Description

HINGHAM INSTITUTION FOR SAVINGS

SUMMARY

Hingham Institution for Savings (HIFS) has never been written up on VIC. At one level, this is not a surprise—the company’s market capitalization is only $488 million, and one-third of the stock is owned by insiders. But in another respect, it is quite surprising.

HIFS, as measured by financial metrics, is among the best-managed banks in the country, and its financial performance has steadily improved over the last 28 years, since the Gaughen family took control. Its return on assets and return on equity ratios are consistently strong, and its efficiency ratio is among the lowest of all banks. Also, it has grown steadily and been profitable through good and bad economic times, with almost negligible losses from non-performing loans. Although the stock is not dirt-cheap, it seems to me to be very reasonably priced given the quality of the company and its prospects.

With the usual caveats of this not being a stock recommendation and the importance of doing your own homework, I believe that, at its current price, the stock can earn higher than average returns (perhaps 15% annualized) over a five- or ten-year period, while incurring lower-than-average risk of permanent capital loss. For those in our community interested in long-term buy-and-hold sleep-well-at-night investments, HIFS fits the bill.

Investing is all about looking forward—trying to anticipate how a company will perform over the coming years or decades. In the case of Hingham, I think that looking back is also very important, to see how the bank has performed over a long period of time, in the hope that this will give us clues as to what to expect in the future.

BACKGROUND

Hingham has been in business since 1834, and is headquartered in Hingham, MA, which is 16 miles south and east of Boston, located in what is called the “South Shore” of Massachusetts, a region along the coast stretching east and south from Boston to Cape Cod. When the bank converted from mutual to stock ownership in 1988, it had only three branches in addition to its main office, and all of these were located in the South Shore region, within a few miles of headquarters. It now has a total of 11 locations. Eight of these are in the South Shore. Another is further south, on the island of Nantucket. In October 2006 Hingham opened a branch in Boston’s South End, perceiving a growth opportunity in that city. And in 2017, after two years of study, Hingham started commercial real estate lending in the Washington D.C. metropolitan area. They see the D.C. area as having similarities to Boston and believe that they can deploy a large amount of capital there over time. The bank purchased a townhouse in Georgetown last year, which is now being renovated to serve as headquarters for Washington D.C. activities.

Hingham converted into a public company in December 1988, after more than 150 years as a mutual savings bank. It offered 1.25 million shares—100% of outstanding shares—to its depositors and employees, and to the local community, at a price in the range of $8.50 to $11.50, with the final price to be determined based on demand. Demand turned out to be tepid, with subscriptions from depositors, employees and local residents aggregating less than 40% of the offered shares. The offering was priced at $8.50, the low end of the range, and the remaining 754,000 unsubscribed shares were sold in an IPO at the same $8.50. Following the offering, book value was $16.61 per share. At the IPO price the bank’s market value was $10.6 million and shareholders’ equity was $20.8 million. (The stock split 3:2 in 1998, and the numbers above have not been adjusted for that split.) At the end of 1988, the bank had assets of $157 million, deposits of $124 million, and net loans outstanding of $118 million.

It didn’t take long for the cockroaches to make their presence known. In early February 1989—barely more than a month after the offering—the bank fired its longtime CEO/President for taking kickbacks from two of the bank’s real estate borrowers; he was subsequently under criminal investigation for fraud and payoffs. (In 1993 he pleaded guilty to 11 of 25 charges filed against him.) The board then installed Paul Bulman, a former Massachusetts Commissioner of Banks (1984-1987), as the new CEO. Bulman had worked at the bank as an Executive Vice President since June 1988 and had been a Trustee of the mutual bank prior to conversion (and had become a director at conversion).

Under Bulman’s stewardship, the bank’s financial performance was abysmal over the following years, with large losses in 1989, 1990, and 1991, a combination of large provisions for bad loans and bloated operating expenses. Over those three years the bank lost 40% of its net worth. 1992 and 1993 were only marginally better, with small losses from operations. After paying dividends in 1989 and 1990, none were paid in 1991, 1992, and 1993.

