Anthony Speciale Stock Market Analyst

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How Great Relationships are Driving This Low PE Bank Stock Higher

Today, we’re going to talk about one particular misconception surrounding the stock market. It’s a very broad statement that in some ways is true and in other ways it’s really not. It’s the idea that stocks with low price-earnings (PE) ratios beat the market.

Now, if you took the whole universe of low PE stocks and compared it to the market, you’d find that the do in fact beat the market by a little bit. However, there’s also a lot of garbage in the mix, and taking that garbage out is one of the ways to take your returns from average to extraordinary.

So, when you look at stocks with low PE ratios and you dig in, you’ll find that a lot of these companies are undervalued for really good reasons. Quite often, they are bad businesses with no upside, and they’re not going anywhere. They should trade at very low PE ratios.

We see this quite often in the commodity business, where low PE ratios mean that it’s that period in the cycle where profits are going to recede. We see this all the time in steel companies, home builders and auto manufacturers, where they look to be trading so cheap but are really at peak profits.

Basically, earnings have grown faster than their stock prices, making the stocks look cheap. But if earnings are going to start to slow, at that point in time, they are probably not actually cheap.

So, there are a lot of reasons why a stock might be cheap, but we want to find those that are going to exceed, excel and have reasons to go higher. And one group of stocks, in particular, has done extraordinarily well when you buy them at very low PE ratios.

It should be no surprise that I’m talking about bank stocks! But not just any bank stocks… I’m talking about banks that are extremely profitable, trading at a very low PE ratios (10 or 11 times earnings tops) that have lots of capital on hand.

These stocks put you in a situation where there’s a big margin of safety in the loan book and the balance sheet. Those stocks have crushed the market by a substantial percentage over the last 10 years.

Moreover, we’re coming off of one of the best 10-year periods in history for the broader market, and low PE bank stocks with sound loan book and solid balance sheets have thrashed the market over that period with less overall volatility. That’s a pretty big deal.

Now, let me give you an example of one of these stocks that is hitting new 52-week highs lately because the earnings have just blown past anything the analysts would have thought they would earn.

PacWest Bancorp

PacWest Bancorp (PACW) is based in Beverly Hills, California, and they’re kind of a specialized bank. They do a lot of business with venture capital funds, with venture capital-backed companies and the executive of both the funds and the companies, so it’s a very profitable form of banking.

They also do a bit of private equity call lending, which is a great business. When a private equity fund gets raised, they don’t immediately take in all of the money. They don’t call the funds until they’re needed and they’ve lined up a deal or a company to buy.

So, what will happen is they’ll find a company to buy, they’ll cut the terms and then call the investor to call up the funds. The investor has a specified number of weeks or months to meet the call and send in the cash. After all, not everyone is sitting around with tens of million of dollars in cash. They may have to arrange some things.

In the interim, the private equity fund will call a bank that’s in this business, like PACW, and borrow the funds on a short-term basis, then pay them back when the investors meet the call. This is an incredibly lucrative form of lending, and to my knowledge there has never been a single bad loan in the entire mix.

The bank really has a niche, specialized market, and they have a total of 69 branches in California. They also have a branch in Colorado where there’s a thriving high-tech, venture capital business as well as in the Research Triangle of Raleigh-Durham, North Carolina, where there is a lot of venture-backed opportunity being created.

Now, they just bought into another cool type of lending by buying a homeowners’ association (HOA) business, which is a fantastic business. You have relationships with HOAs all over the country, and they have very sticky and lower-cost deposits. They also borrow quite a bit of money and pay on advantageous terms for various projects around the communities.

For example, they might make a loan to do some improvements and then pay it back as the HOA dues eventually come in, so it’s a great, high-return business. In fact, in PACW’s announcement for the deal, they expect to do a long-term, internal rate of return of about 20%, so it’s going to add some value to the bank over time.

They also do a lot of asset-backed lending. Much like they have the relationships with the big private equity funds and the big venture capital firms, they also have relationships with a lot of the big real estate investment funds as well. They do a lot of that type of institutional real estate lending.

So, this is a really neat bank in a super-strong, niche market that I think is going to continue to drive profits forward at a very fast pace. And in spite of that, we are only going to pay about 10 times earnings for this. And as rates go higher going into 2022, that’s going to widen net interest margins and drive profits even higher still.

PACW is a low PE stock with a super-strong balance sheet and a ridiculously solid loan book that I think has a lot of upside potential.