Geoff Gannon March 21, 2016

Don’t Pick Between Prosperity (PB) and Frost (CFR) – Buy them Both

An investor interested in Texas banks should simply buy both Prosperity and Frost. These two biggest Texas based banks are among the best banks in the U.S. They each have their risks. Frost makes energy loans. And Prosperity does not have especially high capital levels. But, these risks should be small because of the conservative attitudes toward lending and acquisitions at each bank. Frost doesn’t make big, transformative acquisitions. And Prosperity is a serial acquirer that has never had high loan losses despite acquiring many different Texas banks.

We can certainly compare Prosperity and Frost. But, my advice and Quan’s advice would be not to buy Prosperity without also buying Frost and not to buy Frost without also buying Prosperity. Unless you have a very, very concentrated portfolio – there is little reason to focus on buying only one bank and not the other.

Prosperity is less interest rate sensitive than Frost. And Prosperity doesn’t make energy loans. So, if your two big concerns are that oil prices will stay low for many, many years to come and the Federal Reserve will keep interest rates at or below zero for many, many years to come – it makes sense to buy Prosperity instead of Frost. I understand some investors may have a feeling about where oil prices or interest rates are headed in the next few years. And they may want to bet on that feeling. But, oil below $30 a barrel is cheap long-term. And a Fed Funds Rate under 1% is low in normal times. So, it doesn’t make much sense to bet against either an increase in oil prices or an increase in the Fed Funds Rate. Buying both Prosperity and Frost can diversify whatever risks Frost has in terms of energy loans and low interest rates. But, I can’t suggest picking Prosperity over Frost. Because, actually, it’s reasonable for rates to rise over the next 5 years and for Frost to benefit far more from that than Prosperity. As for energy loans, the truth is that while Frost might have to write-off a lot of energy loans if oil stays below $30 for years – those losses would not bring Frost’s tangible equity levels lower than Prosperity’s. In other words, Frost can charge-off a lot of its energy loan portfolio and still have higher tangible equity to total assets after doing so than Prosperity does now. So, it’s not logical to prefer a bank with lower tangible equity levels over a bank with higher tangible equity levels just because the bank with higher tangible equity might charge-off loans that would still leave it more highly capitalized than the bank that doesn’t charge-off any loans. So, again, I see no reason to prefer Prosperity over Frost because of energy loans. Low oil prices will cause bad headlines at Frost and not at Prosperity. But, bad headlines don’t necessarily make for a bad stock.

What about interest rates? This one is speculative. But, it’s also a meaningful difference between Prosperity and Frost. If you really did know what the Fed Funds Rate would be at various points in the future – you could discriminate between Prosperity and Frost on that basis. For example, Quan and I estimate that based on today’s interest rates, Prosperity is more than 10% cheaper than Frost. However, based on a 3% Fed Funds rate – which we consider normal – Prosperity would actually be about 20% more expensive than Frost. So, is Prosperity cheaper than Frost or more expensive? In my opinion, Prosperity is more expensive than Frost. I always look at normal earnings. If you’re analyzing an oil company while oil is $27 a barrel and you expect oil to be $55 a barrel in 2021, then you would estimate 2021 earnings based on $55 a barrel. And if you’re a long-term investor, it doesn’t matter what earnings are in 2016 when you buy the stock. It matters what earnings will be in 2021 when you sell the stock. I think the same rule applies to interest rates – except only more so. Central banks have implemented negative interest rates in other parts of the world. It’s technically possible the Fed could do that in the U.S. But, is it important to consider? There are real problems with having interest rates very close to zero and even bigger problems when interest rates are below zero. It’s not reasonable to believe that a negative 3% Fed Funds Rate in 2021 is as likely as a positive 3% Fed Funds Rate in 2021. And yet we know that Frost will benefit more from higher rates than Prosperity. So, with interest rates as close to zero as they are – we would expect higher rates to be a more likely event in 5 years’ time than lower rates. This is speculative. But, it’s not speculative in quite the same way as looking at $38 a barrel oil today and wondering whether oil is more likely to be at $76 a barrel in 2021 or $19 a barrel in 2021. Long-term costs would suggest $76 a barrel might be a little more likely than $19 a barrel. But, $19 a barrel is not an unreasonable price for oil in quite the same way that a negative yield on money is an unreasonable price for a loan. Oil at $19 a barrel in 2021 would not be as odd an occurrence as a meaningfully negative Fed Funds rate in 2021. So, Prosperity is cheaper than Frost now because interest rates are abnormally low now. But, Frost is cheaper under any reasonable “normal” interest rate scenario. That’s why I consider Frost the cheaper stock. You shouldn’t price a stock based on what it’s earning in an abnormal present. You should price it against what it will earn in a normal future.

Prosperity might have more upside. Quan believes Prosperity’s organic growth has a 20% or better after-tax return on equity. He also thinks any acquisitions Prosperity does should have a 13% or better after-tax return on equity. The stock has a 2.5% dividend yield. So, the only part of the future return equation that could be sub-standard is the reinvestment of that dividend. Prosperity may be able to earn between 13% and 20% on the earnings it retains. It’s unlikely you can earn that much on the dividends it pays you. But, as long as the dividend payout ratio is low, it’s unlikely your total return will be pulled below 10% a year.

Prosperity has a P/E around 11 today. Historically, it has traded at between 13 and 20 times earnings. So, the stock is cheap relative to its own past. It’s not clear why this is. Prosperity is a Texas bank. Some investors may worry that Texas real estate will perform poorly in an oil bust. They may worry about Prosperity’s real estate loans in areas like Houston where energy companies are large employers and large office tenants. Energy loans are only 5.5% of Prosperity’s loan portfolio. That’s 2.7% of earning assets. Losses on those loans can’t meaningfully increase risk at all for shareholders. To put this in perspective, if every energy loan Prosperity made defaulted and Prosperity recovered zero cents on the dollar in all these defaults – Prosperity could cover all of the losses out of roughly one year’s earnings. Investors may also dislike all regional banks because of interest rate sensitivity. But, Prosperity is fine with low rates. The Fed Funds rate declined from over 5% to less than 0.25% from 2007 to 2014. During that time, Prosperity grew earnings per share by 12% a year. At worst, the risk that investors are worried about for the next 7 years is that the Fed Funds Rate is fairly flat near zero – not that it declines by five full percentage points. So, Prosperity was a growth stock over the last 7 years when rates were falling rapidly. No one expects rapidly falling interest rates. So, the next 7 years should present Prosperity with interest rates that are easier to cope with than the last 7 years. Right now, Prosperity’s net interest margin is in line with the bank’s long-term historical average net interest margin. Honestly, Prosperity’s net interest margin doesn’t vary much with the Fed Funds rate. So, concerns about the Fed not raising rates as fast or at all as expected are an argument against buying Frost right now. They aren’t an argument against buying Prosperity. It’s also worth mentioning that we are really only debating the upside here. Even if interest rates don’t rise, Frost is a cheap stock that will deliver good returns. It just won’t deliver great returns quickly if rates stay near zero. Prosperity’s upside is pretty similar regardless of what happens with interest rates.

So, if you are concerned about energy loans and believe the Fed will not raise rates – you might prefer Prosperity over Frost. Quan and I aren’t that worried about energy loans. And we expect the Fed Funds rate to be a lot higher in 5 years than it is today. So, if you’re a long-term buy and hold investor, we suggest putting equal amounts of your money into the two biggest Texas based banks: Frost and Prosperity