Quality & Growth for Cheap
For buy & hold investors, there are only two ways to generate returns in excess of the market. I’m going to go over these two ways and highlight a company which I believe checks both boxes on how to generate excess returns: FB Financial (NYSE: FBK).
The first way is to buy into a company when unfavorable outcomes for the company are already priced into the stock. This can happen when fear around a given stock results in a price so depressed, that most negative possibilities are priced in. This leaves significant room for upside in holding the stock, as any outcome other than the worst possible one will lead to a positive revaluation of the company, which requires an ability to stay rational as fear drives the actions of other market participants. This also requires a thorough understanding of what the range of negative outcomes are, and the likelihood of those outcomes compared to what’s priced in the market. Successful historical examples of this include buying tech businesses following the dot-com crash, financials following the great recession, etc.
The second way to generate returns in excess of the market is to buy into a company in which you recognize more upside than what is priced into the company’s stock. This does not require the company’s stock to be trading at a depressed valuation. This can be done when the market is pricing in a range of positive future outcomes for the company, but you have an even more favorable range of outcomes in mind. A successful example of this would be buying Amazon in 2017. The market was already pricing in a positive future for Amazon — you would have paid 7x as much per dollar of revenue to buy Amazon as you would to buy Walmart, but this rich valuation turned out to be not rich enough, as the market has even more appreciation now for the growth and resilience of Amazon. Owning Amazon since 2017 resulted in a ~300% return compared to a ~100% return owning Walmart over the same period.
An example of a company that I believe has elements of both ways to make excess returns is FB Financial (NYSE: FBK).
For some background, FB Financial is a bank holding company with ~6.5B in banking assets that serves primarily the metropolitan markets of Tennessee, as well as markets in Northern Alabama, Northern Georgia and Kentucky. Before I get into the characteristics that I believe make FB Financial an attractive investment, I think it’s important to understand regional banks and their reason for existence.
The banking industry went through a wave of consolidation over the past couple decades which has resulted in national banking chains with over 100B in assets now being responsible for a significant majority of the total banking assets in the U.S. as can be seen in the chart below:
This wave of consolidation was a natural response to the scale needed to deploy investments in technology around digital and mobile, as well as to manage fixed regulatory costs. Large institutions were best positioned to meet the heightened expectations of consumers with these needed large investments in tech. Despite this, the assets held by small and medium institutions have not shrunk significantly since 1998. This is because well-run banks with under 10B in assets can still provide a unique value proposition to borrowers, and have earned some staying power as a result, despite their obvious disadvantages in being able to develop their own technology.
At their best, smaller banks are able to understand the unique characteristics of the regions they serve, build personal relationships with clients and make quick decisions, in a way that larger institutions would struggle to match. Smaller banks can also leverage partnerships with Fintechs and utilize technology as a service to offer similar digital products to consumers, without significant upfront capital investment. In my view, the decline in smaller banking institutions is not because of insurmountable challenges, but rather, the result of these banks failing to fully deliver on the competitive advantages they do have, while finding creative ways to neutralize the technology advantages of larger institutions.
Not all small banks have failed to do this. The management team at FB Financial utilizes these regional bank advantages and has an offering of digital resources similar to what you’d get out of a much larger institution. This has enabled the company to achieve a higher return on equity than giants like JP Morgan, all the while growing the top line at about 20% annually. This management, led by James Ayers, who purchased this business in 1988, and continues to own a bit over 40% of the stock, has a long track record of profitability and growth.
The management team does deserve credit for these historical results, but there were also significant tailwinds coming from the local economies they serve. Banks use deposits from people that have money and lend it to other people that need money. These people depositing and borrowing money have their income streams all tied to strength of the local economy. For deposits and lending to grow, it is necessary for the economies in which the banks serve, to also grow. The best banker will struggle to produce strong results in a stagnant economy (see any bank serving Western Europe over the past decade), and even a mediocre banker can find a way to shine in a booming economy. FB Financial has been serving markets that have experienced significant economic growth, and I believe the tailwinds are there for this to continue.
The population of Nashville, which is responsible for ~54% of FB Financial’s deposits, grew ~40% since 1990. The economy is thriving and continues to attract domestic migration. I believe this growth is poised to continue.
Tennessee is often ranked as one of the best states in rankings of fiscal stability. Many states in the US, including some of the surrounding ones, have inadequately funded pensions that are forcing policymakers to raise taxes on citizens already saddled with significant tax burdens.
We’ve already been seeing a rise in domestic migration from states with high taxes and housing expenses to states with lower taxes and overall living costs. I expect this to continue as publicly funded pension shortfalls take an even larger toll on fiscally irresponsible states in the coming years. Tennessee is well positioned to benefit from this trend:
For better or for worse, the mechanisms driving these domestic migration trends are likely here to stay. The main metropolitan markets served by FB Financial are likely to continue to grow as a result, which will serve as a tailwind for future growth and profitability.
Another key tailwind to consider for FB Financial is a rise in interest rates. Banks make money based on the spread between the interest they give to depositors and the interest they collect from borrowers. When interest rates rise, this spread widens and generates more profit for the bank. In response to the current economic downturn, interest rates have hit all time lows, which is a big reason why bank shares are in the gutter. However, if you believe Covid will eventually be managed away, it’s likely that rates won’t stay this low for long. As rates rise, banking assets will likely outperform.
This is a bank with a strong track record of disciplined growth as well as clear short and long term tailwinds for success. The question now becomes how much do you have to pay to own it. The current market cap of the bank is about $750M, which is slightly less than the difference between the assets and liabilities on its balance sheet (book value). This is a business that can grow rapidly and is capable of producing double digit returns on equity in a world where 10 year treasury bonds yield 0.61%, and you can buy this business for no premium to book value. This market is pricing in a lot of unfavorable outcomes for this business. I believe a range of positive outcomes is much more likely, and as a result, this is an attractive investment.