Later Than Usual
Sorry for posting later in the month than usual. I usually like to publish around the middle of the month, especially after non-farm payrolls which can move markets. But this month I am publishing at the end of the month because I am in the process of switching jobs (from healthcare to automotive data science) and due to a short vacation to visit my brother in Dallas, Texas. Two interesting excursions I was able to do in Dallas with my brother: (a) eat at Texas Roadhouse – the subject of last month’s blog post, and (b) visit a Nebraska Furniture Mart – the famous retailer owned by Berkshire Hathaway. Both were super-fun excursions, of interest to value investors! More to come on those excursions later!
Following last month’s decision to take a break from writing about the S&P500 (focused on component of S&P Midcap 400 instead), this month I will be writing about a component of the S&P Smallcap 600. Smallcaps need to be evaluated even more gently than midcaps, because these are smaller companies and usually earlier in their stage of growth and maturity. I found a few companies worth writing about, and maybe someday a few of these companies will “graduate” to the midcap and largecap universe.
Time is a Friend
I like the company CVB Financial (CVBF). It is a holding company for a bank called “Citizens Business Bank” headquartered in Ontario, California (not to be confused with a different bank in Rhode Island with a similar name). In case you are wondering where the name (“CVB”) comes from, Citizens Business Bank used to be called “Chino Valley Bank” (CVB) and originally catered to milk farmers in Southern California. Looking back at the financial results to 1989, there is evidence of consistency and improvement (a bit rockier than other companies written about on this blog), but nonetheless impressive given the company’s size, dividend history, and industry sector (banks and financials tend to be affected by the short-term credit cycle). I do not try to forecast CVBF’s future stock price and/or future financial results, and I have no special secret knowledge about CVBF. Everything I like about the company is based on information out in the open. You can verify everything here by yourself.
CVBF is one of the most consistently improving companies in the S&P Smallcap 600 based on the past 30 years of financial results (with the exception of the 2007-2012 timeframe). Although the company did not grow during that 6-year period between 2007-2012, the earnings were still positive and the company consistently paid out dividends to shareholders. If this were a largecap company in the S&P 500, I might throw out this company from consideration, but since this is a smallcap company I will be much more forgiving due to CVBF’s other admirable traits (and comparison with other smallcaps). The first place I like to look is the historical diluted earnings-per-share (EPS). Diluted EPS is the simplest easiest way to check historical resilience, because it includes the dilutive effects of stock options and stock based compensation. Some management teams hide compensation costs by diluting the shareholders, so it’s important to account for that dilution, rather than simply looking at basic earnings-per-share.
During economic recessions, “correlations go to one” (falling tide lowers all ships) … the negative business conditions (namely shortage of credit and liquidity) impact almost all companies … we would expect to see companies stop growing, companies lose money, companies stop paying dividends, and companies raise capital via equity and debt financing. In the case of CVBF, I am encouraged to see that CVBF didn’t lose money nor suspend its dividend during this period (although the diluted-EPS stopped growing during the 2007-2009 recession. Although this bumpy period lasted 6 years until 2012, the diluted-EPS seems to have normalized from 2013 onward. Over the long term, time has been kind to this business.
Time is the friend of the wonderful business, the enemy of the mediocre.Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1989
As a general rule, I tend to avoid investing in the 3 F’s: Fashion, Financials, and Pharmaceuticals. Sometimes these companies go through periods of tremendous growth, but then the profits can suddenly dry up unexpectedly and lose money. Moreover the inventory accounting for the 3 F’s are tricky, because the carrying cost for fashion and financials can be subjective, and should not be relied upon for liquidation analysis. Pharmaceuticals businesses revenue forecasts are based on the current patent portfolio and/or future product pipeline, but these are very difficult to estimate with any certainty if the patents are suddenly invalidated or the drugs have severely adverse outcomes. Perhaps I will write about the 3 F’s in greater detail in the future.
