Real Talk with Martin Friedman of FJ Capital Management

Oct 12 2017 | 6:47pm ET

Editor's note: This afternoon, we sit down with Martin Friedman, co-founder and CEO of FJ Capital Management and discuss the major trends and events in the community banking sector. His firm reported on Oct. 6 that merger and acquisition activity in the U.S. micro- and small-capitalization community bank sector would continue in the year ahead. It predicts that M&A activity could rival and possibly exceed the previous record of the mid-1990s consolidation that followed the savings and loan crisis.

Friedman founded the firm in 2007 and is the portfolio manager for the flagship Financial Opportunity Fund, an event-driven strategy focused on the U.S. community and regional bank sector. He also created in the Spring of 2015, the Financial Opportunity Long/Short Fund, a lower net, broader financial services fund with lower market volatility and beta that has produced strong risk-adjusted returns.

FINalternatives: What attracted you to the community bank sector?

Friedman: We were attracted by the fact that the community bank space finances small and mid-size business with a funding advantage that consists of core deposits that essentially have a moat created by participation in the FDIC insurance program.  Also, the business is driven by scale, which has led to a structural consolidation trend. 

The space offers compelling returns for investors who dig in and understand each bank’s key drivers, whether it is M&A (buy or sell-side), organic growth or other catalysts unique to a particular bank. 

There are approximately 930 public banks, which naturally offers a large and diverse set of opportunities.  Finally, we have been investing in banks for several decades, and we have always liked investing in a sector we know well and where we believe we have a competitive advantage.

Do you prefer to own targets banks or acquiring banks?

We see compelling opportunity investing in buyers and sellers. We are agnostic as long as we can make our 15%+ return target. Sellers are good investments because you get the initial takeout premium while owning the buyers can be very profitable because of the operating leverage buyers get on a transaction -- that is buyers can typically get 20% to 40% in cost saves by cutting duplicative costs and closing overlapping branches. 

To this point, roughly 40% of the performance of our flagship, long-biased bank fund has been driven by owning the buyers and sellers in M&A transactions. Since inception, we have owned about 320 banks, and 160 have participated in this ongoing structural consolidation trend.

The consolidation trade has been ongoing for a long time now. How much longer will it continue?

In our recent white paper, Booming M&A Cycle Creates Investment Opportunity,” we note the structural bank consolidation trend is still in early innings of its post-crisis run, and the total number of banks, the most by far among the world’s developed economies, will likely decrease by at least 50% over the next 10 to 15 years. 

Drivers of this trend include bank profitability challenges, cost savings, management and board fatigue, commercial real estate lending concentration, liquidity needs and regulatory reform. We believe that higher bank stock valuations, potential regulatory relief and deposit pressures from rising interest rates will support an acceleration in consolidation over the next decade or so. 

Do you prefer a passive or activist approach to investing in community banks?

We do not consider ourselves to be activist investors, which initiate proxy fights for board seats and push for a sale of the company.  That said, we do consider ourselves to be active investors in that we frequently meet at conferences with the management teams of our portfolio companies, and we take the initiative to call them if we are trying to understand better how they plan to create value for shareholders.

Our view is that there are a large investable community and regional bank universe and would rather find the management teams that think like shareholders -- that is, they have a significant amount of their net worth in their stock and are therefore aligned and act in the best interest of shareholders.

This could mean they consider a sale of the bank or they continue to run the bank on a standalone basis to create greater profitability and growth. Our perspective is that investing in banks run by management teams focused on shareholders will generate returns superior to investing in banks run by what we call “rental CEOs."

These are CEOs with little to no skin in the game, who are looking to keep their paychecks coming even if considering a sale is the right thing to do for shareholders. In this regard, we have a selection bias and believe our modeling and market knowledge can tell us when a management team is acting in the best interest of shareholders.

What is the state of the community bank sector today?

There are nearly 6,000 public and private community and regional banks, totaling $300 billion in aggregate market cap.  This provides an evolving set of opportunities due to both business model and capital markets inefficiencies.

On this note, we should touch on regulatory reform. The banking sector initially outperformed after the Presidential election last November, only to retrace much of those substantial gains as political volatility called the President’s pro-growth agenda into question. 

Relative to other sectors, the market expects banks will benefit most from initiatives under the Trump Administration, including deregulation, normalization of the Fed’s balance sheet, a gradual increase in interest rates and corporate tax reform.  Banks stand to benefit from any degree of success in the pro-business aspects of the Administration’s agenda.

More Bio on Martin Friedman

Friedman is currently a member of the Board of Directors of Reston, VA-based commercial bank Access National (ANCX) since 2009. In 2013, as part of the recapitalization of Anchor Bank, Madison Wisconsin; Friedman was elected to the Board of Directors where he served on the Board of the bank holding company and compensation committee. He served on the Board of Directors of Guaranty Savings Bank in Metairie, Louisiana from 2008 to 2009.

Friedman brings more than 28 years of experience in and around the commercial and investment banking industries, in which he applied and developed skills in financial analysis with expertise in financial institutions, corporate finance, SEC and banking compliance, and management.

He was previously Director of Research for Friedman, Billings, Ramsey Group, a research, and securities trading firm, from 1998 to 2007. Before that, he was a securities analyst, focusing on the financial services industry with the same firm from 1992 to 1998. 

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This interview was conducted by Tim Melvin, a community bank expert and author of The Community Bank Investor Monthly.

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