In March 1992, troubled by the weakening state of the bank, the FDIC required it to enter into a Memorandum of Understanding, a written agreement to “restore stability and soundness” to the bank by prohibiting continuing unsafe and unsound banking practices.

Enter the Gaughens. By 1992, there were already two Gaughens on Hingham’s board, and they were large shareholders with extensive experience in banking. Robert H. Gaughen, Jr., then 42, was elected to Hingham’s board in 1991. He was then a partner at the unimaginatively named law firm of Gaughen, Gaughen & Gaughen. He owned 55,864 shares (4.47%) of Hingham, and had been President of East Weymouth Savings Bank for several years until the bank was sold in 1988 (see below). His father, Robert H. Gaughen, Sr., 76, owned another 80,850 shares (6.47%) of Hingham, giving them a combined stake of almost 11% in 1991.

Robert Sr. was elected to Hingham’s board the following year. He had more than 30 years of banking experience, including 16 years as president and another seven as chairman of East Weymouth Savings Bank. (He was chairman of that bank when his son was president.) Under the Gaughens, East Weymouth went public in November 1985 at $5 per share (adjusted for a subsequent stock split) and was sold to another bank in April 1988 for $20 per share, a 300% gain from IPO to sale in about two and a half years.

By the time of Robert Sr.’s election to the board in 1992, he and Robert Jr. owned a combined 12.89% of Hingham’s shares. A year later, when Robert Sr. launched a proxy fight nominating a slate of six directors to run in opposition to the board’s slate, he owned 8.5% of the outstanding shares and Robert Jr. owned 5.8%—father and son owned a combined 14.3% of the company. The father had bought some of his shares in the conversion, had owned almost one-third of his shares since 1989, and had purchased the rest since then. The market price had been below $6 over much of that period and had dropped to as low as $1.625 in 1990. (Again, these have not been adjusted for the 1998 3:2 stock split.)

Robert Sr. was concerned about the governance under the then management team. He cited the FDIC MOU, the bank’s losses, the elimination of dividends, and excessive management compensation in a period of losses. He also pointed out that the incumbent directors had drifted away from Hingham’s community banking roots. By way of example, he cited a $5 million loan to a dog racing track not in the bank’s primary market area that had been recently approved by board members. In addition to the unusual nature of the loan for a community thrift, this was a large loan at that time relative to the bank’s total loan portfolio of about $70 million.

https://www.hinghamsavings.com/assets/2020/07/Gaughen-Proxy.pdf

https://www.hinghamsavings.com/assets/2020/07/Gaughen-Fight-Letters.pdf

Robert Sr. won the proxy fight decisively, with his dissident slate of directors getting 805,000 votes and the incumbents getting 309,000. He remained a director. His son, Robert Jr., then 44, was promptly elected Chairman, President, and CEO of the bank. At the time he said that the new management team intended to reduce non-performing assets and return the bank to profitability based on core operating earnings, through a return to “banking basics.” Almost 28 years later, Robert Jr. is still Chairman and CEO, and it would be hard to argue that he has not fulfilled the promise he made in 1993. Robert Sr. died in November 1997, four and a half years after winning the proxy battle.

The first chart below shows the stock price performance of HIFS from its IPO in 1988 to the end of 1996 (all adjusted for a 1998 3:2 stock split). The Gaughens took control in April 1993, in the middle of that period.

HIFS Stock Price 1988-1996

The next chart shows HIFS’s stock price from the time the Gaughens took control in 1993 to the present. The price was about $6 (adjusted for the 1998 split) when they stepped in; it is about $228 today. The dividend yield has typically been between 1% and 2% in recent years, adding somewhat to the total return.

HIFS Stock Price 4/30/1993 to 1/29/2021

WHAT DOES HINGHAM DO?

As previously mentioned, Hingham Institution for Savings has 11 locations: eight in the South Shore towns of Hingham, Cohasset, Hull, and Norwell; one further south in Nantucket; one in Boston’s South End; and one in Washington D.C.

