From Wall Street to Main Street, it is well known by now that the banking industry is in a period of stress. Three regional US banks – Silicon Valley, Signature, and First Republic – experienced sudden but significant deposit outflows (i.e., classic bank runs) in March of 2023 that ultimately led to their collapse and seizure by regulators. More than two months since the crisis began, the debate remains as to whether more banks will fail.
The current crisis has been well covered by the financial press, but the extent to which it shocked and surprised the investment community is worth exploring. According to FactSet data, there were 68 sell-side brokerage ratings issued across the three aforementioned banks as of December 31, 2022; and yet, just two of those ratings were “Sell” recommendations. Even at Boston Trust Walden, where investing in high quality companies is the core of our investment philosophy, our quantitative assessment tools scored these banks highly relative to industry peers. Our quantitative tools identified all three banks as having attractive growth and profitability characteristics due to their past success in attracting deposits and building their capital bases. Furthermore, few traditional bank metrics suggested looming failure.
At Boston Trust Walden, we adhere to a disciplined investment process that does not rely on quantitative tools alone. For every stock we research, we conduct rigorous fundamental analysis, which requires the analyst to have a thorough understanding of the company’s business model, the macroeconomic environment, the complexities of financial accounting, and valuation. We are attuned to the risk of “Type 1 errors” (i.e., false positives) that can result from quantitative scoring. While the quantitative tools we use are well suited to evaluate a company’s past success, the qualitative analysis we conduct provides important context that helps us understand a company’s ability to sustain its prior success in the future.
In the case of these three banks, the conclusions we drew from our fundamental analysis led us to avoid purchasing Silicon Valley Bank and First Republic Bank, and to sell our position in Signature Bank in January of 2023, months before the run occurred. To be clear, we did not predict the bank runs that erupted in March but concluded that these stocks were not a good fit for our investment discipline.
Ironically but not surprisingly given what we know now, some of the desirable characteristics the quantitative tools identified and that we later questioned in our research were also clues into what drove the eventual collapse of these banks. For example, the rapid deposit growth these three banks enjoyed during the pandemic when the economy experienced an unprecedented influx of liquidity led us to question what might occur if the tide shifted and depositors began to seek higher yields on their cash. Further, as the Federal Reserve began its rate hiking cycle, it became increasingly likely that bank earnings would be pressured by banks paying out more on their deposits while earning the same, fixed rates on many of the long-term bonds they had purchased at historically low rates in a reach for yield. Finally, these banks’ stocks had previously traded at a premium to industry peers, so we had concerns about whether or not the deteriorating fundamentals could support share prices. While these issues weren’t necessarily unique to Silicon Valley, Signature, and First Republic, they appeared to be more extreme at these banks relative to peers.
It is important to note that our quantitative tools worked as intended – they identified markers of what had made these banks successful in the past. However, the tools did not account for the unique risks at play – risks that had been building up in a rapidly shifting landscape involving a global pandemic, monetary and fiscal stimulus, and subsequent tightening, all within a three-year timeframe. While fundamental analysis cannot guarantee success – after all, the benefit of hindsight has illuminated failures on the part of bank management teams – it does present us with opportunities to gain a research advantage, especially in environments like these when many quantitative methods struggle to assess extreme events. Whether it’s understanding the intricacies of how banks choose to account for investments on the balance sheet, reading company filings to understand the character and composition of deposits, or layering in how varying macroeconomic environments can impact prospective results, fundamental analysts can provide insights during challenging environments that quantitative tools are not designed to capture.
Importantly, the future will yield new, unique risks, whether in banking, other industries, or across the market. Thus, while we will continue to utilize quantitative tools and methodologies to aid our investment process, we will rely heavily on our disciplined, balanced approach to equity analysis to guide investment decision-making on behalf of our clients.