The Dividend Mailbox

Taking Advantage of Uncertainty

May 22, 2023 Greg Denewiler Season 1 Episode 23
The Dividend Mailbox
Taking Advantage of Uncertainty
Show Notes Transcript

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By now, almost everyone has heard of the turmoil in the banking sector. The current scenario is much different from that of 2008 yet investors are nonetheless on edge. That has presented the long-term investor with an opportunity to scoop up well-managed banks at an attractive price. But buyer beware, there is a big difference between the haves and the have-nots. Although there may very well be more turbulence in the short term, there are a few candidates worth analyzing. 


Considering the sell-off in the banking sector, Greg presents a new investment idea to add to our model portfolio. He makes the case that M&T Bank ($MTB) is conservatively managed and poised for continued dividend growth, even in rough seas. Later he explains why we sold a third of our Clorox ($CLX) position and addresses a listener’s question about cash investments. 

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This is Greg Denewiler, and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.



Welcome to episode 23 of The Dividend Mailbox. Today we have a new investment idea and it's going to come from the banking sector. And one of the reasons why we're going here right now is because, especially in the regional bank space, some of them have gotten cheap and the whole group has sold off by a fairly significant margin. So, we've got one that we want to present to you and we'll go through the reasons why. And in the past, we've stayed a little light there in the banking sector, but I think you'll enjoy this idea, or at least it'll give you something to think about. And then we're going to go into why we sold a third of the Clorox position recently, and then we'll finish with a listener question about cash.



So, we've come up with a new idea to add to the model portfolio. This is a company that we have followed for quite a while. We have a relatively small position in it, but we are looking to turn it into one of the model portfolio positions, which will take us back up to 13 stocks since we sold Intel a few months ago. But before we give you the name, I'd like to set the stage a little bit. It is a regional bank, and if you've been watching the news or following the financial markets at all, banks have been in the headlines, and we've had several major bank failures in the last few months. If you look at the regional bank ETF, they're down roughly 40%. They've rallied slightly off the bottom, but they're still down a lot. We're always looking for a value-driven idea. Clearly, they've gotten a lot cheaper than where they were at the beginning of the year, so that's part of the main driver of why we're going to focus on a regional bank currently. But the bigger issue is, and what I hope you see as we go into which bank we're actually looking at purchasing right now— there is a big difference between the haves and the have-nots and with what's going on in the banking sector. 

But to understand a little bit of, “Okay, why take a risk in a bank right now when sometimes it's hard to tell what they're really doing?” Well, the first thing you need to know is what is different between 2008 and currently? We touched on this concept in the last few episodes, but again, just to remind you, you really need to step back and just look overall. What does a bank do? They take deposits in and then they loan out the money. There's a third piece of it, and that is that if they don't make enough loans and they get enough deposits in, or their deposit base is big enough, part of what they do with that money is they create a portfolio of investments. Usually, they're just mortgage-backed bonds or treasuries or some high-grade security, highly rated security. In 2008, you may remember that the banking crisis pretty much was driven around— it started with the subprime loan situation where if you were alive and breathing, you could pretty much qualify for a home mortgage. The theory was that if you package a bunch of high-risk loans together, then you can carve out a piece of it and make it AA or a AAA security, because statistically, and if you go back historically, well, the housing market had never had a significant hit to it. So, therefore, the assumption was they're just not all going to default. Well, as we find out, most of them did default, so that's what created the banking crisis. But it was centered around a credit issue, and it basically was the quality of the loan portfolio that got into trouble. There was huge credit exposure there that nobody really anticipated, even the Fed, and that's what created the 2008 banking crisis.

