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March 5, 2020
Dear Friends and Fellow Investors:
As you know, we don’t often send “interim updates” – owing primarily to our philosophy and approach of remaining focused on the long-term. However, occasionally we feel compelled to provide some commentary between releases of our Newsletters. There are various times when markets can test the mettle of investors. This is one such time. The lingering impacts on the equity and bond markets following the outbreak of the coronavirus is, understandably, the current issue testing investors commitment and resolve to their portfolios. With our professional management of your resources, we’ve recovered from past declines and have produced good cumulative returns. We fully anticipate that will be the case this time as well. To borrow an old phrase popularized by the staid British, our message is direct, strong and time-tested: Keep Calm and Carry On! As you may deduce from the borrowed slogan above, I sometimes lack originality and like to plagiarize from others. Therefore, mimicking David Letterman, I propose the following “Top Ten” reasons why I encourage all of us to remain level-headed and sanguine about the investment(s) in our Bank Stock Funds. Here goes: The Financial Services Industry is not, in any way shape or form, in crisis! Bank are exceedingly well-capitalized; there aren’t any exotic financial instruments ready to destroy bank’s balance sheets; liquidity is strong and not in danger of evaporating; loan underwriting and the resulting loan quality inherent in banks portfolios remain at very strong levels; profits are at or near all-time highs and regulators are ensuring strict compliance with all bank rules and regulations. The so-called “stress-tests” imposed by law and implemented by regulators, post the Great Recession, reveal the situation is nothing remotely like we faced in 2008-09. Don’t let your minds wander and think that the current market correction is due to weaknesses in banks. It is not. THE SPECIFIC BANKS in our portfolios are among the very best of the best! As you know, we scour the country to find outstanding community banks. While the industry as a whole is as strong as can be, OUR BANKS are the cream-of-the-crop. They have really strong loan portfolios; a stable and reliable funding base; loyalty from their clients based on the outstanding service-oriented cultures they maintain; more stable margins than the large banks; and a diverse revenue stream. Maybe most importantly, our banks are “over-capitalized”. Which leads me to our next point. Many of our banks are using some of their excess capital to “buy back” their stock (or increase dividend payouts) in the face of their bargain stock prices. The boards and management teams of our banks are very bright folks. Like most of us, they understand that the current dip in their stock price is probably very temporary. They are using this down-drift in price to recapture their shares and drive future earnings per share higher. These activities are helping provide support levels to share prices – which we believe is totally appropriate and justified. Banks make money a lot of different ways! While lower interest rates will continue to put pressure on the net interest margin of banks, they have also led to a boom in mortgage refinancing activity. Banks enjoy substantial “fee income” from the refinancing activity of homeowners. The following link is an article we wrote a while back emphasizing the multitude of ways in which banks generate revenue – Bank Insights Dec. 2019. You may want to review this if you missed it. Remember: Buffet loves banks and 40% of Berkshire’s publicly-traded stock portfolio is invested in banks. Not all banks are created equal! Community Banks are very different from super-regional and money-center banks. A very common phenomenon in community banks (which is not at all prevalent in bigger banks) is that lenders impose “floors” on their loan rates. Bigger banks with larger, more sophisticated clients are far less likely to be able to impose a minimum interest rate on their middle-market or large corporate borrowers. Conversely, community banks which lend to small-businesses are able to utilize minimum interest rates on loans to their clients who are more loyal and who want a long-term “relationship” with their banks – not just a transactional connection. Access to credit is more important to small businesses than price alone. All this is to say that while all banks will experience some pressure on net interest margins due to the lower interest rate environment, community banks are unlikely to see their margins shrink as much as big banks. Finally, it is both the absolute level of interest rates and the shape of the yield curve that influences margins at banks. Recently, the yield curve has steepened and that will provide some help to banks as it relates to net interest margins. If we experience a recession, we believe it would likely be short and not drastic. In our last Newsletter, we used the example of a snake eating an egg to illustrate supply and demand imbalances. Demand may be curtailed in the short-run (based on both supply shortages and actual drop in demand for certain luxuries, like travel & entertainment) – but we believe “pent-up core demand” for goods and services will portend a quick and robust bounce back of economic activity when this issue subsides. And remember, it is an election year. The Administration is likely to do all in its power to make sure the economy is not in a recession by election day. Market-timers lose. At various times in the past, we’ve presented to you graphic illustrations of the benefits of long-term, buy and hold investing. Missing out on the 5, 10 or 20 best days in the market can dramatically and negatively impact your overall returns. Trying to “time” the market is – at best – difficult, if not impossible. History shows that investors rarely jump back in to the market at the low point of a dip; thereby missing the opportunity to recapture declines. Additionally, there are tax consequences when selling securities at a gain – which our portfolios still have. We say again, keep calm and carry on. Once this flu season and the coronavirus passes, the bounce-back in the market is likely to come fast and furious. From what we’ve read and from the medical professionals we’ve spoken with, this outbreak will eventually end. Whenever it does, hold on. Things are likely to spring back rapidly. Maintaining diversification works! Even those that are committed to remaining in the market can be tempted to participate in “sector rotation” – moving from one hot segment to the next. We advise against this activity. We know that our segment, i.e. financial services, will do well in the long-run. Don’t bail out on banks as part of your portfolio. No reason to do so. Where else in the world should you put your money? Many folks are flying to U.S. Treasuries as a safe haven. This has increased demand driving up bond prices and driving down bond yields. I think a little math may be helpful here. If an investor buys a 10 year bond yielding 1% today, and a year later the yield on bonds increase to 2%, the principal value of the 1% bond a year from now will decrease by 10%. Using the same scenario and assuming the yield a year from now goes to 3% the principal value of the bond would go down by 20%. OUCH! No thank you! Point is: we’ve seen volatility in equity markets before.
So, one last time, Keep Calm and Carry On! As always, if you have any questions or comments, please contact us at 574-243-6501 or by reply to this email. And, for the truly courageous among you, call if you wish to take advantage of this dip and increase your investment in our Funds. With warmest personal regards,
John & Adam
John W. Rosenthal, Sr.
President & CEO
John W. Rosenthal Capital Management, Inc.
574-276-1128
Adam Henry
Chief Administrative Officer
John W. Rosenthal Capital Management, Inc.
440-667-5974
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