The Secret Sauce Inside of Banking’s Top Stocks

When Gregory Garrabrants took over in 2007 as president and chief executive officer at BofI Holding, an 18-year-old internet banking pioneer, he brought with him the radical idea that a technology-centric business model didn’t have to sacrifice good customer service on the altar of high efficiency.

Ten years ago, according to Garrabrants, the company was focused on an “extraordinarily low cost model” where the company wanted to have little, if any, in-person interaction with its customers, but instead push them entirely towards the bank’s online channel. “One of the things I wanted to do was have a very strong customer focus, but I wanted to do it without branches because I very much believe that the customer experience can be very good without having a branch-based network,” Garrabrants says. “I wanted … to try to eliminate the idea that you had to have this stark tradeoff between getting a good value on your deposit products and [good] customer service.”

Improving customer service was just one idea that Garrabrants had for improving the profitability of the company-he also had to build out the asset side of the balance sheet, which can be a challenge for internet banks. Andrew Liesch, a securities analyst who covers BofI Holding for Sandler O’Neill + Partners, says the company’s return on equity was in the 5 percent range before Garrabrants took over, although Garrabrants had told the board of directors when he interviewed for the CEO position that he could boost that into the mid-teens. Garrabrants told Liesch later that the bank’s board was surprised by that statement because “it had never contemplated getting up to that level of profitability,” Liesch says.

Whatever initial skepticism BofI Holding’s board might have had, the bank’s performance over the past decade has validated Garrabrants’ ideas. In a ranking of 384 publicly traded bank stocks for total return over a 10-year period through June 2017, the San Diego, California-based BofI Holding came out on top with a total return of 1,210 percent-nearly twice that of the second ranked bank. “He had a vison for how to get there and I think one of the reasons why investors like this stock is that the bank just put up a 17.78 percent return on equity, and the stock has increased in book value by 18 to 20 percent a year.”

The ultimate report card for the management team and board for any public bank is its stock price-particularly over a long period of time, where the stock’s performance is more likely to be determined by individual factors like strategy and quality of management than by market shifts that tend to favor (or disfavor) all banks more or less equally. But in an industry where the core products are commodities, why is the stock performance of some banks markedly better than most others? It may be because of an idea to do something radically different, as in the case of BofI Holding, which built its strategy around a new distribution system. It could be a string of successful acquisitions that enables a bank to accelerate its growth in a soft economy. It could be a CEO who pushes the bank forward, or the advantage of being a low cost producer-or a combination of those and other factors.

Those were some of the factors that enabled a group of 10 publicly traded banks to post industry-leading performances for total return (stock price appreciation plus reinvested dividends) over a 10-year period through June 2017. From this group, Bank Director magazine chose to focus on four banks that provide an interesting contrast in business models, strategies and markets, which underscores the fact that there is more than one path to high performance. In addition to BofI Holding, three other outperformers included Home BancShares, which placed fourth; Southern Missouri Bancorp, which came in sixth; and First Financial Bankshares, which placed ninth. The ranking was constructed by the investment bank Sandler O’Neill + Partners using data from Factset and S&P Global Market Intelligence.

For each of the four banks, there is a set of critical factors that have helped drive their performance as reflected in their stock price. For BofI, one of those factors is the successful execution of an online-only strategy that focuses on customer service, and places technology at the center of everything it does. The $8.5 billion asset bank offers a variety of consumer and business deposit products nationwide while sourcing loans in a number of carefully developed niches, including single-family residential, commercial real estate, C&I and small business. “We’ve tried to build a broad base of [lending] businesses slowly and methodically so that we’re not dependent on any one business,” Garrabrants explains. While single-family lending has been the dominate lending category to date, “we’ve continued to diversify by building C&I lending platforms and commercial real estate, and we have a number of incubator-type businesses that we think will contribute to our growth over time,” he adds.

With an efficiency ratio of 36.08 percent for its 2017 fiscal year, which concluded on June 30, BofI also has the advantage of being a low-cost producer. “The model certainly works from an operating cost standpoint,” says Liesch. The bank’s low-cost base allows it to pay up for deposits while also continuing to invest in its technology platform, while it’s also better than most traditional banks at using data to find good, high-margin loans. “They have the lower cost basis plus a strong margin that gets the profitability to where it is [today] and ultimately [has driven its] strong performance over the last decade,” Liesch says.

