Wednesday, December 9, 2009

Interview with Andrew Boord – Manager of The Fenimore Banking Research Portfolio

Below is an interview I did with Andrew Boord, Manager of The Fenimore Banking Research Portfolio. If you’ve never heard of Andrew, then he may just be one of the best business analysts you’ve never heard of (though he’ll never admit it!). You can also download the interview: HERE. Enjoy!

Interview with Andrew Boord – Manager of The Fenimore Banking Research Portfolio

JK: Let’s start by having you give us a little background on yourself, your professional career, and Fenimore Asset Management.

AB: I never really intended to be an analyst. I earned a couple of accounting degrees and became a CPA. At the time I was studying accounting frauds and thought about going for a PhD. But one thing led to another and I spent a few intense years as a short seller.

Eventually I found my calling as an analyst and portfolio manager in the long-only, small to mid cap value world. I’ve dedicated most of the last decade to banking and transportation.

I joined Fenimore 4.5 years ago as an analyst. Our primary focus is managing $1.3 billion of small to mid cap value equities across two mutual funds and a few hundred separate accounts. Fenimore is what I would call a “quality value” shop, as opposed to a “deep value” shop. We focus on buying the best companies, usually with tons of free cash flow and high returns on capital, at attractive prices. We pride ourselves on doing quality, ground up research on a modest number of names. With low turnover we often build in-depth knowledge of a particular company over the years.

JK: You launched the firm’s banking product a little over a year ago and, from what I understand, you are the one in charge making the investment decisions. Tell us a little about that product, why you decided to pursue it, what the goals are for that product, and how the performance was for the first year.

AB: The Fenimore Banking Research Portfolio is a separate account offering. Each account holds about 15-20 investments, primarily micro to small cap community banks.

After a decade or so of following small to mid sized banks for our broader products, the timing was right to launch this offering. So about two years ago I began laying the groundwork on my own time. In October of 2008 we launched our first account, which consisted of my money and some Fenimore was kind enough to contribute. I could see that banks were headed for tough times, although I underestimated just how tough. This may sound counter intuitive, but historically every downdraft in the banking cycle has preceded a multi-year period of very healthy returns as earnings rebounded and valuations returned to “normal.” I expected wonderful opportunities to buy great banks at what would ultimately prove to be cheap valuations.

Also, I was ready. After years of daydreaming about a bank investment strategy, the time came when I was ready, primarily in terms of accumulated knowledge. Thankfully, everyone at Fenimore agreed and gave their blessing to pursue this project.

We have only been taking outside money for a few weeks, but we are off to a nice start. We may only accumulate a few million dollars in the first year, but that is plenty to get started.

My goal, first and foremost, is to put up impressive long-term, after-tax returns. If I pull that off, then everything else will fall in line with minimal effort. I am pleased with our start. Our first account is up 8% before fees since our October 13, 2008 start through November 30, 2009, which is modest but obviously much better than the various bank indices. It helped that I gradually invested our cash as the market cratered.

Ultimately, I would like to build a modest-sized business within Fenimore. Perhaps $100-$200 million spread across 20-30 positions. I am much less interested in being so large that I must own hundreds of positions or shift into large cap banks.

JK: From what I’ve heard, banks have had a few issues over the past couple of years. Many banks have gone under and many investors have been burned by investing in banks too early. But as value investors know, amid chaos comes opportunity and it is usually worthwhile over the long run to be greedy when others are fearful. So, can you give us a little more insight into your bottom-up selection process? How do you separate the potential good banks from the crowd? What do you view as the most important metrics when analyzing a bank? What type of system or database do you use to keep track of the industry? Etc.

AB: Those are certainly the key questions. In many ways, this is the best time ever to study banks. In less treacherous times, all the bankers tell you how wonderful they are and it is quite difficult to judge the truth of the matter. Now however, the tide has gone out and it is readily apparent that many banks were swimming naked. The worst bankers are now self identifying.

I am looking for something very specific. Most of our banks earn a mid-teens or better return on equity (ROE), but with lower than average credit risk. Think about basic economics. Banks with lower than average credit risk also earn less than average on their loans. So to produce a solid return on equity they must either possess very low cost deposits or spend considerably less on back office operations than peers. Banks that take a lot of credit risk are like shooting stars – beautiful right until they disintegrate. However, a bank with low costs deposits and efficient operations is creating sustainable value for shareholders. So the vast majority of my efforts are focused on finding these banks.

Finding high quality, micro cap community banks is not overly complex, just hard work. The one who looks under the most rocks wins. I try to find evidence of superior banks any way I can. I read as much as possible about banking, which turns up ideas occasionally. Obviously, Baseline screens are interesting, as are American Banker’s lists of banks with high ROEs or ROAs. I also assembled a list of every publicly-traded bank I could find, roughly 1100 in total, and began compiling some basic statistics.