Now we're in a whole different situation. It's really not a credit problem at all, at least not yet. We may end up getting into a credit problem with commercial real estate loans and such, where you've got a lot of vacancies, but it is not starting as a credit problem. It is starting out as a loss in their investment portfolio. There are really only two ways to pick up income in the bond market, and one of them is to take more credit risk, (which is buying riskier bonds that have higher degrees of potential default). And the other one is to go out and buy longer-term maturity bonds. In a normal rate environment, longer maturities pay more interest than shorter ones. Well, if you're a bank and you have billions of dollars invested in a bond portfolio and they bought longer-term maturities so they could earn higher interest rates, what has happened with the move up in interest rates is the value of those bond portfolios has declined. It's wiped out a portion or a significant portion of the bank's equity because of the loss in their bond portfolios. And in today's environment where you've got social media, you've got the internet, you've got new cycles that almost run by the minute, a bank run now… Well, I'll just tell you this. I saw a cartoon a month or so ago, and basically, it had a pair of tennis shoes and an iPhone. The caption was “Bank runs then, and bank runs now.” You used to have to stand in line and get your money out. Now you go on an iPhone and transfer it. It's a difference of days to literally minutes. So, in today's environment, we've had some mismatches in liabilities and assets. 

An asset of a bank is its loan portfolio and its investment portfolio, and its liabilities are its deposits because they have to pay those back to its depositors. So, when you throw in a panic, you get an old-fashioned run, and that's how you end up with a bank failure. But when you have uncertainty in the marketplace, it creates opportunities. And what happens is investors sell first and they ask questions later. If you look now at some of these cases, we're at 25-year lows. So that's why we're starting to look in the bank space. We normally don't do a whole lot there because, not to beat a dead horse here, but one of the issues with banks is you just don't know exactly what is in their portfolio or what problems may be lurking. You really have to go back and look at history and look at how the bank has managed historically. Then there is a little bit of an issue of faith, but on another level, you really do that with any company you buy.



So now I'm going to talk about MTB. M&T Bank is a bank that was first started in 1856. It's one of the oldest banks in the country, and originally it was started as a Manufacturers and Traders Trust Company, hence the initials M and T. Over the last century plus, M&T has slowly acquired other banks, and in fact, that's how we originally got exposure to it, when they took over Wilmington Trust.


Wilmington Trust was another very old-line bank that was started back on the Upper East Coast, and one of the great things about Wilmington Trust, it was a position that I originally took in 2002, and I bought it because it was a conservatively run bank. They had virtually no subprime loans. They specialized in the mid-market, which are companies that have revenue roughly between $10 and a $100 million, and it had a big trust operation to manage wealthy family’s money. They didn't have too much consumer credit risk. They weren't very heavy in auto automobile loans. It was kind of everything you wanted in a bank and the trust side of the business is much more predictable.

It really was a case of: this is the bank that you really wanted to work with, and that became their demise. Because of what happened in these mid-markets, as you approached 2008, they would work with these regional-like home builders, car dealers, and family businesses, and as the recession of 2008 hit, they had some loans that started to get behind on their payments. And what you would hope would happen, if you have a banking relationship, you want a bank that will work with you, and when you have some cash flow issues, that they're going to be a little flexible. And that's exactly what they were trying to do. But as things deteriorated in the overall economy and as the banking situation continued to decline, The FDIC literally came in on a weekend and said: “you have too many loans that are in arrears, they're not current in their payments.” Therefore, they forced them to merge with another bank because if they wrote all the assets down to market value, their loan portfolio didn't meet the equity requirements. So, they forced them to merge, and that's when M&T Bank came in and took them over. 

That became my original exposure, and it was a small piece for a long time. But as you look at the history of it, I started reading some of the annual reports and Robert Wilmers was the CEO for decades, and he had an excellent reputation as the community bank that you would want to do business with. He wrote great shareholder letters. You can actually go back and read them, but he died in 2017, and that's when Renee Jones took over. So, M&T has a good culture. They've had a pretty conservatively managed bank in the past. In fact, one of the best statistics that you can use is going all the way back to 1976, they've never had a quarter where they lost money. So even going through the recession of 2008 and 2009, M&T Bank has been profitable. And then another measure that we obviously put a lot of weight on is their dividend. And if you go through 2008-2009, again, M&T bank never cut their dividend. So that's just another great testament to how the bank has been managed historically.

