A Bank Putting on a Clinic in Efficiency and Quality Lending
I recently became a shareholder of Hingham Institute for Savings (HIFS) after being an admirer of the company for a few years. I decided to take another hard look at the business once I noticed that its stock was down over 40% year-to-date despite its book value and earning power being higher than a year ago. The changing interest rate environment could bring about a difficult period for Hingham in the near future though. Despite the difficult outlook in the short term, I decided that the current valuation presented a nice opportunity to become an owner of this business.
Hingham Institute for Savings (HIFS)
Banking is an underrated industry right now, yet it can be a really good business to be in. Investors still might be scarred from the painful experience in 2008 and 2009. Generals always fight the last war. Entrepreneurs seem to be uninterested in starting new companies in the field as well. In 1921, there were 30,456 banks in the US. The number of banks stood at just 4,377 by the end of 2020. This is a decline of 86% in the supply of banking competitors while the demand for financial services still remains among consumers. The regulatory environment in banking could be blamed as one source for the decline in the number of firms in the industry. Another explanation could be that for some reason the starry eyed college kid is more drawn to other industries. Bill Gates and Mark Zuckerberg didn’t drop out of Harvard with the eagerness to go create a new community bank that serves depositors more efficiently. Although investors need to be selective about which bank to own, certain companies have proven to create immense value for shareholders. Hingham is one of those companies.
Hingham was founded in 1834, making it one of the oldest banks in America. The bank is located in Hingham, Massachusetts and has really focused on that surrounding area including Boston and Nantucket. Hingham operated as a mutual savings bank until 1988 when it undertook a conversion to stock form. A mutual savings bank is owned by its depositors, while Hingham is now owned by its shareholders.
Hingham had total equity of $10.3 million in 1987, 153 years after it was founded. The equity capital of the firm increased to $20.8 million the next year mostly due to the mutual conversion. Despite its long history, this was a very small institution. From 1988 to 1991, Hingham lost around 40% of stockholders’ equity and the former President of the bank was indicted on 25 counts related to bank fraud and the receipt of kickbacks. Things weren’t looking too great for Hingham back in the early 1990’s. That all changed when the Gaughen family stepped in. They became the largest shareholders and won a proxy battle to take control of the firm. Robert Gaughen, Jr. joined the board of Hingham in 1991. He had experience running a different bank in the surrounding area. His father, Robert Gaughen, Sr., joined the board the following year. Robert Gaughen, Jr. is now the Chairman and CEO, while his son Patrick Gaughen is currently the President and COO.
Once the Gaughen family took over, Hingham became an excellent example in how to correctly run a bank. While it is by no means easy, the banking business is pretty simple. A bank that operates efficiently and avoids getting into trouble with its loans will make a nice profit. Although Hingham was run poorly prior to the change in management, the firm is now one of the most efficient banks in the country after steadily improving each year. It basically hasn’t lost money on its loans either.
The efficiency of a bank shows up in its non-interest expenses. Since the mutual conversion in 1988 until 2021, non-interest expense has increased 8.5x at Hingham. Over the same period, deposits have grown by 19.3x and loans have multiplied by 25.4x. Being efficient doesn’t necessarily mean cutting costs. A bank can achieve efficiency improvements through leveraging more work (making more loans, servicing more depositors) through a similar number of employees or offices. The bank had 45 full-time employees in 1988, while it employed 75 full-time people at the end of 2021. The bank is making more than 25 times the amount of loans that it did in 1988, while the staff hasn’t even doubled. That is an incredible achievement in efficiency, and is the result of the excellent team in place at the bank.
Hingham mostly makes loans on commercial real estate in the form of multifamily properties like apartments. The firm does some residential mortgages as well. At the end of 2021, 76% of its loans were in commercial real estate, 19% in residential real estate, and 5% in commercial and residential construction. The bank is highly concentrated in Massachusetts, but it started expanding to other areas in recent years. Hingham started loan operations in Washington DC near the end of 2016, and began lending in San Francisco near the end of 2021. Massachusetts represented 70% of its loans at the end of 2021, while DC and San Francisco accounted for 27% and 3%, respectively.
If a bank makes a bad loan that cannot be repaid, the loan ends up being accounted for as a charge-off. Hingham had net charge-offs of $200,000 and $493,000 in 2008 and 2009, respectively. There are no zeros missing there. The net charge-offs were only 0.03% of total loans in 2008 and 0.07% in 2009. For comparison, the commercial real estate loan charge-offs for US banks reached 3.27% of average loans in the fourth quarter of 2009. Hingham charged-off 0.06% of average loans in 2011 and 0.03% in 2012, but the sum of all net charge-offs has been negative since that time. This means that there were more recoveries than charge-offs. So far, Hingham has a spotless lending record since the change in management during the early 1990’s. The firm has been profitable every year since then as well in terms of net income.
Skin in the game is an important concept in life, and banking is no exception. A bank eventually goes out of business if it makes bad loans. You can blame incompetence in some cases, but a major reason bad loans are made is because of a lack of skin in the game. In the lead up to the financial crisis in 2008, many of the firms who made mortgage loans immediately sold them off to investors. This meant that the mortgage originators were unaffected by delinquencies, and were incentivized to continue making loans no matter the consequences. Additionally, a management team or CEO who owns little stock in the firm they manage might not be ruined financially on a personal level despite their firm going under. This can lead management to take foolish risks that will help net income today but might lead to trouble someday down the road. Management might be retired by the time that the trouble finally shows up in the financials of the institution.
