Description

HIFS

I recommend entering a long position on Hingham Institution for Savings, ticker

name HIFS, whose closing price yesterday was $220/share. This is a conservatively

ran, reasonably priced, small (market cap 480M) regional bank in Massachusetts.

Don't expect spectacular returns here; but I think this can give us 10%+ annual

return over the long run with minimum downside risk.

HIFS has been written up twice before on VIC, one at 2021-02-21 at $228/share

right before its fantastic rise to $410+/share on January 2022:

https://valueinvestorsclub.com/idea/HINGHAM_INSTITUTION_FOR_SAVINGS/8616396604

(This one also has lots of interesting historical details.) the other was at

2022-08-12 at $292/share after the 2022 pull back:

https://valueinvestorsclub.com/idea/HINGHAM_INSTN_FOR_SAVINGS/7487822077

Later on the stock dropped to about $160/share in late 2023, amid general fear

after the Silicon Valley Bank crisis, HIFS's own NIM margin compression, etc.

If you think banks are hard to understand thus un-investable, or thinks the

coming uncertain interest rate environment would obliterate HIFS's earnings

power, or you think the minimum return threshold for good investment is 30%+,

then you should stop here.

HIFS is a Massachusetts chartered savings bank headquartered in Hingham, MA.

It's the only financial institution headquartered in Hingham. (After all, Hingham's

population is only 24284 according to wikipedia) Besides headquarter, it has

offices in Boston and a few small cities in MA, and one office in the Washington

DC area. This is one of the oldest banks in the US, having been in business for

190 years since 1834.

Thesis points.

1. Very conservative lending practice.

2. Unusual funding strategy suited for growing a small bank.

3. Low operating cost; the bank runs very efficiently.

4. Incentive alignment of insiders.

5. Inflecting point: NIM finally started to rise since rates hike.

1. Very conservative lending practice.

"Banking is a very good business, unless you do dumb things." -- Warren Buffett

This sentence is always on the first page of HIFS's investor presentation. Also,

before the main topic, they always first have a page listing what the bank DOES

NOT do:

This is what they do. The bank has a total loan book of 3.9B, representing of

about 87% of total assets. The bank is mostly focused on real estate mortgage

with over 99% of the loan portfolio secured by real estate mortgage loans. The

loan portfolio is the bank's primary earning assets:

(1): geographic allocation: Massachusetts 67%, Washington DC 30%, San Francisco

     Bay Area 3%; for YE 2023.

(2): Three categories:

       2a. CRE loans.   total 3.155B, account for 80% of the loan portfolio.

           generally have maturities < 15 years, rates are initially fixed then

           adjustable afterwards, usually have "step-down" prepayment fees if

           paid off prior to maturity. Loan to value not exceeding 75% based on

           min(HIFS's estimate of value, independent appraised value) of the

           collateral.

           Prior to the 2008 GFC, more than half of loan book have fixed rate.

           US interest rate rose from 1% to 5% during 2004-2006 and HIFS's net

           income dropped by 25%; when rates began to drop in 2007, the bank's

           profits recovered. Notice HIFS's peak to trough drop in stock price

           during GFC is only 30%. After GFC, HIFS intentionally switched to

           adjusted rate loans to be more robust against interest rate fluctuations.

           Now about 3/4 of the entire loan portfolio has adjusted rate.

       2b. Residential Real Estate Loans. 516M, 13% of the loan portfolio.

       2c. Construction Loans. 268M, 7% of the loan portfolio.

More over, except the CEO Robert Gaughen can approve HELOC loans up to 250K USD,

no lenders or officers of the bank can approve these loans. All loans must be

approved by the executive committee. Single loan > 2M USD requires the approval

of the full board. Also, HIFS installed a policy since 1993 (when Robert Gaughen

took over the bank in a proxy fight) forbiding the bank to originate loans to

directors or officers of the bank, large shareholders, etc.

At June 30 2024, non-performing asses totaled 0.04% of total assets (all are

owner occupant loans), compared with 0.03% at YE 2023 and 0% at June 2023.

The bank doesn't have any non-performing commercial real estate loans. Also, during

GFC, HIFS's net charge offs percentages were lower than 10bps while US banks

averaged over 3%.

2. Unusual funding strategy suited for growing a small bank.

All banks (actually, all businesses) are sensitive to interest rate. Mostly through

assets on their balance sheet. Most banks enjoy increased profitability when rates

rise, because their assets can earn more while the interest cost on their deposit

base only rise very slowly, or not rise at all. Banks invest in offices, branches,

bankers, so that their deposit customers are "sticky"; they won't walk away

simply because money market funds pays more. Therefore:

    NIM = asset_yield - deposit_interest

increases in a rising rates environment because the 2nd term doesn't move.

However, this is deceptive, because for the business as a whole, we should really

be thinking about:

    (asset_yield - deposit_interest - non_interest_cost/Portfolio) * Portfolio

Only very large banks can spread the depositor acquisition cost to a very large

customer base (i.e. R = non_interest_cost / Portfolio being small); for small

banks, attracting more deposits requires correspondingly higher non_interest_cost;

thus "stick zero rate deposits" are not really zero cost funding to them. (That's

one important reason why banks were consolidating over the past several decades)

Knowing this (I guess), HIFS is intentionally using a different funding strategy.

At year end 2023, they have 1.693B borrowed funds from FHLB, 38% of total assets.

And in the deposit part, only a small portion (7% of total assets) is demand

deposit:

If we just look at interest cost, FHLB (Federal Home Loan Banks see this wiki

if you don't know FHLB https://en.wikipedia.org/wiki/Federal_Home_Loan_Banks )

loans are very expensive; much more expensive than deposits. FHLB loan costs

rise with interest rate. It's meant to provide temporary liquidity; it's structured

so that banks purely borrowing from FHLB then lend money to RE mortgages will not

make money.

The average rate paid on FHLB borrowings on YE 2023 was 4.75%! This is terribly

expensive.  I won't go into details about how this part of the funding cost is

affected by the short term interest rate. The management team is very adept at

playing these things; after all, they experienced rapidly rising rates once in GFC.

Summary: HIFS is not only "asset interest rate very sensitive", but also

"liability interest rate very sensitive". HIFS has lower NIM when rates rise.

HIFS deposit is fully insured, via a combination of FDIC and Massachusetts DIC.

Majority of the bank's non loan assets are held at with the federal reserve.

Cash accounts for almost 8.7% (components of KRE average 5.3%).

If we step back and look at "sticky zero cost deposit" (with its deposit acquisition

cost) VS "expensive other source of funding like FHLB" (with its high rates) from

a holistic angle, it's really the "all in cost" that's important for the bank as

a business; and for small banks, it's not clear the first option is better.

This naturally leads to our discussion of:

3. Low operating cost; the bank runs very efficiently.

HIFS is obsessively focused on cost reduction; efficiency is in their genes.

(Or more precisely, in Gaughen family's...) The bank has only 92 employees, compared

with 107 employees on 2007; considering the growth in loan portfolio, book value,

stock price, etc over the intervening years, the bank was obviously becoming more

efficient. If we measure efficiency by (HIFS uses this measure):

    operating cost / total assets

This was 1.39% on 2013 one decade ago, and 0.74% on 2021, 0.7% on 2022, 0.67%

on 2023. HIFS also has much higher per employee revenue compared with other

component companies of KRE (the regional banking ETF).

HIFS 2023 efficiency ratio is 57% (due to rates hike), while the average over

the previous five years was 27% (way lower than industry average). The problem

is this: during the 2007-2008 GFC, HIFS was redeemed by Fed cutting rates, but

we are 180 degrees from that; we might be in a prolonged medium to high rates

environment. Was HIFS's good performance over the past 15 years simply because

their funding strategy is tuned for low rates? I think the answer is no, and the

continued growth over the past 30 years was coming from the efficiency improvement.

If you look at their per-share-book-value history, it's 15% annual growth were all organic from

retained earnings.

4. Incentive alignment of insiders. Heavy Skin in the Game!

The company was taken over by the current CEO Robert Gaughen in 1993 (when he

was 42 years old; willingness to work on the same boring stuff for over 30 years

is a good attribute for banking executives), and the current COO Patrick Gaughen

is his son. Combined, they own almost 1/3 of the company, and their stock holdings

is worth more than 30x their annual compensation. They don't egregiously issue

stocks / options to themselves. In fact, there is very little equity dilution.

HIFS currently has 2,170,400 shares outstanding, compared with 1,875,000 when it

IPO-ed in 1988, total dilution 15% over 36 years, or 0.4% per year.

5. Inflecting point: NIM finally started to rise since rates hike.

The NIM for 2024 Q1, Q2 are 0.85%, 0.96%. This 11bps improvement was the first

quarter the net interest margin expanded since the Fed began raising rates in

early 2022. The improvement was due to increase in earning assets yield, and the

funding cost remained stable compared with Q1. Also, the efficiency ratio

Q1 -> Q2 dropped 77% -> 68%. We are seeing the tide turning. My hypothesis is that

HIFS is not just a luck beneficiary of zero rates environment, but really earns

its place by being a low cost operator. Now book-value-per-share = 190, P/B=1.16

is a good entry point.

Conclusion: HIFS was growing book value per share 15% annually over the past 30 years due to continuously improving efficiency (instead of simply benefiting from ZIRP due to its funding strategy). Mr market thinks raising rates is killing HIFS thus offering it at P/B=1.16. We should buy now.

Catalyst

NIM, efficiency ratio continue to improve over the next few quarters