The company’s success was by no means guaranteed, since the online-only model has proven to be a difficult slog for many of the banks that have attempted it. Most online banks today are either owned by larger financial services organizations or funded by private equity groups. BofI Holding’s 1,210 percent total return stems in part from the fact that in 2007, when Garrabrants took over as CEO, the stock was trading as low as $1.50 a share, which Liesch says was actually below its book value. Through September of this year, the stock was trading in the range of $25 a share.

BofI’s secret sauce is its technology-forward banking platform, which appeals to a growing number of consumers today. What investors get when they buy the stock is both performance and a bet on the future of banking. One challenge the bank will face going forward is controlling its funding costs as interest rates gradually increase. “They benefited from lower interest rates over the last several years,” says Liesch. “I think there’s still some questions out there among investors on how the cost of deposits are going to react as short-term interest rates continue to increase … They need to be able to make certain they can book new loans at higher yields if they need to add deposits at higher rates as well.”

BofI also has been the focus of considerable short selling since the middle of 2015, and through mid-September the short interest in the bank’s stock was approximately 40 percent of its outstanding shares. The issue traces back to a lawsuit filed by a former internal auditor in October 2015, who claimed that the company violated whistleblower protection laws after he raised concerns about various alleged improprieties. Since then, anonymous bloggers have published reports saying that the bank has engaged in improper loan underwriting practices, violated anti-money laundering rules and used improper accounting practices. The company has claimed that it is not under investigation by the Securities and Exchange Commission, which it says the agency has confirmed, and most analysts-including Liesch-continue to recommend the stock.

If BofI Holding is a creature of the internet, it could be said that Conway, Arkansas-based Home BancShares is a product of the bank M&A market, led by its chairman and largest individual shareholder, John W. “Johnny” Allison. The bank placed fourth on the ranking with a 10-year total return of 495 percent.

Allison, who had never worked as a banker, led an investment group that applied for a bank charter and formed First State Bank in 1999. Since then, Allison and his M&A team have done 20 acquisitions that include heathy banks, banks acquired in loss share agreements with the Federal Deposit Insurance Corp. and loan pools. Allison oversees the M&A program while his management team runs the bank. Now at $10.8 billion in assets, Home BancShares’ Centennial Bank subsidiary (Home adopted that name for its banking unit after a 2003 acquisition of an institution by that name) has branches throughout Arkansas, Florida and South Alabama, and a single branch in New York that came as part of a 2015 acquisition.

Allison is tough negotiator who’s determined not to overpay for a deal. “Johnny’s walked away from deals just because a CEO will demand that they pay for his car when they do the deal, and he’s like, ‘We’re not paying for your car. Pay for your own car. The bank doesn’t pay for my car,’” says Sandler O’Neill securities analyst Stephen Scouten, who covers Home BancShares. “They’re going to pay you what they think your bank is worth today, not what you think it will be worth two or three years from now. Then, he’ll turn it into what he thinks you could have made it into in three years.”

One of the ways that Allison does that is to aggressively strip costs out of his acquired banks, driven by his determination that all of his deals should be accretive to earnings per share on the day of closing. “You hear about all of these deals that earn back the dilution in two, three, four years-that’s all B.S. in my opinion,” he says. “We’ve never [taken] dilution from day one. We don’t and we won’t.”

And yet even apart from Allison’s acquisitions, Home BancShares is a highly efficient operator, recording a 37.48 percent efficiency ratio in the first six months of 2017. Allison says it’s simply a cultural mindset at Home to be very tough on expenses. “I’m not a banker, I’m a businessman,” says Allison. “I run it like a business. I don’t run it like a bank.”

The secret sauce in Home BancShares’ stock is that underlying efficiency combined with Allison’s cost-centric deal making. Those factors combined have helped propel the bank’s profitability. The bank has been “a poster child for efficiency over the past five to seven years,” says Scouten. “And [it’s] been known as a bank that’s going to be very disciplined about what it’s willing to pay on those deals, and then [it’s] going to make them work.”

What are investors getting when they own Home BancShares’ stock? Clearly they are buying into a consolidation story, since that is the bank’s central strategy. But Allison says they are getting something more as well. “They’re buying me and my management team,” he says. “They’re buying the fact that I’m the largest shareholder and 85 percent of my net worth is tied up in this stock. They know that I’m not going to go out there and do something stupid.” Home BancShares’ biggest challenge in the future will be finding enough good deals to sustain the bank’s growth and profitability, although Allison seems unconcerned that he might run out of acquisitions. “I think we’ve got a lot of runway left,” he says.