At times you just have to do the dirty work of looking at SEC filings and call reports for as many banks as possible. For instance, I recently looked at 10-Q filings for dozens of Pennsylvania community banks and narrowed it down to about six to investigate further.

Once I find a bank exhibiting superior quantitative metrics then I come at it from a qualitative side too. The numbers are just the “effect,” but the management is the “cause.” I love to talk to bankers. I always learn something, if not about the bank in question, then about the industry, the economy, or other banks. To really understand a bank I have to know management. That just takes time. My job is to put in that time.

In the case of the Pennsylvania banks, my next step is to read as much as possible about each bank. If I am still interested then I will contact them about setting up a visit or at least a phone call with someone in senior management. So far I have visited two and will see a third next week. This process will likely produce one or two banks which I can then purchase if they trade down to a discounted valuation. Thankfully, I only need to own about 20 or 30 banks, so I feel no pressure to force one of these ideas into the portfolio.

Again, most of my efforts are directed toward finding the best banks earning a mid-teens or better ROE with low credit risk. Hopefully, I can then accumulate stock cheaply. This way I avoid much of the worst pain from bad loans. At times the worst banks will outperform, but I believe over the long term a portfolio of well run banks should win the race.

JK: I know you have an investing checklist for banks that you run your ideas through. What are the main categories on your checklist and how many items are currently on the list? What benefits have you gained from using the checklist?

AB: While the checklist is full of questions, some vague and theoretical and some very specific and technical, they are designed to do two things: make sure I completely understand the bank and to avoid significant mistakes. I need to be as sure as possible that I understand all the key aspects of the story. Kind of like Porter’s SWOT analysis. Fortunately or unfortunately, after looking at hundreds of banks I have seen many, many ways for a bank to shoot itself in the foot. So I try very hard to look for all the various warning signs I can think of, like too many land loans, growing loans too fast late in the cycle, overpaying for acquisitions, an asset/liability mismatch, etc. The checklist changes regularly and is truly a living document.

I need the checklist to help organize my thoughts, to make sure I don’t skip any steps, or become overly enamored with a strong personality. I have always been disorganized and disheveled, thinking about ten things at once. I multitask well enough to keep most of the balls in the air, but it is way too easy to skip a step or forget to ask a question. You know how the world works – it is that one missed variable that blows you up.

JK: Can you discuss some of the current macro risks for banks? Many people have mentioned that there are still big write downs to come in the industry – largely as a result of the commercial real estate problems, growing number of home foreclosures, and the Option ARM and Alt-A resets that lie ahead. How do you incorporate those types of macro risks in your analysis? How has government involvement affected the smaller banks you focus on, both on an absolute level and relative to bigger competitors? What positive effect has this period had on the well-run banks?

AB: You are absolutely right that more problems are coming. Where I differ from some is in my opinion of the extent and universality of the problem. Some investors conclude that the sky is falling and that the answer is to avoid all financials. I believe you can make healthy returns on well run banks with modest credit problems and even a few special companies intent on buying or financing distressed real estate. With so many investors panicked, you get a nice margin of safety.

For instance, I think there is a big difference between a commercial real estate loan on a midtown Manhattan office building purchased at the top of the market by a speculator using a 90%+ loan to value (LTV) vs. a 65% LTV, owner-occupied warehouse loan with personal guarantees in Scranton, or some other market that never experienced a spike in real estate prices. In the first example, the lender is in major trouble. But if a community bank has a diversified portfolio of loans like the second example, then sure they will take some losses, but they will be able to get through the downturn. Particularly if their pre-tax, pre-provision earnings are strong, which is something I look for.

I also want to play offense. You are absolutely right that a great deal of bad commercial real estate loans must be dealt with. However, somebody is going to be able to buy or finance these underlying buildings at attractive prices. A great example of a potential beneficiary is Winthrop Resources (FUR), a small finance REIT with plenty of capital and a CEO who is very scrappy -- the kind of guy who will buy or finance distressed real estate on good terms and then fight like mad to improve the building. FUR is one of the few non-bank financials we own in the Banking Research Portfolios.

The impact of government intervention is tricky to judge. Government intervention is rarely helpful. I have definite ideas on what should be done, but I am under no illusion that logic is a component of the process in Washington. So I am watching the various bills and proposed regulatory rules closely. I think in most instances the rules can be dealt with. For example, efforts to limit non-sufficient fund (NSFs) fees will just lead to the rest of us paying higher fees. Banks will not suddenly become benevolent aid societies. They will find another way to make money.