Well, as we look at this regional bank, one thing you have to keep in mind is we're talking about two separate portfolios in general. There's the investment portfolio where they take some of the deposit money and they go out and invest it and try to earn more money, and then there's the loan portfolio where they're going out and loaning the money. And each portfolio has its own separate subgroups involved in it. 

Currently one of the big focuses in the banking sector right now is bank portfolios. Well, let's take a look at the 10-K for M&T Bank ending in December of 2022 and it shows that they had total investment securities of a little over $25 billion. At the end of March 31st, 2023, they have $28.4 billion, so their investment portfolio has actually grown. I will be the first to tell you that number in and of itself doesn't really tell you much because you don't know what kind of losses are built into that portfolio. And when you look at a bank's investment securities, their portfolio is really divided into two groups.


It's divided into available-for-sale and then held-to-maturity. And from an accounting standpoint, there’s a significant difference because what a bank puts in the available-for-sale, they what they call mark-to-market and they show the current value of the portfolio each quarter. In the held-to-maturity section, there, because the bank's intentions are to hold them, they don't have to mark them to market. When we look at their available-for-sale portfolio, they have a cost of $11.3 billion, and the unrealized losses that are on that side of their portfolio are about $350 million. Well, that's only 3% of their portfolio. If you look at the held-to-maturity part of their bond portfolio, they have $16.2 billion and the unrealized losses are just slightly over $1 billion, so that's about 6.3%. The combined value of the investment portfolio is down about 5%. So that number is fairly small considering the interest rate increases that we've had and a lot of these other banks have had portfolio losses that are 15%, 20%, or more. So from that standpoint, their portfolio is really in pretty good shape. 

The next thing you want to look at is, “Okay, what does their loan portfolio look like?” The first section that we're going to look at is investor owned. These are the properties where you go out, you buy the building, and you buy for the rental income you're not actually using the property yourself. Well, here we've got it divided into retail, apartments, office, health facilities, hotels, industrial warehouses, and others. As of the end of December 2022, that entire portfolio consists of $26 billion. The single largest component of the investor-owned space is retail, that's 14%. Then you've got apartments at 13%, offices at 12%, and it declines from there. So, you have no major risk in any one's sector. 

Then the other side of their loan portfolio is owner-occupied properties, which, these are properties that the person who owns the building is a tenant for at least part of the property. Again, it's broken up into recreational and car dealerships, basically retail health services, wholesale manufacturing, real estate investors, and others. The single biggest component is 5%, and then they're all spread out from there. So, there is no significant exposure in any one area there, and that whole group represents about 23% of their commercial loan portfolio. And I think the good news there is those tend to probably be a little bit more stable because the tenants are actually using the property. So, if you look at their total loan portfolio, including all the real estate, residential, home equity lines, automobile loans, and everything, it's a total of $128 billion. They have about $30 billion in residential. They have automobile of about $4 billion. Again, it's a pretty diversified loan portfolio as a whole. 

But then the next piece of this is, “Okay, you know, we've got good diversification, but are any of these loans significant?” And what I mean by that is if you take the size of their outstanding loans, you've got 9% that are less than $1 million. You've got 36% that are between $1 and $10 million. You've got 32% that are between $10 and $30 million, and you got 13% that are between $30 and $50 million. 7% between $50 and $100 million. 3% that are greater than $100 million. So, they do not have significant loan exposure in any one loan, which is another, I think, good sign because if a bank has a concentration in some really large loans and just one of those loans becomes distressed or defaults, then a single loss can really affect a bank's assets. And that is sometimes how bank runs get started. 

So I think we've pretty much shown here that they're in decent shape, as good as you could hope, and their portfolio is fairly well diversified and the bank is reasonably healthy. So now we're going to move into what has been the problem with a lot of banks here recently, and that's their deposit base.

If you look at their deposits at the end of 2022, including their savings and checking, they had total deposits of $158 billion. Of that number, time deposits that were over the $250,000 insurance level only amounted to about $1 billion. So it's a pretty small number, and if there's going to be a run on this bank, it's not going to be because it deposits, it's going to be something else.

