Four reasons we're bullish on regional banks

As long-term bank investors, we believe that the banking industry could be headed toward a period of prosperity in 2016. In our view, the Fed's recent move to increase interest rates by 25 basis points, as well as the potential for future increases, should be seen as a positive for banks. These institutions should generate improved earnings and provide investors with an attractive opportunity in a rising-rate environment.

We're bullish on regional bank stocks for a number of reasons in addition to rising rates. First, banks benefit from an improving economy, as their earnings are closely tied to changes in the domestic economy. Traditional merger-and-acquisition activity, which slowed during the 2008 financial crisis, should remain robust as valuations and earnings improve. Delinquent and nonperforming loans will likely remain below historical levels in the near term, which should limit credit losses to banks and support future earnings. Our fundamental analysis includes a review of a bank's capital, asset quality, earnings, liquidity, and sensitivity to interest rates, a framework that's similar to the method federal regulators employ when analyzing banks.

The U.S. banking industry's earnings power has remained intact following the financial crisis, and we see potential for increased strength as loan growth accelerates and interest rates rise. Bank earnings have had a close correlation with the domestic economy and, as the economy improves, increased loan growth should provide stimulus for earnings.

Recently, the low absolute level of rates has restrained bank earnings, as it reduces the spread between what banks can earn on their loans and the interest they pay on deposits. However, as rates rise, banks will likely be able to increase the interest rates assessed on new loans and on some existing loans that carry a variable interest rate that are tied to market rates. The largest source of funds for most U.S. banks is deposits, but we believe rate increases on deposits will lag behind the interest-rate changes on loans due to a surplus of deposits in the banking system. Specifically, the industry's loan-to-deposit ratio is currently at 79%, versus a long-term average of over 97%, highlighting that loan growth has lagged deposit growth since the financial crisis, and the banking system is flush with deposits.¹

We think traditional merger-and-acquisition activity will accelerate, driven by overcapacity, increased regulatory and technology costs, and a focus on improving efficiencies. Greater scale disseminates increased compliance and regulatory costs across a wider asset base; in addition, many institutions have excess capital that can be put to use by making acquisitions. Bank assets can be accounted for more accurately today versus the uncertainties of 2008, as real estate prices and transaction volumes have increased, making it easier for buyers to value acquisition targets. As for sellers, bank valuations have recovered from their lows, providing the necessary incentive for banks' management to be more comfortable with receiving a fair takeout price for their shareholders.

With the total number of U.S. banks today at approximately 6,300, down from about 18,000 in the mid-1980s, the industry trend toward consolidation is clear. In fact, companies in our portfolio have been involved in more than 50 transactions since the beginning of 2014. We believe that there's significant room, however, for even more consolidation in the future. We expect the industry to shrink to about 3,000 over the next decade.

A strong current credit environment has led to lower credit-related costs, which has provided a tailwind for bank earnings. Nonperforming assets have declined significantly, and bank loan loss provisioning and net charge-offs have normalized. The credit quality of borrowers remains healthy, and further improvement in the economy will likely keep credit costs low for the next several years.

We remain watchful of the potential impact of lower oil prices on corporate borrowers in the energy industry, as earnings for these companies could be depressed due to lower oil and gas prices; however, less than 10% of our fund's holdings has material lending exposure to energy firms. Further, lower gas and home heating costs provide consumers with greater discretionary income to purchase other goods and services, which helps offset the macroeconomic effect of lower energy prices.

The valuation of regional banks remains attractive relative to historical levels. The long-term average of regional banks' price-to-book ratio is about 1.8x, which is considerably higher than the 1.3x recently recorded.² Other fundamentals for banks are also supportive, such as returns on equity of 8% to 12%, expected growth in book value of 7% to 11%, and dividend yields of 1% to 3%. While much of the recent downturn in the market appears related to slowing growth in China and a slight downturn in global demand for U.S. goods due to the stronger U.S. dollar, many smaller domestic-focused banks generally have little direct lending exposure to multinational companies.

We believe the confluence of a rising interest-rate environment, attractive fundamentals, and the continued industry consolidation makes U.S. bank stocks a very attractive investment opportunity in 2016.

1 U.S. Federal Reserve, 12/16/15. 2 S&P Dow Jones Indices, 12/31/15.