Hingham is unusual and different from most other banks in that they try to do very few things, and to do those very well. The list of things they don’t do (see below) is much longer than what they do.

The Gaughens like Buffett’s quote: “Banking is a very good business, unless you do dumb things.”

Hingham does three things:

(1)   Commercial real estate lending: Primarily multifamily housing – either larger apartment buildings or portfolios of smaller buildings or sometimes apartment buildings with a retail component. The bulk of what they do in commercial real estate lending is for buildings that people live in—i.e., no office buildings, shopping centers, warehouses, etc.

(2)   Residential real estate lending: They do this entirely for their own portfolio, i.e., they don’t sell loans originated by them, don’t participate in government programs, don’t buy secondary loans from others.

(3)   Personal and commercial deposit banking, which serves to fund their lending activities.

They are also obsessed with cost control, with “reducing waste through an ongoing process of continuous improvement,” and this shows up in improvements in the bank’s efficiency ratio over the years, to a remarkably low level today.

WHAT DOES HINGHAM NOT DO?

Rather than list these activities myself, I’ve provided below a slide that lists what Hingham doesn’t do. In their words, “If it’s unsecured, if it moves, if it floats, if it flies, if it sits in your wallet, we’re probably not interested.” Their argument is that they can’t differentiate themselves in these areas. Similarly, no wealth management, no trust department, no advisory services, for the same reasons. This laser-like focus is unusual, but seems to work very well for them, based on their results. The Gaughens have also never made an acquisition of another bank in the 28 years they have run Hingham.

SOME UNUSUAL THINGS

At the 2020 (virtual) annual meeting, Patrick Gaughen (the president) made a comment about the bank having some unusual and unique default provisions. When pressed for more information, Patrick gave an example. He said that their contracts had no debt service coverage ratio covenants. But the interest rate on commercial mortgages in default was 18%, and the bank moves rapidly to enforce that. The grace period on those loans is 10 days. On day 11 the bank is on the phone with a defaulting borrower to understand what was happening. The bank’s experience was that the 18% rate was what they internally call “a very hot pan” – borrowers wouldn’t want to touch it twice. This proactivity by the bank tends to encourage a financially stressed borrower to prioritize payments to Hingham over its other obligations, reducing non-performing loans and losses over time.

Another unusual aspect of HIFS is that they periodically make minority passive equity investments, generally in private or public financial service companies that they understand and where they feel they can make a difference or benefit from the company’s products or services. In these situations, they are not paying the control premium that would be necessary if they were to acquire a whole bank. At the end of 2020 and 2019 they had $38.4 million and $47.2 million, respectively, of such equity investments on their balance sheet; no more detail is available. This activity is unlikely to move the needle for the bank, but that doesn’t prevent me from fantasizing about, say, a $5 million investment for 25% of a fintech startup that sells out or goes public in a couple of years for a price north of $1 billion. Pure fantasy.

FINANCIAL PERFORMANCE

Because the current management and board of Hingham is controlled by one family, who have successfully run the bank for almost 28 years, we necessarily have to rely on their past record of promises and performance to form a judgement as to how the company will perform in the future.

Below are tables providing summary financial information for Hingham for the last 35 years, going back to 1986, three years before the bank’s conversion from mutual to public, and seven years before the Gaughen family took control. I have condensed the information to consolidate some unnecessary detail, but I realize that there is much to absorb. The three tables below provide some information on each of the 35 years. The three tables after that provide some key numbers at five-year intervals to give perspective on longer-term trends.

If your eyes glaze over from staring at too many numbers, skip the three longer tables and jump straight to the five-year interval tables which follow. Those should make it obvious why I like this bank. Below those tables I will briefly summarize the key conclusions I have drawn from these numbers.

The first three tables above, which provide Hingham’s financial statistics by year for the last 35 years, are included to illustrate several aspects of the bank’s financial performance. Total assets and outstanding loans have grown every year since the Gaughens took over in 1993. The top line—probably best defined as net interest income for a bank—has increased almost as consistently, with occasional small declines as interest rates and spreads fluctuate. Loan loss provisions are small, even in tough economic times. Operating expenses have increased at a far slower rate than the growth in assets and in revenue (net interest income). Management appears obsessed and relentless about taking unnecessary costs out of the business and are reluctant to increase overhead in any form. This translates into a dramatic improvement in the efficiency ratio of the bank over the last 25 years.

