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Expert Perspective

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Investment e.Perspective

Current Issue | April 27, 2017

TINA the ”Return Taker”

By: James Mahoney, CFA, Senior Investment Strategist & Oxford Investment Fellow


Have you met Fed Chair Janet Yellen's best friend? You would recognize her if you saw her. She loves low discount rates, is an expert on why P/E multiples can stay high, despises inflation and is constantly asking you the investor, to come up with a better idea. Yes, I'm talking about TINA, "There Is No Alternative", the ever present stock market cheerleader. TINA is smart and she knows how to win an argument. She knows you need a return – like now – and her logic is undeniable. Stocks are the only game in town. Bond yields are way too low, no recession is in the cards and whoever lost money owning dividend paying stocks?

Now before I get on TINA's bad side, let me quickly say she makes some fair points and she has a reasonable head on her shoulders when it comes to game theory, central bank policy and how markets work. However, she's kind of lazy. Stocks are an alternative to be sure, but they currently are a crowded alternative with many reluctant low-conviction buyers. Equity investors are "return takers" and will only earn the risk premium the market gives them - much of it already having been pulled forward into the present by TINA's popular thinking.

However, secular changes on the regulatory front have created opportunities for investors who are nimble and insightful to be more than "return takers". Many underestimate the large impact Dodd-Frank and The Volcker Rule have had in financial markets. Banks have been forced to take several steps back in how they use their balance sheets, including proprietary trading activity, inventory held by primary dealers, currency hedging, lending activities and other areas in which they deploy capital. The number of commercial banks in the US has declined roughly 30% over the past decade. Aggregate issuance of small business loans across the ten largest US banks has declined roughly 38% from the pre-crisis era. While home mortgage and auto rates have fallen since 2008, rates on other forms of consumer credit (eg. credit cards) have actually increased. Intensive financial regulation has created compelling opportunities for investors willing to fill the capital void left by retreating banks to become "return makers".

Being a "Return Maker"
So, what are these opportunities to be a "return maker"? It may sound a bit counter-intuitive, but how about in the banking sector itself? No, I'm not here to declare how the looming Fed rate hike is supposed to be great for banks. That's fairly straight forward and well understood. What's not nearly as understood is the mega trend in bank consolidation that was shifted into high gear by the financial crisis and continues today (see chart below). Banks face high operating costs given regulatory reporting burdens, balance sheet restrictions and low rates across the yield curve. Regulatory asset thresholds that deem banks Systemically Important Financial Institutions (SIFIs) further support this trend. As smaller banks near SIFI thresholds they have all the incentive in the world not to creep past these limits, but to leap past them via merger or acquisition. Mergers and acquisitions (M&A) offer banks shared overhead costs, regional complements in loan/deposit bases and a means to reduce unwanted exposure to assets such as commercial real estate.

The small community bank and financial services space is especially ripe for skilled niche active managers to pick winners and losers in a less trafficked corner of the capital markets. Above market returns await managers who can identify banks with exceptionally valuable attributes in the current landscape, such as regional strengths, needed sticky deposits and solid loan growth.

Remember the Good Old Days?
In the good old days banks actually used to lend money. In the current environment, not so much. Another related investment opportunity created by bank retrenchment is in non-bank or specialty finance lending. Investors have an opportunity to earn very attractive risk-adjusted returns – and yield – by providing capital to lenders serving un-banked or under-banked consumers and small businesses. Additionally, new technologies have lowered overhead for non-bank lenders, improved the loan application experience and had positive implications for both underwriting and customer acquisition.

Why Specialty Finance Lending?

  • High Income Anchors Outcomes – High single-digit to mid-double-digit yields offer a narrower range of return outcomes and compelling value in a low yield world.
  • Consumer Focus – The US consumer remains a pocket of strength in the US economy. While the corporate sector has releveraged to engage in stock buybacks, consumers have deleveraged as the personal savings rate has ticked higher. Consumer debt service ratios (see below chart) are at historically low levels. A falling unemployment rate and rising income growth provide additional support.
  • Short Duration Amortizing Credit – Underlying loans are amortizing with 1-2 year duration – favorable compared to corporate bonds with longer duration "bullet" maturities. These features provide a notable macroeconomic hedge for investors as they allow lenders to more quickly adjust underwriting as market conditions change.
  • Undercapitalized Opportunity – Lower/middle market specialty finance represents a niche area of the market with limited competition that is generally "off the radar" in both size and scope for many large/mega funds and asset managers.
  • Opportunity for Credit Enhancement – Skilled specialist managers can add additional value through negotiated credit enhancement, structuring and due diligence.
  • Mitigates The J-Curve – Private specialty finance strategies can mitigate negative J-curve dynamics typically associated with private equity investing given their yield component and shorter fund lives.

TINA's voice may be the loudest, but investors shouldn't let her dominate their thinking or portfolios. With the economic expansion and current bull market well advanced in years, investors would be wise to avoid crowds and allocate to under-owned corners of the market to achieve their return objectives going forward.

The above commentary represent the opinions of the authors as of 9.29.16 and are subject to change at any time due to market or economic conditions or other factors.