Specifically financial companies are very sensitive to the short-term credit cycle. For some investors, financial companies are attractive they tend to be generous dividend payers. I’ll make an exception for CVBF because of the dividend history, and the potential to be a platform for future bank acquisitions (discussed later).
I can say very strongly the United States financial system has never been as healthy in my lifetime. But it’s been very painful for financial stocks, because as you de-lever and de-risk, you make less money, and therefore it hurts your stock price. So the last 6 years or so have been extremely painful for financial stocks, especially banks, as they have delevered and derisked.Steve Eisman (investor profiled in “The Big Short”), EFN Interview on January 30, 2017, via YouTube video.
Dividends and Retained Earnings
CVBF has a consistent dividend history based on the past 30 years (with the exception of 2005, 2008, and the flat-period from 2008-2012). But the dividends seem to have normalized the past 6 years since 2013 and are again showing a consistent growth profile. In 1989, CVBF paid a dividend of $0.007 per share (in the chart rounded up to $0.01 per share); in 2018 CVBF paid a dividend of $0.56 per share. The dividend growth during the 1989-2018 period represents a compound annual growth rate of 16.31%. The company pays out a substantial percentage of its annual profits as dividends, between 41% and 61% since 2007. For dividend investors, this is a good sign of a stable dividend payer even during recessions.
Buffett Ratio (aka “RORE”)
An important evaluation metric is how well does the management team reinvested retained earnings for future earnings growth? In other words, if the management team is retaining some portion of the profits, the investor should expect to see a return on investment on the retained earnings … otherwise it would have been better for the company to pay out all of the profits as a dividend and let the investor invest the dividends elsewhere. The reality is that many mediocre companies require constant reinvestment just to keep them afloat (i.e. “money pits”), without earning any return for the investor … these “money-pit” companies should be avoided for long-term resilient investing (exception for venture-style investments with option-like-payoffs, but that is a discussion for another day). In the case of CVBF, I like the Return on Retained Earnings over the long-term (a simple metric I call the “Buffett Ratio”).
Here is a high-level description of Return on Retained Earnings. The concept is a bit tricky so here is a second article that discusses RORE. Getting the inputs to the formula is simple if you have access to the historical data, so I’ll provide the inputs below.
- Step 1: Cumulative Basic EPS over time period (1989-2018): $16.723
- Step 2: Cumulative Dividends-Per-Share over time period (1989-2018): $7.18
- Step 3: Cumulative Retained Earnings over time period (1989-2018): $9.543
- (Note: Step 3 = Step 1 – Step 2)
- Step 4: Basic EPS at beginning of time period (1989): $0.129
- Step 5: Basic EPS at end of time period (2018): $1.25
- Step 6: Growth in Basic EPS over time period (1989-2018): $1.121
- (Note: Step 6 = Step 6 – Step 5)
- Step 7: Return on Retained Earnings over time period (1989-2018): 11.75%
- (Note: Step 7 = Step 6 divided by Step 3)
The Return on Retained Earnings over the 1989-2018 period is 11.75%. Let’s think through what that 11.75% means. Every year the management team of CVBF takes the annual profits of the business and divides it into 2 piles: (1) payout some as dividends to shareholders, (2) keep some to reinvest back into the business. We keep track of the amount in pile #2 (cumulative retained earnings) … in other words, the management team is keeping part of “my profits” and strives to be “good stewards of my capital”. The way I will measure the management team’s effectiveness of being “good stewards of my capital” is how much did they grow the profits from the beginning of the period to the end of the period? (growth in basic EPS). Then I ask how well did the management team grow profits as compared to what they kept of “my profits” (cumulative retained earnings). For CVB Financial, answer is 11.75% during this long period. So for every $1.00 of my profits that the management team keeps, it reinvests them in projects that grow the profits by 11.75 cents.
