Royce Investment Partners Commentary: Bullish on Quality Small-Cap Banks

Most small-cap regional and/or community banks have been unpopular with investors, an avoidance that stretches back to the failures of Silicon Valley Bank and First Republic Bank early in 2023. More recently, the highly uncertain prospects for commercial real estate (CRE) and credit in a post-pandemic world where working from home has become more common have been keeping many investors away. In our view, however, not all CRE is created equally. Most industry observers, for example, are focused on office space in large citiesyet the small community and regional banks in which we invest have little or no exposure to high rises in major metropolitan areas, instead having exposure to medical offices or low-rise buildings in the suburbs. Geography matters a lot. New York, Chicago, San Francisco, and St. Louis, for example, have notably different CRE markets than Dallas, Miami, and Nashville.

Underwriting also matters. Most of the banks we look at have loan to value ratios in the 50-60% range, which is important because it provides us with a meaningful margin of potential safety if things go wrong. So, while we think there will be some pain in office CRE, we think it's going to be mostly borne by the larger banks, though it's a smaller percentage of their respective balance sheets. Commercial mortgage-backed securities (CMBS), life insurance companies, and family offices also have CRE exposure, though typically not to the regional and community banks that we traffic in.

Additionally, credit remains pristine two-and-a-half years into the most aggressive rate hiking cycle we've ever seen. We think rates will normalize and will do so in a manageable fashion. We expect that net charge offsthe bad loans that banks have to write off as a percentage of their loanswill be in the range of 15-25 basis points, up from five today. To put that in context, during the 2007-08 Great Financial Crisis, they peaked at around 300 basis points, so we're talking a fraction of those levels in terms of credit. We also think the market hasn't yet appreciated how much capital has been raised in real estate private equity, and private equity more broadly. We think that's going to help asset valuations when the banking system encounters any stress. In fact, we believe that a significant amount of credit risk has migrated out of the banking industry into private credit, which has seen exponential growth over the last several years.

Equally important, we are also seeing stabilization in net interest margins (NIMS). For example, we expect about 80% of the banks we hold to exit 2024 with higher NIMS than where they started the year. In 2025, we expect almost all of them to see expanded NIMS. Another important issue is regulation, though that is mostly limited to banks with at least $100 billion in assets, which is not the type of bank that we own. We think that this could be a fundamental positive for our bank holdings as the regulatory burdens hit those larger enterprises and create opportunities for the smaller banks.

In addition, we have a contrarian view around interest rates. Most observers think that rates being higher for longer is bad news for banks, but we think this narrative gets some important elements wrong. Certainly, rates going from 0-5% in short order was painful, and any reduction in rates would be helpful to NIMs in the near term. Yet, we had a 0% interest rate environment for several years following the Great Financial Crisis, when deposits flooded the banking system. With banks having ample capital coming in throughout the ZIRP, or zero interest rate period, there was considerable competition for loans. That period of intensified competition saw rates of return fall, which created a poor environment for banks.

With today's more normalized cost of capital, the competition for loans looks likely to decrease. Certain smaller banks are struggling, which is creating loan growth opportunities for those small banks that are fundamentally stronger. For these banks, a more historically typical interest rate environment is a positive. In our view, these banks can not only potentially take advantage of the mistakes other banks have made, including their difficulties lending today because of mistakes they made in the past, but should also be in position to further consolidate the industry.

Finally, when we analyze companies, we look at share prices and try to determine what the market is discounting. In examining current bank valuations, we think investors are assuming that the industry climate from the recent past will stretch well into the future. They seem to think that credit conditions are soon going to be bad at some point in the current cycle, similar to what they were during the Great Financial Crisis, which doesn't seem at all realistic to us. There also seems to be a conviction that the yield curve is going to remain inverted indefinitely. Yield curves can stay inverted for prolonged periods, but they do not stay inverted permanently, so this also seems unrealistic. Finally, other investors may be assuming that banks will not be able to grow loans for the next several years. Again, we simply do not buy into the notion that the economy is going to stall or contract in ways that will preclude healthy loan growth. Based on the analyses we have done and the conversations we've had with many banks' management teams, we simply don't think that's a valid assumption, so we feel confident in the long-term prospects for our holdings in banks.

Mr. Lewis's and Mr. Hintz's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

This article first appeared on GuruFocus.