So just to summarize again, you know, the bond portfolio, they didn't take too much risk there and they haven't had that much downside. It's only been about 5% through the end of March for their bond portfolio, so that's in decent shape. Then the loan portfolio, it's pretty diversified. They're spread out in a lot of different areas, and they don't have any real concentration risk. Really, their risk is just overall what a bank is going to have just for being a bank, and it's probably as well managed as you could hope. And then we looked at deposits, and that's a big one. There just doesn't appear to be a catalyst of why anybody would be motivated to move their money out of the bank because of fear of FDIC insurance not covering their deposits. Most all of it is covered, so that is pretty much taken care of. 



The question may be now, “Okay, why are we buying this bank?” As I first mentioned, the whole entire banking sector has taken a pretty hard hit, and in this case, M&T Bank is no exception. A little over a year ago, the bank had a high— the stock had a high of $190. Right now, it's $114, so it's down significantly from its high, but that alone doesn't tell you a whole lot. One, just from a standpoint of historical perspective, in 2002, they had revenue of $1.8 billion. In 2012, they had revenue of $4.3 billion. In 2022, they ended up with revenue of $8.2 billion. So the bank has continually grown even through 2008 and 2009.

And another measure that I want to look at before we actually look at how it's valued— shareholders’ equity, and I think this is really important. It was 6.5 billion in 2007. At the end of 2008, which was into the recession, their shareholder's equity had actually grown slightly to $6.8 billion. In December 2009, 7.8 billion. Then not going through all these numbers, but in 2019, right before the big collapse in 2020, they had $15.7 billion. December of 2020 at $16.2 billion after 30% of the economy had been shut down. And now at the end of March, they're at $25.4 billion, so shareholders' equity has continued to grow. Shareholders' equity is really important because that's how they support their loan portfolio, and a bank makes most of its money through their loan portfolio, and it's a strong signal when they're able to grow it even through recessions.

Now let's look at how it's valued. The big measure for banks is price to book, and right now book is around $137 per share. In the last 25 years, the average for M&T bank has been 1.7 times book. If you look at the past five years, the average has been 1.34. The high was 2 times book, and the low was 0.78. Currently, it's just a little over 0.8, and even if you take it out to the past 25 years, we're really close to a 25-year low on how this stock is valued currently. And if you look at earnings in 2002, they earned $4.90, a little over $4.90. 2012, they earned a little over $7.50. 2022, around $11.50, and the estimate for this year in 2023 is a little over $16.50 a share. So, you've had really good earnings growth, and based on its current earnings projections, right now the stock is only trading at about between seven and eight times earnings. From an earnings standpoint, it's pretty cheap, but obviously, earnings are more volatile. The great thing about the price-to-book is book value doesn't change too much from quarter to quarter or year to year. It's a much slower-moving number. So, I think it's, it's some comfort that that is also trading extremely cheap. 

But why are we buying the stock? Well, we want the dividend. Well, currently the dividend, which is almost 4.5% from a dividend yield standpoint with the stock at $114, historically, this bank has a great track record of growing their dividend. In 2002, it $1.05. In 2012, the dividend was up to $2.80 and in 2022 it's $4.80, so it's almost doubled in the last decade. In the last 20 years, they've grown their dividend by 7.9% a year, so they definitely have been shareholder friendly. The payout ratio, which is if you look at earnings and they earn a dollar and if the dividend is 50 cents, that means they pay out 50% of it. Well, in 2002, they paid 20% of their earnings out in a dividend. 2012, it was 37%. 2022, it's 42%. And if you look at the 10-year average, it's around 40%. So, looking at the potential dividend growth for M&T, if they only earn $15 in 2025 and don't grow earnings much over the next two years, it can grow at to $5.90, which would be the 40% payout. That gives you the 7.2% dividend growth that we're looking for to have a dividend double in 10 years. 