The one positive I see is a significant decline in competition. While loan growth is limited, spreads and terms on new loans are improving. Over the past two years most of the worst lenders that were under pricing failed and the “shadow banking system” (e.g., CDOs) dissipated. At the same time, new bank charters are rare. Therefore, you have less competition. It will be interesting to see how long this lasts, but the banking system could resemble the one we had twenty or so years ago. Banks had plenty of deposits (often more than they could loan out), healthier spreads, strong capital ratios, and returns on equity at the best banks were in the mid to high teens. I could live with that.

JK: In your October letter, you mentioned Cambridge Trust (CATC) and Burke & Herbert Bank & Trust (BHRB) as banks that fit your criteria. Can you briefly discuss why you like those banks and/or any others that you are able to reveal that may give readers a good idea of the types of things you are looking to invest in?

AB: As I said earlier, the factors I really admire in a strong bank are low cost deposits, combined with lower risk lending, and efficient operations. Both CATC and BHRB score very highly on these metrics.

Cambridge operates in some very nice areas of Boston and has extremely low cost deposits. In the third quarter they paid only 0.70% on $870 million of deposits and borrowings, the second lowest among banks I follow. This was invested in $500 million of loans and $440 million of bonds. Their credit performance has been outstanding, with only 0.28% of loans not performing. CATC’s efficiency ratio (operating expenses as a percentage of total revenues) is “middle of the road” at 66%. They are also growing nicely thanks to the renewed interest of customers in community banks. The end product was 24% earnings growth and a 16% ROE in the third quarter.

Burke & Herbert is a rather unusual bank in Northern Virginia. They are an old school, high touch business bank. They too have very low costs deposits (1.22%), not quite as low as CATC’s but still impressive. BHRB is extremely lean, with an efficiency ratio of 40%. They take a little more credit risk, but so far loan losses are very modest. BHRB posted an amazing 17% ROE in the third quarter and grew earnings 24%. We purchased shares at about 1.5x tangible book earlier this year, but the stock has since moved higher.

These are two shining examples of the kind of banks I want to partner with. It is difficult to find banks like these, but thankfully we don’t have to find too many of them.

JK: What new insights have you gained from the investing environment over the last year or two and/or what old lessons have been especially reinforced during this time?

AB: Frankly, I am frustrated with myself. We avoided most of the worst situations because we keep an extensive list of risks to avoid such as large derivatives books, repo financing, subprime loans, fast growers with huge egos, etc. And we tried very hard to understand mysteries like, “Who buys the riskiest pieces of subprime securitizations?” And “How can a REIT make a good ROE on a new building at a 5% cap rate, just like they did at 9% cap rates?” It is amazing how many people, who were dependent on sustaining an unsound situation, gave us answers with perfect delivery (they sounded great) that did not hold up to further investigation.

When you worry, but nothing goes wrong for years at a time, you begin to wonder if maybe you are just missing some factor. About the time you get sick of reading Jim Grant or Fred Hickey complain about some bubble, you should actually double your focus, not avoid the uncomfortable. We sold H&R Block because of their subprime business and most of our REITs when their valuations skyrocketed. But I missed the severity of the underlying problem and most of the second and third derivative impacts. I expected the subprime bubble to pop, but failed to anticipate the impact on home prices and then home equity lending and the resulting impact on consumer spending. I was surprised when one of our insurance holdings, Protective Life (PL), took massive marks in its loan portfolio. We own a book manufacturer who now does not sell as many home improvement titles because fewer people are interested in that new deck or addition. The vast majority of our holdings did not face near death experiences and will be fine, but nonetheless I could have executed better.

The one group of people that did not fail are what we now affectionately call “retired bankers.” There is a long list of great bankers who sold out before the cycle turned. Remember Golden West, Northfork, Southtrust, National Commerce, Pacific Crest, or Alabama National? Next time a large number of smart bankers retire you will find me at the pool with all my money in T-bills.

My personal response is multi-tiered. First, to realize I need more patience and confidence. Self awareness is probably the most important, yet most difficult, aspect of investing. Second, I need to improve and broaden my knowledge of both macroeconomics and the bond market. In the past few months I focused my reading on economic and financial history and Austrian economics. Perhaps the banking panic of 1893 can shed light on today. I also began studying more macroeconomic data, particularly reports related to banking. Infallibility is out of reach, but perhaps I can avoid making the same mistakes twice.

JK: Finally, if someone is interested in investing in the Banking Research Portfolio, how do they go about doing investing with you? What is the account minimum and management fee?

AB: Thanks for the plug. We offer separate accounts with a minimum investment of $250,000 and a 1% management fee. Each account typically holds 15-20 positions. If anyone is interested, then they should email me at Thanks Joe.

JK: Thank you, Andrew.

*Nothing in this interview should be taken as a recommendation to buy or sell a security. Please do your own research before making an investment decision.