uncertainty associated with Defined Benefit Pension Plan.
• Lack of communication by board and management about Buybacks.
• Interest Rate Sensitivity/Market Risk/Cash Position.
• Not a fan of stock buybacks.

Reasons for Selling AROW Shares

It is very unusual for me to sell a bank that I hold in my long-term buy-and-hold bank portfolio.

The key driver in my decision to sell was a desire to reduce overall direct bank exposure.

Here is why I began selling AROW shares from December 2022 to March 2023:

• Auto concentration
• Exposure to Market (Interest Rate) Risk.
• Funding Costs/NIM/NII
• Buyback activity less than expected.

Auto Loan Concentration

While auto lending concentration was a strength in my 2021 view when interest rates were low, that strength became a weakness as the Fed raised interest rates faster than any time in history.

Monitoring Credit Risk

The bank's total loan book grew almost 12% in 2022. Auto loans were up 16%. That's a lot of growth heading into a possible recession.

Net Interest Margin/Net Interest Income Pressure

As noted below, Arrow has not released its 2022 10-K. Investors need the 10-K to gage Market/Interest Rate Risk.

Looking back at the bank's 4Q 2022 earnings release , AROW's Net Interest Income for Q4 2022 was essentially flat compared to the same quarter one year earlier ($39.9 million vs. $39.6 million).

Bear in mind that auto loans are the biggest driver of NII for AROW (35.54% of loans in 4Q 2022). Though auto loans grew 16% year-over-year, the average yield, the auto loan growth DID NOT produce improved NII.

No NII Growth in 2022

The bank's funding costs increased in 4Q to .52% compared to .10% for the same period in 2021. (Source: FDIC Call Report / BankRegData .)

Unfortunately, the 42-basis point increase in funding cost was not offset by a corresponding improvement in earning asset yield.

Since auto lending is the main driver of interest income for AROW, it is important to note that the average yield of the auto loan book was 4.07% for the fourth quarter of 2022 compared to 3.92% for the fourth quarter of 2021.

Arrow Watch Items: 2023 and Beyond

10-K

I am old-school when it comes to financial reporting. By that I mean that I worry when a bank cannot meet expected reporting schedules.

For several weeks I have been looking for AROW to issue its 10-K so I can review key matters, especially "Quantitative and Qualitative Disclosures about Market Risk."

AROW filed a report with the SEC on March 16, 2023 indicating that its 10-K will be late. The filing indicates :

"Arrow Financial Corporation, a New York corporation (the "Company"), is unable to file its Annual Report on Form 10-K for the fiscal year ended December 31, 2022 (the "2022 Form 10-K"), within the time period prescribed without unreasonable effort or expense. The Company requires additional time to complete the assessment of the effectiveness of internal controls over financial reporting as of December 31, 2022. As a result of the foregoing, KPMG LLP, the Company's independent registered accounting firm, has not yet completed its audit procedures."

My guess, and this is just a guess, is that the delay is associated with a staffing issue. I say this for two reasons:

First, AROW brought on a new CFO in February . Presumably, the new CFO needs extra time to confirm controls and reporting are sound before signing off on regulatory and legal disclosures. I know that I would not sign off on SEC documents before knowing for sure that I have a strong handle on financial controls and reporting.

Second, the March 16 SEC notice of late filing includes this comment:

"Notwithstanding the foregoing, the Company does not expect any material change to the financial results included in the 2022 Form 10-K compared to those included in the Company's earnings press release furnished to the Securities and Exchange Commission under the Company's Current Report on Form 8-K filed January 30, 2023 ("January Form 8-K")."

On April 5th, the bank received a NASDAQ Noncompliance Notice . That's not a good look.

The absence of a timely 10-K raises all kinds of questions including ones about the reliability of internal controls and reporting.

Credit Quality/Auto Loan Growth

I would be surprised if AROW's credit metrics deteriorate significantly in 2023-2024 given the bank's long-time record of superior credit risk management. However, if auto loan performance deteriorates in 2023, selling pressure on AROW shares likely will accelerate at an even faster pace than seen in March and April 2023. Keep a close eye on Provision when Q1 2023 earnings are announced April 27 pre-market.