If you've been a listener for a while, you may remember we used to use— our target was 6%. Well, we've actually bumped it to 7.2% now just to give us a little bit more margin of error so that if we fall back, we're still showing some pretty strong growth numbers. 7.2% is just slightly above what the historical S&P 500 dividend has grown by. So, I don't think we're reaching too much here, but M&T Bank fits that model. You may also be thinking, “Okay, these guys keep telling me their sweet spot is, uh, is around a 3%, 4% dividend yield, and now you're pushing a little higher than that. My comment to that would be, in this case, it's really because of overall market distress in the banking sector that's created value here. You really have to look under the hood and as we look at the bond portfolio, the credit quality of the loan portfolio, we just think in this case we're getting a little higher yield but we're not taking too much risk for it. And as I mentioned earlier on the payout ratio, we've got room for this dividend to grow, so we're not just buying a high-yield story. 

And just another note, if you look at corporate BBB debt, a lot of the regional banks now trade 2-3% higher than a similar BBB-rated bond. If you look at MTB’s debt, it trades about 1% higher than its similar-rated corporate debt. So that's a strong indication that the market is a little more confident in their portfolio. 

So why do we want to own a boring bank? Well, a: the 4.5% plus dividend yield that is likely going to grow over time. That's point number one. But point number two, you look for a catalyst. If you look at the price-to-book, Right now we're paying slightly more than 0.8 times booked for it, and it takes even five years and it goes back to the 25-year average of 1.7 times, you have in effect, doubled the price of the stock, plus you've earned all those dividends over that period of time. Those kinds of situations we will take all day long. 

So, we are looking to buy it. We're looking for just a little bit more weakness. We're not going to take a whole position in it yet, because one of the problems that's out there and everybody sees it is, and I really hate to say this, but you know, with the whole debt ceiling debate going on, you've got some headline risk there. And one thing that I think definitely is coming is— we still really haven't seen any headline risk yet on the commercial real estate side because with all the office vacancies and prices starting to weaken there and with what's happened in the banking sector, we quite likely are going to see a little bit more weakness. You know, we will see as the economy develops. But one thing you got to remember, M&T Bank has been through this before and they've shown the ability to manage in tough environments. They stayed profitable through 1980, through the 90s recession, through ‘08. Part of what you invest in is management, so I think they've got a good culture and it's cheap enough that I think it deserves a position in our model portfolio. 



But now transitioning to Clorox, it's a little bit of the opposite side of that story. You may remember, we bought the company as a, basically reversion to the mean story. Their margins had taken a big hit because of several factors. We're not going to go back into that, you can go back to the previous podcast to listen to it if you'd like. But basically, we were looking for margins to recover that was going to have a direct impact on earnings, which would continue to allow them to grow their dividend. Well, the story as it's unfolded in the last year and a half that we've held it, there is a reversion to the mean. About two weeks ago, they announced earnings. They had pretty good numbers. You know, you are seeing better profit margins. They have increased prices to offset inflation, however, it's been a little slower to unfold than what we were hoping for. It's probably six to 12 months behind what we had hoped would happen here.

So we took advantage of a pop in the stock. It was actually traded up into the mid to high $170 s on the earnings release, so we decided to sell a third of it since it just doesn't look like we're going to get earnings growth out of that for the next year or two. 

Just to give you a review of how we go through the process of evaluating dividend growth: currently, the earnings estimates for Clorox for 2025 are $6.51. Their average payout ratio has been between 50% and 60% historically. So, with the dividend currently at $4.72, without any growth there at all, that gives you a dividend payout of 73% using the $6.50 number in 2025. So it's pretty hard to come up with a strong case where short term we're going to see much there. You know, long term, this is a strong brand business, but we have to look at where we're at in the short term and how we're going to continue to meet our goal. Fortunately, we had a chance to get out of part of the stock position at an attractive price.