Luckily for shareholders, this is not the case at Hingham. The board of directors, led by the Gaughen family, own over 30% of the bank. Additionally, the loans originated by Hingham remain on the balance sheet and are not sold off. Each time a loan is made, management’s own capital is at risk. This can help explain the spotless lending track record over the past few decades at Hingham. No individual at the bank has lending authority alone. Each loan is reviewed and approved by the executive committee. Any loan over $2 million is reviewed by the full board of directors, which highlights how serious Hingham takes its lending operations.
Over time, the stock price has represented the excellent results of Hingham’s operations. The split adjusted stock price was $6.50 per share at the end of 1993. By the end of 2021, the stock price had risen to $419.88 per share. This is a compound annual growth rate of 16.1% over the 28 year period. The firm paid a small annual dividend over this time period as well. The stock price decreased by over 40% this year to around $250 per share. Even after this decline, the stock has still compounded at over 13% per year since 1993. The returns have mostly come from the bank compounding its book value through retained earnings, but there has been multiple expansion as well. The book value of Hingham compounded at an annual rate of 11.8% from 1993 to 2021. The excess returns above this 11.8% figure can be attributed to multiple expansion. Hingham was selling for a discount to book value in 1993, while it sold for a steep 2.5 times book value at the end of 2021. Our purchase price was at a valuation closer to 1.4 times book. In recent years, the book value has compounded at an even higher rate as the firm has become more profitable through operating leverage. Book value has compounded at a rate of 15.6% per year over the last decade, and at a rate of 17% per year over the last 5 years ending in 2021. No matter which date you measure it at, the bank has created plenty of value for shareholders over time.
A Difficult Period for Hingham
Hingham doesn’t have a particularly strong deposit base. The bank is working on changing that, as management has focused on growing its specialized deposit group in recent years. Non-interest bearing deposits made up 10.8% of deposits in 2014, and that figure has grown to 16.2% in the most recent quarter. While Hingham has shown improvement in its deposit base, there are plenty of banks out there with a stronger group of deposits both in terms of funding costs as well as in the stickiness of the deposit relationships.
As the management of Hingham points out, the bank is liability sensitive. This means that Hingham feels the pain of rising interest rates more quickly on its liability side. The loans that it makes on the asset side adjust more slowly over time. This means that Hingham could be in store for a difficult period right now. The inverted yield curve is an especially difficult issue for a bank like Hingham that is liability sensitive.
The reason why Hingham is liability sensitive is because it depends on wholesale funding. The bank has a significant amount of its funding coming from brokered CD’s and borrowings from the Federal Home Loan Bank (FHLB). Margins are currently under pressure. Although the short term may be difficult for Hingham, the efficiency of the bank’s operations has me confident that they will handle the short term difficulties and continue compounding shareholder capital.
Hingham had an average balance of $3.2 billion in interest bearing liabilities in the 3rd quarter of this year. The bank paid an annualized yield of 1.13% on those deposits and borrowings. In addition, the bank had $410 million of non-interest bearing deposits. Combined, Hingham had $3.6 billion in deposits and borrowings. If I annualize the most recent quarter, Hingham had non-interest expense of $27.5 million. This non-interest expense equals 0.76% of deposits and borrowings. This is incredibly low, highlighting the efficiency of Hingham. This means that the all in cost of funding was 1.89%, with 1.13% coming from interest costs and 0.76% coming from overhead and other non-interest costs. Two efficient banks with incredible scale, Wells Fargo and Bank of America, don’t come close to matching the efficiency of Hingham. The non-interest expense of Wells Fargo was 3.6% of deposits in 2021, while the number was 2.9% at Bank of America. Even if interest costs are high for Hingham due to their wholesale deposits, its ultra low non-interest expense will keep the bank competitive even in a difficult period of rising interest rates.
At the end of the day, Hingham is managed by excellent bankers. The bank is extremely efficient with its expenses, and has avoided losing money on its lending. This is a recipe for success. In addition, management has treated shareholders with respect. This makes sense, as the leaders of Hingham are the largest shareholders of the company. Although Hingham might experience lower returns on equity in the next year or two due to the interest rate environment, I believe this situation allowed for us to buy the bank at an acceptable valuation.
In 2021, Hingham earned a return on average equity of 20.62%. When Hingham experienced a difficult period in 2007 leading up to the recession, it earned a return on equity of 8.4%. Since I paid a premium valuation of 1.4 times book value, I can’t own a bank that earns 8.4% on equity all the time. A few years of this low return every now and then is no problem though. The company has grown since 2007 and should be able to enjoy greater economies of scale now in terms of non-interest expense. If Hingham can average a return on equity of 14%, then this would be equivalent to a return of about 10% on our purchase price. The bank has earned above 14% on equity plenty of times in the past, which gave me the confidence to pay the premium valuation that was offered in the market. I will have some homework to do going forward, as it will be important to watch the performance of the loan portfolio over time in new regions like Washington DC and San Francisco. Additionally, it will be interesting to see how the bank responds to the difficult interest rate environment in terms of its funding and liquidity. I am confident that Hingham has the right team in place to handle these challenges though.
*Disclaimer:
This newsletter has been prepared for informational and educational purposes only, and solely represents our views with respect to certain securities, markets, and other financial matters. It should not be used as the sole basis of any investment or financial decision, and should be construed to render any legal, tax, or other professional advice. The statements made herein are solely based on our research, and any forward-looking statements should not be construed to guarantee any particular outcome. All investment strategies involve risk, including our strategy of seeking out a concentration of undervalued companies in the pursuit of potential long-term appreciation. Past performance of an investment is no indication of its future returns, we make no guarantees whatsoever about any future investment returns.
Investment advisory services offered by McDonough Investments, LLC, an investment adviser principally registered in the State of Michigan and registered or exempt from registration in other jurisdictions as applicable.