Another bank that relies on acquisitions to help drive its growth and profitability is Popular Bluff, Missouri-based Southern Missouri Bancorp, which placed sixth on the ranking, with a total return of 453 percent. The $1.7 billion asset bank does business in Missouri, Arkansas and Illinois, which don’t contain a lot of strong growth markets and by themselves could not support the long-term growth and profitability that has helped propel Southern Missouri’s stock price. “We can grow 8 to 10 percent organically, but to continue to generate returns, we have to do profitable acquisitions,” says Greg A. Steffens, the bank’s president and CEO. Southern Missouri has completed seven acquisitions since 2010 and announced an eighth deal in August, “and we feel like we need to continue to do some of those profitable acquisitions to be able to continue to provide enhanced returns to our shareholders,” he adds.

The bank has done a good job of growing loans, including commercial and industrial loans, as well as commercial and residential real estate loans, but it also looks to M&A deals for growth as well. In its 2017 fiscal year, which ran through June 30, the loan portfolio increased by $262 million, or 23 percent, from the prior year, primarily due to an earlier acquisition. And one of the things that Steffens looks for in an acquisition is a bank that is flush with deposits. “We are able to generate more loan growth than deposit growth, and acquisitions help fund part of the mismatch between our loan growth and our deposit growth,” he says. “We need to be able to acquire institutions that have a little more deposits than they do loans.”

When it comes to organic loan growth, Steffens believes that Southern Missouri’s strong identity as a community bank with a 130-year old history has helped it expand market share in communities where the underlying economy isn’t growing much, although its 3.82 net interest margin-the lowest of all four banks-would suggest that it must still compete on price as well. “They do a good job with the growth that’s in their markets and they do an even better job taking market share,” says Liesch, who covers the stock for Sandler O’Neill.

Southern Missouri’s secret sauce is its ability to acquire banks with low loan-to-deposit ratios and use that funding to fuel its organic loan growth. And what do investors get for their money? A company that offers solid profitability and growth pursuing a traditional community bank strategy.

If there was one characteristic that defines Abilene, Texas-based First Financial Bankshares, which placed ninth with a total return of 336 percent, it’s discipline. “We know who we are. We know what we can do, and we don’t do things that we don’t know,” says Chairman and CEO F. Scott Dueser. The $6.9 billion asset bank operates only in Texas and prefers to locate its branches on the outskirts of strong growth markets like Dallas/Ft. Worth and Houston where there is less competition from larger banks and the pricing pressure on loans is generally less. “They’ve really just stuck with that strategy of being very disciplined about staying in the markets that they know really well,” says securities analyst Brad Milsaps, who covers First Financial for Sandler O’Neill.

First Financial’s other characteristics include high efficiency. It has an efficiency ratio through the first six months of the year of 49.32 percent. It also has a record for excellent asset quality going back years; the bank is not a big energy lender and was not hurt by the sharp decline in crude oil prices in the latter half of 2015. And Dueser says he is constantly looking for ways to improve the bank’s operations, including repricing deposit accounts and, whenever possible, loans. First Financial is, simply, one of the best managed banks in the country.

Like Home BancShares and Southern Missouri, First Financial is always on the lookout for acquisitions. Dueser prefers good banks in growing markets with quality management teams that want to stay in place-and in Texas, those characteristics almost always come with a hefty price tag. Here again, First Financial’s discipline comes into play. Dueser wants to buy good banks, but he’s not willing to overpay. In an interview, Dueser speaks admiringly of Allison at Home BancShares. “I’m a huge Johnny Allison fan,” Dueser says. “Not only do I like what he does, but I like Johnny a lot and consider him a friend. In Texas, it’s harder to buy banks, let me just say that, because everybody wants to be in Texas. You’ve got a market where there are lots of buyers and not many sellers. In other states, it’s different.”

First Financial’s secret sauce is a level of self awareness that helps keep it out of trouble. “They know what they’re good at and they stick to it and don’t really stray from that strategy,” says Milsaps. What do investors get when they buy the bank’s stock? “Consistency,” says Milsaps, whether it’s “consistency with profitability, earnings or asset quality.” And the bank’s challenge going forward? Finding a couple of good M&A deals that will expand its franchise and accelerate its growth. And on that topic, Dueser takes a philosophical approach. “You’ve got to deal with the cards that you’re dealt,” he says. “I would be a Johnny Allison if I could.”