Most of the growth has been financed by retained profits, with very little dilution in the share capital. As a result, EPS and per share book value have consistently grown over the years.

The three tables directly above this section provide the same information at five-year intervals, which helps to highlight the growth and improvements over time. The balance sheet has grown, loan loss provisions and non-performing loans have been very low, and cost control has been remarkable, with the efficiency ratio at levels rarely seen in banking. The return on assets and return on equity ratios are very strong for a bank.

CAPITAL ALLOCATION

Hingham pays a regular quarterly dividend and occasional special dividends (generally in the fourth quarter of each year). In recent years the “regular” dividend has been raised each quarter. The last 12 dividends were $0.34, $0.35, $0.36, $0.87 (including a $0.50 special dividend), $0.38, $0.39, $0.40, $1.01 (including a $0.60 special dividend), $0.42, $0.43, $0.45, $1.17 (including a $0.70 special dividend). If this trend continues, we can extrapolate and expect $0.49, $0.51, $0.53, and $1.35 over the four quarters of this year, or $2.88 for the year. The payout ratio has been 10%-15% in recent years.

The bank has never done any stock buybacks. They have indicated that repurchases are possible in the future, but not to expect them.

Instead, their strong preference is to redeploy profits back into their business. All of their growth over the last 28 years has been organic; they have never acquired another bank and it is unlikely that they will in the foreseeable future. Their opposition to acquisitions is the control premium they would have likely have to pay in such transactions.

DILUTION

The number of shares outstanding has increased from 1,875,000 (adjusted for a 3:2 split in 1998) at the time of the 1988 IPO to 2,137,900 at the end of 2020, an increase of 14 percent over 28 years. All of this increase has come from stock compensation plans.

NEPOTISM??

There are clear indications of nepotism at Hingham, at least on its board of directors. I find it difficult to know how to think about this, but, given the bank’s strong track record, I am inclined to give them the benefit of the doubt.

At the time Robert Gaughen, Sr. won his proxy fight against the previous administration in 1993, he and his son were already on the board. Robert Jr. immediately became President and CEO. Robert Jr.’s brother Kevin W. Gaughen joined the board of directors in 1994. Also, two of Robert Sr.’s grandsons became directors during that period—Robert A. Lane, then 26, in 1993, and Julio R. Hernando, then 23, in 1994. (These two were presumably sons of Robert Sr.’s daughters.) Given their relative youth, it would be difficult to argue that they were elected based on their wealth of experience. Julio, in fact, was a law student at Suffolk University Law School when he assumed his seat in the boardroom. And speaking of law school, all of these five men are attorneys. Robert Sr. and his two sons, Robert Jr. and Kevin, were the three Gaughens in the law firm of Gaughen, Gaughen & Gaughen, though it’s not clear which Gaughen had top billing.

(“Gaughen, Gaughen & Gaughen, good morning, how may I help you?”

“Yes, could I speak with Mr. Gaughen?”

“I’m sorry, sir, he’s out of the office.”

“Oh, in that case could I speak with Mr. Gaughen?”

“I’m sorry, he’s on a phone call right now.”

“Uh, then how about Mr. Gaughen?”

“Yes sir, he’s in the office. Please hold while I transfer your call.”)

That law firm has now evolved into Gaughen, Gaughen, Lane & Hernando LLP, still very much a family outfit.

The bank’s current board of directors has 15 members; six of these are progeny (one son and five grandchildren) of Robert H. Gaughen, Sr.

Of the remaining nine directors, three were on Robert Sr.’s dissident slate in 1993, and the others (or most of them) have strong ties to the Gaughen clan. The board and the bank are very much in their control.