We bought the first position in October of ‘21, so we've had it for a year and a half. We bought it at $160, then we did add to it a few more times, all the way down to $137. So even if you just used the $160 number, selling it at $173, the total return has been about 7% on it. That's versus the S&P that has had a loss for that same period of about 2.5% on a total return basis. So the good news is we are beating the market and on parts of it that we own, we are in better shape. But again, we're not trying to beat the S&P 500 over a six-month, one-year, two-year period. In the end, we're after dividend growth, so that is where our discipline comes from. And even though the stock has been profitable, you know, right now we've had penny increases and we're running out of time to keep our 7.2% hurdle rate in place. So we wanted to free up capital. But the reason why we've left really two-thirds of the position in there is because that takes it down now to where it's not such a weight on the portfolio. But it does still pay almost a 3% dividend and it is a pretty consistent, predictable company. If they get the reversion to the mean, they can start to play catch up, but we don't want to take the risk with the entire position.

That's why we decided to sell part of it. MTB we think right now is a much better candidate. So that's where we're looking to move some of the cash over to, where we've got a much better dividend yield. It is a little higher risk story, however, it's also got much more room for dividend growth. So, I hope that kind of helps you give you a quick overview of how we apply our dividend growth strategy as we go through the market conditions over time.



So now let's turn to a listener question. Something that is possibly on the minds of a lot of people, and actually we're experiencing a little bit of it ourselves because we do have about 15% of our model portfolio— it's in cash right now, and it's earning almost 5%. So this is the question that we picked for this month: “Why not take 5% from a six-month treasury right now, earning a little more than 5% and just not even mess with worrying about what happens in the stock market right now with the banking scenario, with the debt ceiling, and are we going to go into a recession? 5% Seems like a great alternative.”

My answer to that will be— I'm going to take you back to when I started in the business. We're going all the way back to 1979. The competition from bonds was… well, I'll just give it to you straight. When I was calling people trying to get them to invest in the stock market, the yield on the S&P 500 roughly was 5% back then, and money markets were yielding anywhere from 14-18% because interest rates were so high. 10 year treasuries were, were yielding up around 12%, I believe, at that point. So, it became obvious: “Why in the world would I want to buy a stock?” Well, the answer was, and I've said this before, you should have mortgaged your house, sold your kids, and put anything you could into the stock market because for the next four decades, we had a phenomenal run in the market. In the 1980s, and 1990s, you were earning well over 10% a year in the S&P 500 over time, and it was an unbelievable opportunity to invest at that point. Now, I will tell you, you have to compare apples and apples, and that is you started at a point in 1980 when the market was trading much cheaper. The S&P 500 had a PE of around eight or nine, and now we're up around 16. So we are, from a valuation standpoint, we're twice as high as that, but even at this point, we're roughly at a long-term market multiple of 16, which is historically roughly where it trades at. Eight… I would really be shocked to see if that's in the cards right now because you had 12% interest rates that took market multiples that low, and it doesn't seem like that's the case.

If you just get market returns going forward, you're up in the eight and 10% and then you're always going to have opportunities, which, you know, we think the banking sector is giving you that right now where you can buy things relatively cheap and you've got great dividend yields and you've got potential dividend growth. There's always something out there going on. But to make a long story short here, 5% in a six-month treasury, you already know that if everything stays the same, a two-year treasury is going to be below 4%. A 10-year treasury is down around 3.5%, so it's not a long-term income strategy and yields on cash they're not going to stay up here permanently. Kind of by definition, if you look historically, they do not earn at least the rate of inflation over time. So, in the end, you're losing your purchasing power and that is not how you create wealth. 

You know, not to overplay the hand, but you have to own some form of equity to create wealth really. Unless you start with a lot of wealth and you're just trying to preserve it and generate a small income, otherwise, it is the growth of equity that's going to create wealth. You can do it in the real estate market, but the reality is the stock market over time gives you better returns. And we can go into that— that should probably be a whole podcast at some point. But for now, I hope you see that the answer is, yeah, current interest rates are attractive, but keep your discipline. It's a great place to put short-term money, but that's it. It's a place to park money. It is not a substitute to grow your capital and to create wealth. 



So, to wrap this episode up, hope you see why we like MTB currently. It's a good candidate for 7.2% dividend growth. And really as a long-term investor, what you're looking for is situations where the marketplace is really uncertain about what the future looks like. And if you look at a company's portfolio and management and their long-term culture, that’s how you can get into a situation where you can really compound money over time.



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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.

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