Mendon Capital Advisors Corp, is Hedgeweek’s “Best Long/Short Manager” award winner for 2012.
President and Chief Investment Officer Anton Schutz (pictured), through the primary investment vehicle, Moors & Mendon Master Fund LP, has returned +23.73% YTD and +14.65% annualized from inception in 1996. The Fund invests in US based financial service companies with a specific focus on mid and small cap community banks.
The fundamental premise of the strategy is the inevitability of consolidation of US banks. Several factors are fueling the push to consolidate. Among them are increased regulatory burdens and capital requirements, sluggish organic loan growth and increased competition, and interest rates, creating investment opportunities for years to come for catalyst driven investors like him. “I think we are going to go from 7,000 banks to between 4,000 and 5,000 over the next five to seven years.”
The firm emphasizes fundamental bottom up research that has been critically important to its success. Schutz’s many years at Chase Manhattan Bank made him acutely aware that institutional investors in financial services stocks tend to be value managers because of three factors; high book value, low P/E ratio, and dividends. These appeal to a basic value manager. Schutz has added a new twist to all of that, with a focus on consolidation. More often than not, particularly for the small cap banks, the management and their Boards are pushed to sell due to the onslaught of new regulation emanating out of Dodd Frank and the other post financial crisis constraints placed on the industry. He recently noted, “We came through one of the worst financial storms of the century.” Schutz looks for finding franchise value driven by M&A and in many cases he is really looking for an M&A catalyst.
“I think with the smaller guys we will see lots and lots of M&A, and I think that it does matter where you are,” says Schutz. “In some parts of the country, your local community bank could still be pretty stressed, places like Georgia could be tough, and places like Florida could be tough.” In those markets, Schutz believes that investors are actually better off owning the buyers. In more stable markets, like in the mid-Atlantic and in New England, sellers are more attractive. The sea and sand states have experienced significant stress. Florida, Georgia and Nevada have experienced the most stress. Massachusetts or Connecticut have not seen as much deterioration. Companies in those regions are healthier, and the buyers have to pay a much bigger premium.
Another noted catalyst that will drive consolidation is loan growth. Banks in many regions are not seeing signs of material loan growth; loan pricing and terms are very competitive. The yield curve remains unfavorable and weaker interest rate margins are creating further pressure. In addition, following the financial crisis, bank regulators continue to be rigorous and in many cases unduly harsh on smaller community banks. Managements and boards are tired from the struggle after having survived through one of the worst crises of the last 100 years. The result of these issues has created an environment in many boardrooms that is tense, helping to motivate a smaller bank to sell. Schutz knows it’s tough for them to access the capital markets in a shareholder-friendly (non dilutive) way, making a lot of them feel boxed out. If they want to grow or if they want to raise money to sell off a bad loan portfolio, or fix their balance sheet so they can restructure the company, it’s hard to access that capital. Therefore, Schutz says the best thing for them to do is to partner with a stronger, slightly bigger company. That gives them a way to spread regulatory costs over a larger base with more operating leverage. In order to gain an understanding of what these banks face, Schutz has spent time on the road in the markets where these banks are located and this has helped give him a competitive advantage in the sector.
Schutz has learned that in order to be successful he needs to exercise high levels of discipline. Once he buys a company because of the potential for a takeover, and the stock price approaches what it would be worth if they sold, he doesn’t wait- he sells. But that’s only part of it. He also spends time examining the bank peers to assess where they are trading in relation to a particular company, whether at a premium or a discount.
“The thing is,” says Schutz, “because I think, particularly the smaller-cap names I own have been so under-owned by large institutions for a long time, they are just starting to go up in price, which also means that I don’t even have to be the smartest guy around, I just have to have a portfolio of these stocks.”
Enter the institutional buyers, who are back in the market for small cap financials. There were several IPOs that were completed over the last couple of months that were well spoken for by investors indicating a real interest in the space. Due to the size of these companies, a capital raise is a way that a big institutional investor can buy a big piece of stock. That’s going to change relative valuation, liquidity, and will change valuation of the entire group.
With the inevitability of consolidation, driven by significant market catalysts, Schutz is well positioned to apply his years of direct experience with many of the subject companies to the benefit of his fund investors.