– Bank stocks hit hard by COVID-19 pandemic on economic shutdown fears

– FRC is a fast-growing midcap bank with niche focus on wealthy and urban areas

– Its stock off over 20% but 20%+ potential recovery possible after shutdown ends

Bank stocks have been the bleeding edge of the coronavirus-related bear market of the past eight weeks.  The financial sector is off big and banks, in particular, are down, too.  The financial sector has fallen 27% as of Monday from the market’s Feb. 19 high; the major banks -34 %, and the regionals minus 37%.  Not a pretty picture.

Yet that should be no surprise to an experienced investor, given their preeminently important position in the American industrial eco-structure, and their critical role in the smooth functioning of the economy. In almost every bear market, if there is fear about the economy, then banks and their stocks take the hit.  Business drops, lending dries up, real estate markets freeze.

In this bear, with the ongoing dislocations caused by the virus-related economic shutdown of the U.S., they been among the biggest focal points or whipping boys for investors.  Consequently, I believe banks, in general, are mispriced, and there is a significant amount of potential dislocation in the financial system.

None of this should be ignored, but it is also true that because U.S. banks are so important that they’ve been heavily regulated to help them survive. The great majority should thrive again. Moreover, as the Federal Reserve’s annual stress tests have shown, the banks are in much better shape than they were in the previous bear market of 2008-09.

That’s key. For an investor interested in the financial sector, it’s paramount to find a high-quality bank that will come out of this crisis with its profitability and business outlook intact for the long term. I believe that the dislocation of fear in the financial system is probably exaggerated. Unless you think the COVID-19 is a problem that will never be solved—and I don’t—then banks could be a good place to prospect for stocks, particularly for a relatively faster recovery.

This could be especially relevant since the governmental authorities have come running with buckets of cash to ease liquidity issues, something that didn’t happen quickly enough in 2008-09, arguably a much worse bear—so far.  As a result, it took longer than for the banking sector to recover, but it did. Banks will be reporting first-quarter results in the next few weeks, so there will be updates on this.

This time around, I believe the group will recover faster. One high-quality bank to look at is First Republic Bank (FRC), a midcap. What investors should find interesting about it is its strong culture, niche markets, and history of being well-run, thanks to a strong founder.

Yesterday, FRC posted first-quarter results that were entirely keeping with its past trend of mid-teens percentage loan growth and earnings growth in the low teens percentage. The bank reported, among other things, that revenue rose 13.5% to $916 million; net interest income was $752 million, up over 11%, and net income of $219 million and $1.20 in EPS, down 4%-5%. Tangible book rose 12%.  Perhaps the biggest negative was that credit losses and unfunded loan commitments rose to $62.4 million from $14 million, but given the times, that doesn’t seem so bad. Nonperforming assets were just 10 basis points of total assets. Total deposits increased to $93.7 billion, up 14.8% compared to a year ago.

One fan of FRC, with a market cap of $16 billion, is Jason Benowitz, a senior portfolio manager at Roosevelt Investment Group, which owns shares of FRC for clients.  The FRC first quarter would have been a good one even without the pandemic, he argues. The bank’s results looked typical for it and management didn’t change guidance for 2020, a good sign, I think.

Benowitz points to a number of enduring FRC traits that make it look appealing at the current stock price of around $95, which is up from $70 but down from $122. If you look at its results, it has been a strong and steady grower, particularly for a bank, with annual rises in the past five years in every major metric from interest income to EPS to dividends. It’s a strong picture and the shares have outperformed the group.

Benowitz attributes this to a concentrated focus in (1) a wealthy clientele, who have at least $1 million in investable assets, and (2) U.S. urban areas.  They cater to the wealthy, a class that’s grown sharply in the 11-year bull market. It’s a major bank in San Francisco, for example, with 10% share of deposits and it’s taking that playbook to New York and Boston, says Benowitz.

The jumbo mortgage is a core product and then that leads to additional products, like lending to the clients’ businesses or nonprofit organization and wealth management. Its underwriting is conservative, with about 80% of loans collateralized by real estate and a low average total loan to value of 55%.

Previous to the drop, the bank’s shares traded over the past five years at an average of 2.2 times book value. With book value now about $54 per share, that suggests the stock could get back to about $115, up over 20%.  And while net interest margin is under some pressure, as it is at all banks thanks to low-interest rates, Benowitz says that seems to be priced into the stock. In the first quarter, it was 2.74%, up from 2.73% in the year ago period.

FRC has no loans to the oil and gas, airline and casino industries and just 2.5% of the loan book to hotel and retail. Nor does it buy back its own common stock. James H. Herbert, II is the founder and chairman and he has instituted a strong customer-centric culture at the bank.

Where I could be wrong:  The pandemic goes on beyond 2020 and the economy continues to be shut down.

Bottom Line:  FRC is a well-run and steadily growing bank, with a relatively cheap valuation.  If the world doesn’t end and the economy gets back on its feet later this year, FRC should be among the beneficiaries.

Prior “Signals”