A related concept is when bond investors model total returns, they make assumptions about the “reinvestment rate”, which is the rate at which the interest payments get reinvested. As I discussed in the June 2019 monthly article, Inside the Yield Book by Marty Leibowitz shows the math that proves the reinvestment rate is a really important part of the overall return (not only the starting yield). In the case of stocks, the starting yield might be the PE ratio or the dividend yield. Said another way, it’s not enough to look at the starting dividend yield or the starting PE ratio, because it doesn’t tell the potential for the dividends and earnings to increase over time (based on the management teams return on retained earnings).
Buybacks and Share Count
The other way for management teams to return capital to shareholders (other than dividends) is through stock buybacks. Not all stock buybacks are good, because the management team has to consider the stock valuation for a buyback compared with other investment projects (e.g. internal capital projects, buying another company, research and development, dividends). In the case of CVBF, this is a company that is still growing and using equity to finance growth (so buybacks are not very aggressive, and the share counts continue to increase). Ordinarily, the increasing sharecount would be a red flag for me, especially if this were a mature largecap company, but given that it’s a smallcap (and because of the earnings and dividend history), I am evaluating CVBF lighter than usual. Below is the annual share buybacks per year.
Comparing the annual share buybacks as a percentage of earnings, CVBF’s historical trend is below 20% of annual earnings deployed as buybacks (with the exception of 2007). In other words, what percentage of the annual profits does management return to shareholders in the form of buybacks? Smart management teams know to buyback stock when it’s cheap and the company’s future looks promising; wasteful management teams buyback stock when it’s expensive and regardless of the future outlook.
A few days ago on July 29, 2019 CVBF announced that it is amending its existing stock repurchase plan, by increasing the maximum number of shares to purchase from 6M shares to 9.5M+ shares. I have to say I am very skeptical of these types of announcements from companies. There is no obligation for the company to actually repurchase shares, and these press releases are very cheap to issue, so I feel like “actions speak louder than words”. These types of press releases announcing an increased stock repurchase authorization are neither positive or negative in my humble opinion.
Management has many different ways to dilute the shareholders, so it’s important to monitor the annual share count. Examples of dilution are: stock options and stock compensation to executives and employees, mergers and acquisitions funded with stock issuance, warrants issued as part of preferred stock or debt financing. We can see below that the CVBF sharecount has increased from 60M shares in 1989 to 121M shares in 2018 (notable bump over 109M in 2017). CVBF had large acquisition in 2018, Community Bank headquartered in Pasadena, CA.
I am intrigued by CVBF’s acquisition of community bank. I will be watching the company’s ability to integrate the acquisition and continue running the company smoothly for shareholders. In the years ahead, I believe we could have a significant recession and it might be possible that small regional banks will be available for sale at attractive prices. If so, it would be beneficial to be CVBF shareholder if the company is able to acquire and integrate a number of these regional banks.
There is a very interesting paper out of NYU about “Acquiring Failed Banks” by a PhD student named Siddharth Vij. I think the main point of his paper is that when a bank acquires a failed bank in an FDIC auction, the acquirer sees large abnormal high positive return on the announcement. His paper was trying to determine if the return is due to to the acquisition of the deposits or the loans, and his research shows the return is mainly due to the deposits. But the broader point is that it’s good to be an acquirer in an FDIC auction. A friend who worked for a commercial bank once told me that some conservative banks have a business model of running a conservative business in normal times, and pursuing FDIC auctions of failed banks during recessions. I could see a possible future where CVBF might be a potential acquirer of failed banks in the next recession. However, given it’s relatively low PE (see below), there is always a possibility it could also be an attractive target in normal times.
CEO Retirement Announcement
One interesting process of writing articles is that sometimes big news happens while I am writing the article. In the process of writing this article, the CEO of CVBF announced he is retiring. Usually I don’t like it when there is big news in the middle of my article, but the share price hasn’t moved too much. And I learned a long time ago, that sometimes when the CEO announces he is retiring, a corporate acquirer suddenly appears and the company ends up being sold in an M&A deal.
Strangely, last month a few days after I published my June 2019 article about TXRH, the President (and interim CFO) at TXRH announced he is abruptly leaving without any explanation. Turned out that TXRH signed him up as a consultant, and shortly thereafter they announced a new CFO.
As a related note, a recent article in the WSJ says a large percentage of CFOs have been retiring recently, because they don’t want to work through an inevitable downturn. In some cases, the retirement is related to cashing in on compensation.
The market also plays a role: CFOs’ compensation often includes restricted equity grants, which in some cases can only be cashed out in full after retirement. A hot stock market has made that option more enticing. The S&P 500 stock index, which recouped losses suffered during the 2008 global financial crisis by 2013, has reached record highs this year.“CFO Retirements Climb as Good Times Roll On” by By Ezequiel Minaya and
Tatyana Shumsky, Wall Street Journal, July 17, 2019
I guess the point here is that these executives have lived through the severe global credit crisis of 2007-2009, so they know how bad things can get. So while they are sitting on big compensations windfalls now, the CFOs want to get out while the gettin’ is still good. And I can’t blame them.
For fun, I like to look at this website (j3sg) that tracks the top holders of a stock. In particular, I am looking for situations where the stock is a top 5 holding for that particular invest. In the case of CVBF, there is a financial advisor in Los Angeles called Cliffwater that is the 3rd largest holder of CVBF, and it represents the largest position in that investor’s portfolio (49.65% of its portfolio). Wow, you almost never see that kind of portfolio concentration!
Long-Term Debt as % of Earnings
Since some companies finance growth through long-term debt, I like to examine the ratio of long-term debt to annual earnings. In other words, how many years of profits would be required to pay off long-term debt? In the case of CVBF, the company has had periods of high leverage in the past, but currently the long-term-debt is approximately 20% of annual earnings (i.e. a few months of CVBF’s profit could pay off the debt).
Interest Rates, Valuation, Yield Curve
The interest rate environment is super-important in evaluating investments, because all investment opportunities are priced based on interest rates. A common benchmark is the U.S. 10-year treasury bond, considered a “risk-free” investment because the US Government can raise funds through many sources such as taxation.
The 10-year treasury is currently yielding 2.02%, so a good investment opportunity with a “margin of safety” would yield at least twice that level at 4.04% yield. According to Yahoo Finance, CVBF has a PE Ratio (TTM) of 16.10, which taking the reciprocal implies an “earnings yield” of 6.21%. Moreover, Yahoo Finance projects a forward dividend of $0.72 which implies a “dividend yield” of 3.27%. The CVBF earnings yield is better than 3x the 10-year treasury bond yield, and the CVBF dividend yields more than 10-year treasuries, while also providing earnings growth potential from the retained earnings.
This month has been very weird from an interest rate standpoint. Today the Federal Reserve announced that it will be cutting short-term rates by 25 basis points, for the first time since December 2008. The President of the United States has suggested that we should be entering a long and aggressive rate cutting cycle due to monetary policy throughout the world. The 10-year rate is below the 3-month rate, and both are below the 2-year and 5-year rates. In a normal yield curve, the interest rates are supposed to be higher for the longer-term vs. shorter-term instruments.
CVB Financial (CVBF) is one of my favorite companies in the S&P 600 Smallcap Index. CVBF is the fifth company I have chosen for a monthly article on this new blog. CVBF has shown relatively consistent dividend and earnings growth over the past 30 years (with some exceptions), conservative liquidity management, modest use of debt. CVBF’s current valuation is attractive relative to benchmark interest rates, and I believe there is still 1-2 years remaining in the short-term economic cycle. There may a potential for CVBF to be a platform for future regional banking acquisitions, particularly during a future recession. For long-term-focused investors, CVBF is worthy of further study.
Disclosure: I own shares in CVB Financial (CVBF) as of publishing this article (July 2019). I have no intention of selling my position in the near future. This article is not a recommendation. Investors should make their own determination of whether or not to buy or sell this stock based upon their specific investment goals, and in consultation with their financial advisor.