Nepotism in a public company generally stinks. That said, the Gaughen family has done a phenomenal job for the bank and all shareholders during their 28 years of control, and I don’t see indications that they have abused their positions. The family are by far the largest shareholders, controlling some 30% of the outstanding shares with a current value of about $150 million. We can hope that the late Robert Sr., Robert Jr., and now President/COO Patrick (Robert Jr.’s son) have ingrained a strong culture at the bank, a combination of conservative lending, cost management, and a growth mindset, that will give Hingham many more years of profitable growth.

When the Gaughens took control of Hingham in 1993, they instituted a policy of not making loans to directors, officers, or principal stockholders of the bank, and any related entities. One potential conflict is that the bank uses the services of the previously mentioned law firm, Gaughen, Gaughen, Lane & Hernando LLP, whose partners are all members of the extended Gaughen family, with three of the partners serving on Hingham’s board. In 2019 these legal fees amounted to $2.1 million, and were for loan originations, foreclosure and collection activities, and other legal work. The bank paid another $942K in fees for title insurance related to loan originations. With the exception of about $169K (less than 6% of the total), all of these legal fees and title insurance fees were reimbursed to the bank by its borrowers, and management feels that the amounts were reasonable for the services provided. For 2018 the numbers were similar; 2020 numbers are not yet available.

Again, given the performance of the bank under the Gaughens’ stewardship, I’m inclined to give them the benefit of the doubt until evidence emerges that they are abusing their positions.

PROSPECTS

What is Hingham’s stock worth? I think it unlikely that the Gaughens will sell the bank, so the appropriate valuation metrics are probably related to some combination of earnings and book value, rather than what Hingham could be worth to another bank. Book value (and tangible BV) per share at the end of 2020 was $137.02. Over the last decade, core return on average equity has averaged 15.5%. In the 2006 to 2008 period, core ROAE ranged between 8.4% and 11.1%; in 2009 it was back to 13.3% — remarkably strong numbers for that period during which many banks were making huge losses. From the late 1990s through 2005, ROAE exceeded 14% on average.

I am inclined to believe that in normal times Hingham’s core ROAE can average more than 15%, as it has in the last decade. The bank is a lot bigger than it was 10 and 20 years ago, and over that period it has managed expenses remarkably well. This shows up in the efficiency ratio which was almost 60% in 1994, the first full year after the Gaughens took charge. It has trended downwards continually since then. In both 2000 and 2005 the efficiency ratio was about 48%. In 2010 it was 44.9%, in 2016, 36.3%, and in 2019, 30.3%. In 2020 the efficiency ratio was a remarkably low 25.4%, as the management team clamped down on costs as soon as the pandemic hit.

Book value should be about $175 at the end of 2022, after dividends paid out over the period. At 15% ROAE, the earning power of the bank will then be about $26 per share. What kind of stock price can one hope for? The bank is now trading at about 11x trailing earnings and about 1.66x BV. A P/E ratio of 14 or 15, which seems fair for a high-quality bank, would translate to a stock price of $364 to $390 at the end of 2022. What about multiple of BV? Over the last 25 years, the stock has often enough traded at between 2x and 2.5x BV. Twice book value would imply a $350 valuation in two years. The prices above imply potential appreciation of about 60% to 75% over two years.

As banks go, Hingham is still very small, with assets of less than $3 billion at the end of 2020. Management has been thoughtful and cautious in growing the bank’s footprint and activities since they took control in 1993. The result has been profitable growth over the period, with seemingly no major blunders. It’s not hard to imagine Hingham growing to $10 billion or more in assets over a number of years, maybe a decade. The bank was one-third of its current asset size in 2009/2010, and profits were then about one-fifth of the current level. Both assets and profits in 1999/2000 were about one-third of the 2009/2010 level.

Over a longer period, 15% annual appreciation in the stock price seems plausible—primarily through earnings growth, with some modest multiple growth. Dividends are modest, at about 1% annually on the current stock price, but have been consistently raised over time.

RISKS

Gaughen family fails to continue executing as well as they have in the past.

Economic cycle or interest rate cycle hurts financial performance.

Catalyst

Time.

Continued growth.