Funding Costs/Net Interest Income/Net Interest Margin

The biggest concern about AROW is net interest margin pressures coming from rising funding costs against flat to declining interest income from the auto book. The risk of shrinking interest income is real as: 1) auto loan growth could reverse during a recession, 2) competitive pressures for prime auto loans caps yields on auto loans.

Buyback Activity

My expectation that AROW would accelerate buybacks proved wrong.

While the board has approved funding to buy back a meaningful number of shares (especially at today's price of $22-$23), the bank has only bought back shares sufficient to cover the annual 3% stock dividend.

As described below, my best guess as to why the bank has not been buying back shares is because of its aggressive auto loan growth in 2022.

Closing Thoughts on Bank Stocks

Risk-Free Investing vs. Banks

I wrote about CD rates on March 9.

My decision to rotate out of bank equities (as well as non-banks) into bank CDs began in the 4th quarter of 2022 when CD rates moved north of 4%. During Q1 CD rates jumped to 5%+ with durations of 3 - 24 months. (I live in a state with no state income tax, thus CDs are as attractive, if not more attractive, than Treasuries.)

Reduction in Bank Exposure in Q1

My "house" limit on direct exposure to bank equities is 10% of investable assets. As of March 31, my exposure to bank equities was 5%. The reduction is the result of:

• Sales of select bank shares including exiting Arrow, First Interstate BancSystem ( FIBK ), and Columbia Banking System ( COLB ) (and Umpqua which merged into COLB). Here are links to my most recent article on FIBK and COLB . I may revisit COLB once 1Q earnings are reported April 26. For reasons stated in my two COLB articles, I like this bank's cost of funds, markets. and business model, though operational risks remain elevated.
• The decline in value of First Republic Bank ( FRC ) which I continue to hold and will hold for foreseeable future; I may increase my position in FRC depending on what investors learn when the troubled bank reports earnings on April 24. FRC has always been my smallest bank holding (cost basis ~/.10% of investable assets). I think they survive this storm, but I am not adding shares until I hear from management. My January 17 article correctly identified liquidity risk but failed to foresee the mass exit of depositors.
• The failure of long-held SVB Financial Inc (SIVBQ) which represented a maximum of 1.0% of investable assets at its peak price in 2022 (and .20% cost basis). Here is a link to my SIVB lessons learned "Post-Mortem" article .
• The overall decline in value of bank stocks including ones held in my long-term buy-and-hold portfolio.

Additions in March and April

• On share price weakness and evidence of insider buying, I was a buyer in mid- and late March 2023 in the following banks: Cullen/Frost Bankers, Inc ( CFR ), First Financial Bankshares, Inc ( FFIN ), and HBT Financial, Inc ( HBT ).
• Late last week I added to positions in HBT and Pathward Financial, Inc ( CASH ), both of which I continue to believe benefit from rising interest rates. I like HBT at <$19 and CASH ~$40. Looking forward to earnings reports from both banks which are each scheduled for April 26.

Expect Bumpy Bank Returns Through September and Accelerating Consolidation Over Next Decade

Historically, bank stock prices are relatively weak from May to September, a topic I addressed in this important article published in January 2021 .

My best guess is that bank stocks bounce around lows between now and September given interest rate and recession fears. I am a buyer on weakness of my favorite High-Quality banks.

Longer term, I expect massive industry consolidation, a theme I addressed in some detail in my 2013 book about the history of US banking. That said, as i addressed in my recent Trustmark article , banks are sold, not bought, and therefore, it is extremely difficult for investors to target with any degree of confidence the banks that are most likely to be sold. In addition, I question whether historic sales premiums will hold up given the uncertainties facing small and mid-size banks.

Caveats

Investors need to do their own research before buying bank stocks. The data presented in this analysis is correct to the best of my judgment, but investors should do their own independent analysis to confirm.

Investors are prudent to quantify their appetite for bank risk given this sector's history of high volatility. My in-house cap is 10% of equity holdings. The actual weighting is dependent on market conditions. In addition, I recommend investors diversify bank holdings across a minimum of ten banks. These banks should encompass different strategies/customer segments, asset classes, and geographies. As a rule, I prefer owning High Quality banks with a long history of generating returns in excess of cost of capital.

For further details see: