Description

Hingham is a small, incredibly well-run bank focused on real estate lending. The return on equity is likely to average 15% - 20% over the next decade and so will an investor’s returns. At 9.8x LTM P/E, Hingham is priced in line with the average bank despite being a far superior business. The price has come down substantially over the last 6 months from over $400 to below $300 today, making for a good (but not mouth-watering) entry-point at 1.7x book value which is near its 5-year low (with the exception of the March 2020 COVID shock). This is a boring business in an established industry with a narrow range of outcomes that is highly likely to outperform the market and yield 4x - 6x over 10 years, making for a great core portfolio holding.

 

For a detailed history on Hingham written with an eloquence I can’t hope to match, I encourage you to read ladera838’s write-up on the company from February 2021. So why now add to ladera’s good work from just 18 months ago? Well a few things have changed. Firstly, interest rates are rising sharply which necessitates a closer look and Hingham’s deposit and loan timing mismatch. Secondly, there is much talk about the "inflated" real estate market where Hingham focuses all its lending, which I’ll argue is not a major concern. And lastly I want to show what the market probably doesn’t fully appreciate which is the Bank’s continued cost efficiency and general superior performance (as reflected by the price relative to other banks), which should result in even better returns in future than has been achieved in the past because of the scale it has started to achieve.

 

 

A well run family bank with a long history

 

I don’t want to repeat the what ladera said but do just want to address his concerns around potential nepotism. Hingham is family-owned (partly at least) and run with multiple Gaughen family members on the board and management. Insider equity ownership is 31.22% and they behave accordingly. In case this family management and board structure worries you, a glance at their operating history should dispel any worries you may have around nepotism. I think their close-knit family culture is likely a key to their success. Hingham can be summarized as an exemplary banking operation run by conservative managers with a deep understanding of real estate lending and an intense focus on costs. Their conservative lending can be seen in their net charge-offs (loan losses) which has averaged close to zero, even through the global financial crisis (“GFC”). Hingham’s return on assets (“ROA”), return on equity (“ROE”) and efficiency ratio are some of the best in the industry and have resulted in a steady compounding of capital over a long period of time. 

 

 

Investment thesis – more of the same please

 

Once the business is understood, I believe you’ll see an investment in Hingham as your quintessential 2-foot bar to step over as opposed to 6-foot hurdle that requires a jump. It is a quality business in a stable, established industry trading at a fair price with large insider ownership. It simply needs to do more of the same in order for an investor to be very satisfied over the next decade. I believe that a 15% annual return over 10 years is highly probable, and with a bit of luck this return could be closer to 20%. The nature of the industry and narrow range of potential outcomes make Hingham a great candidate for a long-term core portfolio holding.

 

As will be shown below, Hingham is not your typical bank. Amongst other metrics, this can be seen in their very low dividend payout ratio where they retain up to 90% of their earnings. So your returns as an investor will come largely from a steady compounding of equity capital (as opposed to dividends), driven by very low-risk loans and their incredibly low costs relative to assets. 

 

The Bank is still small at just over $3bn in assets, giving it substantial room to continue making low-risk real estate loans. Five years ago it expanded outside of Massachusetts into Washington DC. When COVID struck they also took the opportunity to start lending in the San Francisco Bay area. Both markets exhibit similar characteristics to those in Massachusetts namely an affluent population, fewer mid-sized ($1bn - $10bn) competitor banks, a large supply of smaller multi-family properties and economic drivers that are likely to underpin a positive employment environment for many years to come.

 

 

Understanding the culture at Hingham is key to understanding why the business is successful

 

I think the culture at a bank is incredibly important to its success, more so than in other businesses. Banking is ultimately a commodity business, so the culture and resultant discipline is often what drives the vast differences in outcomes between individual banks.  There needs to be humility and clear boundaries in place. There cannot be a group of managers that chase earnings growth without focusing on risks first. But culture can be difficult to identify from the outside and often a long and successful financial history - assuming the same management is in place - is a guide. 

 

In the case of Hingham there are also other clues. I encourage you to watch one of the most recent annual meeting videos that can be found on the Hingham website. Almost all the talking is done by Patrick Gaughen and he is supported by his dad, Robert Jr. The elements I like the most are the reserved tone, the humble admissions of what they aren’t good at alongside an intense focus on what they know well, and the deeply ingrained appreciation of focusing on the fundamentals. Now I can’t say I stumbled across Hingham through watching these videos. I was initially just attracted by their long and consistent financial metrics, especially their high return on equity. What these videos gave me is a sense of comfort that I would be investing alongside a very sound and conservative group of people that know their own business extremely well. My opinion wasn’t hurt by the fact that they espouse Warren Buffett’s principles and ethos, but as Patrick Gaughen warns: beware of managers who pepper their presentations with Buffett quotes.

 

I’d like to highlight a few of the more unusual aspects of their business to give you an idea of how they behave differently and resist the institutional imperative:

 

·      They avoid most forms of lending that other banks engage in and their list of what they don’t do as a bank is far longer than what they do. They actually publish this list. In Patrick’s words: “If it floats, flies, drives or moves, we don’t lend on it.” They do no commercial or industrial lending. Real estate lending is their niche and they stick to it.

·      Nobody at the Bank has lending authority and every loan must be approved by the executive committee or the entire board of directors. Most sizeable loans are granted only after a member of the executive committee has visited the site in question. The executive committee and board members are also shareholders – they understand alignment.

·      They don’t have any of the typical revaluation or debt service covenants in their loan contracts. This is because they prefer their lending to be what they term as “submarine transactions” - whatever happens with the waves on the surface or in the first 20 feet of water won’t affect them at all. They heavily favour low leverage deals and focus intensely on the collateral. Their average loan-to-value across their book is approximately 53%.

·      Their default provisions are severe and applied “unusually forcefully”. As soon as a payment is more than 10 days late, an interest rate of 18% start to kick in. They view this as a “very hot pan” that a borrower will usually not touch twice and accordingly the borrower tends to prioritse payments to Hingham.

·      Hingham retains all of its own loans and does not purchase mortgages from other banks – they want to control the lending relationships themselves and want to have personally assessed the loans on their books.

 

Lastly, as one would expect of any good Buffett disciple, its clear that management focusses intensely on capital allocation. As Hingham shareholders themselves they understand the need to compound capital at attractive rates, which is important since they retain most of their earnings. They favour organic growth above minority equity investments, and have all-but-outlawed control equity investments because of the control premium, loss of management focus and elusive synergies. Do not expect them to make control-acquisitions with your money.

 

 

The financial history of Hingham

 

Below, I have chosen to show Hingham’s performance going back to 2005. This is to incorporate a few years leading up to the GFC and to illustrate the very consistent performance of the Bank over a long period of time. 

 

The Bank has been performing exceptionally well over this 17 year period. At the heart of the average 13.8% core return on equity it achieved is its ever-improving cost efficiency, with costs one-third lower than the industry average. This return on equity is even more impressive considering that Hingham retains most of its earnings, with a current dividend payout ratio of below 10% compared to more than 50% for the industry. In addition, Hingham has hardly lost any money through net charge-offs, despite consistently growing its loan book at an average of 12% per annum over this period. This is good news considering its concentrated asset base consisting almost entirely of real estate loans, a departure from the industry which has an average split of about 30% in lower-yielding securities and 70% in loans. 

 

The deposit side of the balance sheet is the Bank’s weakest aspect, with more expensive term certificates and wholesale government borrowing making up about 60% of the liabilities with only 15% made up by low-cost savings and demand deposits (the balance comes from money market deposits). This liability mix is at least partly intentional, with management stating that operational costs can be kept lower by not overspending on just attracting low-cost deposits but rather considering “liability costs” holistically.

 

There are many numbers to digest on the following page, so I’ve highlighted a few rows for the reader to take careful note of. From top to bottom:

 

·      Loans to deposits is particularly high (the industry average is closer to 70%) since Hingham invests in  almost no fixed-income securities and they fund 22% of their liabilities with wholesale short-term debt from the Federal Home Loan Bank of Boston.

 

·      The allowance for loan losses is remarkably consistent as a percentage of gross loans, highlighting management’s firm grasp of credit risk and their conservative, aligned approach to lending. The allowance did rise slightly in the years following the GFC, but this increase was tiny in comparison to the market.

 

·      Although Hingham does not really invest in fixed-income securities any longer, they do have a fairly sizeable equity portfolio which was started in earnest in 2013. Before then the investment securities consisted largely of debt securities from government-sponsored entities.

 

·      Hingham makes very little from non-interest income. Their products are simple and deposit fees are either low or zero. This is intentional. The more recent figures in non-interest income largely represent unrealized gains in equity securities which are adjusted for a little further down.

 

·      As a provider of credit Hingham is exceptional, as can be seen by the almost non-existent net charge-offs as a percentage of average loans over the 17-year period (the industry averaged net charge-offs of 0.78% per year over this same period).

 

·      What makes Hingham truly exceptional in the banking industry is their extremely low operating expenses. This is their core competitive advantage over most other banks. I’ve shown this as a percentage of net earning assets instead of the more conventional “efficiency ratio” because the latter is affected by movements in the net interest margin (“NIM”).

 

·      The core return on assets and core return on equity have both risen steadily over the years, largely due to tight cost-control. Reference to “core” removes the effects of volatile mark-to-market unrealized gains from the equity portfolio from the net income, as well as other once-off items. This ensures we’re considered just the ongoing bank earnings and excluding lumpy equity returns. Assuming the equity portfolio grows, this should add to the core return on assets and equity of the Bank over time.

 

·      Lastly, management has only minimally diluted the equity through share options, with the shares outstanding only increasing by 0.3% per year over 17 years.

 

 

 

 

Hingham in comparison to the general banking industry

 

I thought it important to put Hingham’s metrics into context by comparing them to the general banking industry. The industry data covers all the FDIC-insured Commercial Banks & Savings Institutions which currently consists of 4,976 entities and data going back to 1984 (when there were more than 15,000 FDIC-insured banks). I’ve again shown Hingham’s results from 2005 / 6 in orange.

 

*Note that the Fed funds rate is plotted at a different scale on the right axis.

 

Historically, higher rate environments have coincided with higher net interest margins, although this may not be a definitive correlation since lending has likely also become more competitive over time. In low-rate environments Hingham will slightly lead the market in net interest margin due its high proportion of term certificates and wholesale debt, together with its high proportion of loans. In higher rate environments the net interest margins will be similar, with Hingham making up for its higher-cost deposits with its higher proportion of loans that yield more than typical fixed-income securities. When the Fed raises rates quickly, Hingham should temporarily lag the market (2006 to 2009, 2017 to 2019) due to its timing mismatch (more on this below), and then in time it will catch up as new loans are added at higher rates. 

 

 

*Net non-interest expense is the difference between non-interest expenses and non-interest income – Hingham has minimal non-interest income but this is not the case for the general banking industry so a fair comparison should use the net figure

 

Hingham’s cost efficiency has become quite pronounced as it has gained scale. This is especially impressive considering that the average bank’s earning assets consists of only 70% loans with 30% allocated to securities requiring lower operating costs to manage. It helps that Hingham doesn’t really have to deal with defaulted loans and resultant work-outs. This cost advantage sets Hingham part from the average bank.

 

 

Hingham’s net charge-offs are almost non-existent… look carefully, they’re there going back to 2006 although are always close to (or equal to) zero.

 

 

The lower operating costs and minimal net charge-offs result in a higher return on assets for Hingham compared to the industry. This gap has widened in recent years largely as a result of the extremely low rate environment helping Hingham’s net interest margin more than most. This low-rate environment is now changing. The key take-outs from this graph is the gradual upward slope of Hingham’s line and their remarkably strong relative performance during the GFC.

 

 

Historically Hingham have operated at higher overall leverage levels. I’d argue that they are able to operate at these levels due to their conservative lending practices. More recently this leverage difference to the market has closed, perhaps indicating fewer loans that meet their standards. Their recent expansion into Washington DC and San Francisco should provide them with ample opportunities to continue conservatively growing their loan book in future.

 

 

The higher leverage and higher return on assets results in a much higher core return on equity for Hingham (again an upward-sloping line). Of particular importance here is the consistency of Hingham’s ROE, especially considering that the industry consists of almost 5,000 different banks today and more in the past, evening out individual results. The core return on equity also excludes the benefit from a growing equity securities book which should add to the overall result over time.

 

If current lower leverage levels are maintained by Hingham, I expect their return on equity to come down a little in the next year or two as interest rates rise and Hingham’s NIM reduces. But even at lower leverage, Hingham should be able to maintain their market-beating ROE because of their cost efficiency.

 

 

Assets – almost all lending is on residential and commercial real estate

 

The loan-portion of the balance sheet is where Hingham shines. The focus has been on commercial real estate which now makes up about 75% of the loan book. There has been a conscious strategy by management to focus on commercial real estate (as opposed to residential real estate) for the following reasons:

 

·      Typically these loans (especially multi-family) have better leverage characteristics than residential real estate. Hingham maxes out at 75% loan-to-value but their average leverage is much lower on average at 53% LTV (as per 2020 annual meeting).

·      The cashflows tend to be more diversified, not reliant on just one or two income streams

·      The legal terms are better than on residential real estate loans and Hingham’s ability to exercise remedies (when needed) is greater.

·      Most importantly, Hingham is better able to differentiate themselves with these customers from a relationship perspective and these customers provide more attractive future reinvestment opportunities.

 

The following graph shows how this focus on building and leveraging their commercial real estate relationships has increased their exposure to this sector over the last decade:

 

 

At first glance this loan mix appears highly concentrated and therefore somewhat risky. But this intense focus on real estate lending gives Hingham an edge, both in terms of costs and their knowledge of this market-segment. One must also consider a few key factors when assessing the lending mix:

 

1.     Real estate lending tends to be one of the safer forms of lending that banks engage in. Typically the underlying customer base servicing the loans (or paying rent for others to service the loans) is very diversified in terms of their sources of income. This is certainly true when compared to commercial & industrial lending where exposure to a single distressed customer can result in large losses. Real estate loans also tend to have high collateral.

 

2.     The GFC is still fresh in the minds of many investors. During this time a housing bubble resulted in large real estate losses and losses on the associated loans. As I’ll argue below, I don’t think the current environment is anywhere near as risky as it was in the years leading up to 2008 and this is especially true for the areas where Hingham does all its lending (Massachusetts, Washington DC & San Francisco).

 

3.     Most importantly, Hingham’s lending track-record is exemplary. Their net charge-offs, even during the GFC, are almost non-existent. They appear to be extremely conservative lenders, and this is strongly driven by the alignment they’ve cultivated amongst senior management. Every loan must first go through their executive committee for approval which meets twice monthly or more often if needed. The executive committee consists of half of the board of directors. Any loans above $1.5m or borrowers with more than $6m total exposure must be approved by the full board of directors. Nobody has individual lending authority, not even the president or CEO. The executive committee and board are also almost all Hingham shareholders. As a group they own about 31% of the shares outstanding. So any lending decisions are made with their personal net worth in mind.

 

Internal estimates of collateral value are used for loan approvals. An external (appraisal) valuation is only checked to ratify a loan approval, which is granted subject to the external valuation coming in above the internal valuation. Very often one of the executive committee members will visit the individual properties to make a first-hand assessment themselves.

 

One may consider this hands-on loan approval process to be unfeasible as the Bank continues to grow. Management is insistent that this is not the case. They have been using this system for 30 years now. Over time the board limits have increased and they’ve also improved the process to make it more efficient. Management believe that there is still ample room for them to grow while being equally hands-on in their lending practices. Its difficult to deny that it has worked for a long time.

 

As mentioned, Hingham expanded into the Washington DC area five years ago. A new geography is always risky for a bank and Hingham started slowly, lending just $60m in each of years 1 and 2 before accelerating. Washington accounted for 27% of new commercial real estate loans originated in 2021. San Francisco is another new region for Hingham. They have just started to lend into that market and I again expect them to go slowly. As the Bank grows its important that they are able to source enough new loans in order to continue being as selective as they have been in the past.

 

 

Assets – equity investments account for 21% of the total business equity

 

Hingham is unusual in a few ways, one of which is their not-insubstantial equity investment portfolio. They view this as both a secondary avenue for capital deployment and an opportunity to learn from other financial and technology players in the market. The equity portfolio as at June 2022 has a value of about $77m which is about 21% of the total equity in the business. Currently Hingham provides very little information on their investment exploits, but a little bit of digging into their 10Ks has allowed me to estimate that since 2013 when they started engaging in equity investments, they’ve earned an IRR of about 10.7% p.a. on the money they’ve deployed - that’s after the recent fall in equities in the last 6 months. Hignham largely targets small financial companies (typically banks) and more recently have invested a little in technology companies. They have a long-term outlook and haven’t done much selling since they started in 2013. The only individual securities they’ve disclosed is the investments they’ve made into Visa and Mastercard. 

 

This portfolio should be monitored, and when it crosses the $100m mark then I expect to see more detailed commentary as they’ll be compelled to publish a 13F. But their conservative approach to everything else they do suggests to me that this portfolio should return satisfactory (if not spectacular) results over time. Organic growth in the loan portfolio remains the stated preference of management from a capital deployment perspective.

 

 

Liabilities – their deposit base is not very strong but they are working on improving that

 

The liability side of Hingham’s balance sheet is weaker than their asset side. They don’t have a very high proportion of low-cost sticky deposits and rely on wholesale government borrowing to supplement their deposit book and help fund their lending. In the recent very low rate environment, Hingham has been able to pay low rates on their interest-bearing deposits and wholesale funding so their net interest margin has been unusually high. But in an environment of rising rates that we are going into now, especially when the rates rise rapidly, Hingham’s net interest margin will temporarily compress as it has in the past. We have already seen this in their 6-month results to June 2022. They run a “liability sensitive” balance sheet.

 

The following graphs show the deposit and wholesale funding mix over time and the cost of that funding.

 

 

 

 

The low-cost deposits (savings accounts, demand deposits and NOW deposits) only make up about 15% of the total. Money market deposits are the next level up in terms of costs and these constitute about 25%. Then term certificates are a significant component at about 40% - these are less sticky, more rate sensitive and rise quickly in cost as the Fed raises rates. Wholesale funding makes up the balance at about 20% – this is the most costly source of funding and is also very rate-sensitive. Hingham sources this wholesale funding from the Federal Home Loan Bank of Boston (“FHLB”) and has reduced their reliance on this source over the last few years. They have a substantial buffer in terms of additional undrawn capacity at the FHLB of $911m.

 

Management’s view is that a mixture of wholesale funding and direct (deposit) funding is appropriate to minimise the total cost of funding the operation (interest + non-interest expenses). Besides the costs thereof, they appear to appreciate the typical counterparty risks for a bank associated with substantial wholesale funding which tend to occur in distressed environments. Hingham have designed their wholesale funding structure to reduce this risk by borrowing from a government source and ensuring they operate well below their available credit capacity. Their conservative lending history should also give any wholesale lender comfort to continue extending credit to Hingham, even during times of distress.

 

Management do understand that their deposit franchise needs work. They have put much effort into their Specialist Deposit Group (SDG) which largely focusses on raising commercial deposits. This is a personalized service offering consisting of a mix of relationship managers and digital banking specialists to assist larger customers with more complex needs. In 2021, SDG was responsible for $648m in retail and business deposits and this has grown at a high rate over the last number of years. They also use their retail banking group with locations in Boston, South Shore and Nantucket to source deposits, although the focus going forward is likely to be on SDG as opposed to the retail network. 

 

Its also important to understand that aside from very specialized services like lockbox banking, Hingham charges almost no deposit fees. They believe that these profit pools are vulnerable to attack and that costs related to services like wire transfers are minimal and have no real link to the fees often charged by other banks. Hingham management have a clear customer focus and long-term mindset.

 

 

Interest rate sensitivity – lower NIM when rates rise

 

Hingham’s balance sheet construction is designed to borrow short (from depositors and wholesale lenders) and lend over the medium to long term. This timing mismatch is arguably greater than for other banks. This exposes the Bank to sudden increases in interest rates where the borrowing interest costs change quickly but the lending interest income takes longer to adjust to the higher rates. The following graph shows the change in the average daily Fed funds rate together with the average interest paid and earned by Hingham each year. Notice how sudden changes in the Fed funds rate (blue bars) results in more rapid changes in the interest paid (grey bars) compared to the interest earned (orange bars) which changes more slowly:

 

 

In times when the Fed funds rate increases rapidly, the net interest margin of Hingham comes under pressure as shown below. Notice the net interest margin changes in 2006 – 2008 and again in 2018 - 2019:

 

 

I will note that Hingham has improved its asset maturity profile significantly since 2005 when it was severely affected by a rise in rates. It has also increased its non-certificate deposits and liability profile. The following tables show the asset and liability split by term and type in 2021 relative to 2005. Take particular note of the proportion of total fixed rate loans as well as the total proportion of wholesale borrowing in 2021 as compared to 2005 – Hingham was clearly more sensitive to rapidly rising rates in the mid-2000s:

 

 

The reason this is important to understand is because of the Fed’s current interest rate trajectory. A rapidly rising rates environment will temporarily reduce Hingham’s net interest margin which is currently at or near an all time high. The cost of their term certificates and wholesale borrowing (and to a lesser extent their money market deposits) will increase almost immediately but their lending book will take longer because of its term profile. (The loan book is somewhat insulated since only 23% of interest-earning assets is fixed-rate lending.) 

 

In Hingham’s 2021 annual report they state that a 100bps instantaneous increase in rates will reduce their net interest income by 5% (± 17bps) and a 200bps instantaneous increase will result in a 10% NIM reduction over 24 months. This may not sound like much but remember that this reduces the return on assets which in turn reduces the return on equity by 10 times this drop. In other words, a 200bps instantaneous interest rate increase will reduce the return on equity over 24 months by about 3.5%.

 

So why invest in Hingham at a time when interest rates are increasing rapidly? Three reasons. The first is that I view this investment over at least 10 years. During such a long period, there will most likely be times when the Fed raises rates quickly. But I estimate returns using through-the-cycle average ROAs so the good and bad times should hopefully even out over time. The second reason is that Hingham is reasonably priced right now relative to the banking and general market (on a P/E basis using core earnings) and its own history (on a price-to-book basis). (I expand on both these elements in the valuation section below.) Lastly, a higher rate environment should be better for banks in general from a NIM perspective and for Hingham in particular once the initial shock of a sudden rate increase subsides. I don’t factor this overall higher rate environment into any of my return projections and consider it cream on the top.

 

One could certainly make the argument that the market will react to a reduction in near-term earnings and the share price could become even more attractive. I think this possibility exists, but I don’t value my ability to predict near-term share price moves and I’d rather own what I consider a wonderful company at a fair price than wait and potentially miss out if the price does not fall.

 

 

The macroeconomic effects on home prices and potential loan defaults for Hingham

 

I don’t like my investment thesis to be reliant on theories or predictions about the macro economy. Such predictions are notoriously difficult to get right because of the complexity of the system – predicting the future of a single business is difficult enough. With Hingham’s exposure to real estate, it would be remiss of me, however, to not at least comment on the potential for a 2008-style housing recession, especially after the recent rapid rise in home prices and the potential for a US recession. What I’m looking for is any obvious red flags that could result in a sustained period of industry loan losses and much lower ROE years for Hingham, dragging down the long-term investment returns as a result. Due to the complexity of the economic system, there will undoubtedly be differing macro views, but I’ll put my stake in the ground as it relates to Hingham.

 

There is no doubt that house prices have risen sharply over the last few years. The following graph shows the annual growth in single family house prices for the top 100 metros, with the growth in the last two years (each ending in Q1) being historically very strong:

 

Source: Purchase-Only Indexes available from the Federal Housing Finance Agency – average of quarterly growth across top 100 metros

 

Similarly, these graphs from the Federal Reserve Bank of Dallas show the “exuberance” in real house prices in the recent past:

 

 

 

 

What I’m particularly focused on with respect to Hingham is house price growth driven by rampant speculation, as was seen in the years leading up to 2008. This is more likely to contribute to large loan losses where even Hingham’s conservative lending practices can’t fully insulate them (coinciding economic recession and rising rates obviously won’t help matters). 

 

Typically the housing market does not experience significant drawdowns, 2008 being the exception, as shown in the table below. As mentioned I’m looking for obvious red flags that could result in very large declines like in 2008, not trying to anticipate minor declines.

 

I would argue that recent growth in house prices has not been driven by speculation but rather by supply and demand dynamics. Following 2008 there has been a massive under-building of homes in the US as seen in the graph below. This, combined with a growing population has resulted in an erosion of the supply glut following the GFC, which has now become a supply shortage. (For a much deeper insight into this dynamic, please read the 2020 LGIH write-up by katana and associated message board.)

 

 

Factors like recent high employment, monetary stimulus and work-from-home likely all contributed to higher housing demand. This under-supply and excess demand resulted in sales inventory levels that are now at record-lows. The following table shows sales inventory levels for the top 25 metropolitan areas in February 2022 compared to February 2019 (note the levels of Boston, Washington and San Francisco in particular since these are relevant to Hingham). Housing under-supply is unlikely to be fixed quickly.

 

 

Much more can be said about supply and demand in housing, particularly related to the number of younger people starting to enter the market, but I think there is some fairly strong support for recent house price growth being driven by a supply-demand imbalance. Of course, speculative home prices are not the only factor that can contribute to real estate loan losses. The financial health of the homeowner is also important, and as can be seen below this is at a very strong level, especially compared to the GFC. The gap between mortgage debt and home equity is the widest its been for more than 20 years.

 

 

In addition, the regions where Hingham concentrates its lending (Massachusetts, California and Virginia) are particularly wealthy which should make them more resilient to an economic downturn compared to the average. This is obviously not definitive as wealthy people can and do stretch themselves financially, but recessions typically affect the poor more severely.

 

 

The areas in which Hingham focusses its lending have also not experienced the level of price increases that other metros have. The following table shows the growth in single family homes for the top 100 metros. I’ve shown the three Hingham-specific regions and also divided the top 100 metros into quartiles based on their recent returns over 3, 10 and 31 years. As you can see Boston, Washington DC and San Francisco are all well outside the top 2 quartiles for their 3 year growth (as seen by their rank) and only San Francisco (which has very little current exposure for Hingham as a new lending region) is in the top 50 metros for its 10 year growth. All three areas have shown strong long-term relative growth, highlighting the long-term attractiveness of the regions. 

 

Data source: Purchase-Only Indexes available from the Federal Housing Finance Agency

 

This type of comparison above is obviously quite simplistic since high growth does not necessarily indicate speculative buying and vice-versa. Some regions may very well justify their high home price growth due to factors like positive net migration of people from other states (with Texas and Florida being recent examples) and strong regional economic growth. This being said, a high level of house price growth leading up to the GFC was a fairly good indicator of subsequent lower relative growth. The following table shows how the metros in the top growth quartiles leading up to the GFC fared in the subsequent 3 and 10 years after the GFC. The pattern is what one would expect from mean reversion. As can also be seen from the table above, over very long periods the difference in growth between the best and worst quartiles is not that large, so large shorter-term relative price moves tend to be brought back to more long-term levels.

 

Source: Purchase-Only Indexes available from the Federal Housing Finance Agency

 

All of this is intended to show that although there has been strong recent house price growth, I think there are very good supply-demand reasons for this and I don’t think it has been driven by much rampant speculation. Additionally, the US homeowner seems to be in a strong financial position, reducing their vulnerability to a recession. For Hingham in particular, they lend in some of the more affluent regions which should provide a further buffer in case of an economic downturn. These regions have also experienced less of a run-up in house prices more recently than many of the other large metros in the country. So from a pure macro-perspective, I don’t see any blatant warning signals for Hingham.

 

 

Valuation – cheaper than the market and in line with other banks despite its superior quality

 

As shown, Hingham is a superior business from a long-term return on equity perspective: 

 

·      Over the 16 year period from 2006 to 2021 - a period which included the GFC - Hingham has average a core return on equity of 13.87% versus 8.10% for the general banking industry. 

·      This superior rate of compounding has been achieved despite a much higher reinvestment rate for Hingham which paid out an average of 22.6% of its net income in dividends versus 64.9% for the general industry. 

·      Hingham’s return on equity has also been steadily improving due to its continued cost efficiency – per dollar of earning assets Hingham is exactly twice as efficient in 2021 (0.71% net operation expenses as a percentage of average earning assets) as compared to the same measure in 2005.

 

Given this superior performance, one would expect Hingham to trade well above the market, but this has not been the case, probably because its small size makes it relatively unknown in a large industry. Hingham has consistently traded at or below both US banks and the S&P 500 from a P/E ratio perspective (as shown below). For me this is a preferred measure to evaluate bank investments as opposed to the popular price-to-book ratio (which is also shown). 

 

From a price-to-book perspective, Hingham is priced well above the general banking industry. This is justified considering its superior historical return on equity. Relative to its own recent valuation, Hingham has seen its share price decline significantly in the last six months and is currently trading at the lower end of its P/B ratio relative to the last five years (1.75x P/B vs 1.99x five year average P/B).

 

*The P/E and P/B ratios shown are all quarterly averages with the exception of the “Latest / LTM to June ‘22” figures – latest US banks P/E is from the end of May 2022

**The S&P 500 P/E ratio shown has been capped at 30x to make graphing more clear. 

***The P/E ratio for Hingham has not been adjusted (so is shown as a casual market observer would view it) except for the latest figures which reflects the “core” earnings after recent (unrealized) losses from equity securities are excluded.

 

I believe that Hingham will continue to earn high returns on equity over the next decade. Its small relative size and recent expansion into San Francisco gives it the ability to continue extending low-risk loans while keeping costs low. It is clearly superior to the average bank and arguably the general market, yet it trades in line with the banking industry and at half the multiple of the S&P 500 on a P/E basis. Hingham is also a better business today than it was 5 or 10 years ago because of its persistent cost efficiency and greater scale. An LTM core P/E ratio of about 10.2x seems more than fair considering its overall quality.

 

Net interest margin has come down by 25bps over the first six months of 2022 relative to the same period last year. This has reduced return on assets by the same amount from 1.93% to 1.68%. The NIM may come down further in the short-term if rates continue to rise but it’s the long-term that matters. Core return on assets and equity have remained high but standard return on assets and equity are reduced by unrealized losses on the equity portfolio. Total assets have grown by 16.4% in the six months to June 2022 which should act as a buffer for the reduction in NIM over the year, making LTM earnings a reasonable valuation metric.

 

Potential return scenarios – a narrow range of attractive outcomes

 

When considering the future returns for Hingham, I’ve considered its historical core return on average assets between 2006 and 2021. This provides a full cycle where the NIM has fluctuated and the Bank has gone through the terrible GFC years. The average return on assets for Hingham over this period was 1.13%.

 

I’ve then adjusted for the cost efficiency that Hingham has generated over time. The Bank is far larger today than it was in 2006 and this scale, combined with their cost discipline, has resulted in leaner operations. The adjustment for cost efficiency each year is simply the difference between 2021’s net operating expenses / average earning assets of 0.71% relative to this same ratio in each year. This results in larger adjustments in early years where the Bank was smaller. The underlying assumption here is that the Bank is not going to get less efficient and a straight average of historical ROA ignores the scale it has built and should maintain.

 

The resulting adjusted return on assets line is shown, with an average value of 1.55%. Note that this uses the core return on assets which excludes returns from the equity portfolio.

 

 

Given this adjusted return on assets as a starting point, I’ve made some assumptions to project the average annual return over 10 years under three scenarios. I consider the downside scenario as less likely than the upside scenario, but still important to keep in mind. I will discuss each assumption below:

 

a.     Since the equity portfolio is not currently included in the core return on assets, I make an annual return assumptions for the current $77m portfolio and express that as a percentage of assets. For reference, a 10% annual return on the equity portfolio adds 0.22% to the return on assets (10% x $77m portfolio / $3 431 total assets).

 

b.     The net interest margin of the industry has come down over time. It is difficult to separate this from the changing Fed funds rate, but I’ve included an assumption where I’ve reduced this margin under the first two scenarios (for market efficiency) resulting in a reduction of the return on assets. This is probably conservative because we’re headed into a higher rates environment.

 

c.     The net charge offs over the last 16 years have been exceptionally low. I hope this will continue but don’t want to bank on it. I’ve included an increased net charge-off rate for each scenario. The risks here relate to lending into new geographies like Washington (5 years ago) and San Francisco (recently). I think caution is ingrained in the culture so I’m not too worried but like some margin of safety.

 

d.     Hingham have consistently improved their operating expense efficiency, averaging a 0.045% improvement (as % of earning assets) per year since 2005. This will become increasingly difficult to maintain from current levels, so I’ve assumed a more modest improvement in two of the scenarios.

 

e.     The dividend payout ratio has reduced consistently at Hingham. I’m assuming that if the Bank is performing well that they will retain more of the profits to compound at the high returns on equity.

 

f.      The assets-to-equity ratio has reduced somewhat in recent years. A target level of about 10x is considered “normal”. The base case assumes the same leverage as in 2021, with a lower level under the downside case. An assets-to-equity of 10.5x for the upside case is still below the five year average for Hingham. 

 

g.     Lastly, the exit multiple is expressed as a price-to-book ratio at the end of the period. Over 10 years this exit multiple doesn’t matter too much as the returns are driven largely by the growth in book value. But I wanted to allow for a higher or lower exit in scenarios where the business performs better or worse. Under the base case the exit multiple is the same as the entry multiple, adding nothing to returns. The higher exit multiple adds 1.7% p.a. to the upside returns (the business has traded at an average P/B of 1.98x over the last five years so this is certainly feasible) and the lower multiple reduces the downside returns by 1.9% reflecting a bank growing book value at just 10% p.a. more in line with the average bank. The 5-year graph below gives context to these P/B assumptions.

The business has to perform at (or slightly below) its historical levels to achieve the base case while maintaining its cost levels. I consider the upside case attainable and the downside case unlikely. The downside case should still see a return that comes close to matching the market from here. But what is equally important for me is that the range of outcomes for an investment in Hingham is fairly narrow. This reflects the high quality nature of the business and its conservative management culture, making it a great option for a core portfolio holding. 

 

 

Conclusion

 

Hingham Institution for Savings offers investors with a business able to compound equity capital at a high (15%+) rate. It operates in an established industry where seismic change is unlikely in the foreseeable future. The current price allows investors to align themselves with a quality management team at a similar multiple to other banks and half the multiple of the market. Short-term performance may be hurt a little by interest rates which are rising rapidly, but this is a long-term hold so is not too relevant for me. This won’t be a 5-bagger in 5 years but the downside is minimal and I think its very likely that Hingham will outperform the broader market by a large margin. The risk-reward profile is certainly in the investor’s favour.

 

Catalyst

Continued steady performance with no loan losses and strong cost controls