Truxton (TRUX): A Small, Fast Growing Private Bank with Extremely Low Net Non-Interest Expense
by PHILIP HUTCHINSON
Overview
Truxton is a small, fast growing private bank with extremely low net non interest expenses due to its wealth management business and very high level of deposits per branch
Truxton Trust is a one-branch private bank and wealth management firm in Nashville, Tennessee. It was founded in 2003 by a group of founders (some – though not all – of whom are also executives at the company) who appear to be a mix of very well-connected members of the Nashville business community and long-time private bankers who spent their prior careers mainly at SunTrust.
There are two parts to Truxton’s business. First, it’s a private bank. So, it takes deposits from rich customers (wealthy individuals, families, trusts, and the like) and lends those deposits out – often to borrowers who are also, or are connected to, its depositors. It also provides other full-service banking services to those clients. So, high-touch, personal service, with clients having dedicated staff at the bank that they know personally, a more bespoke approach to lending, etc, compared to the more statistically driven and cost focussed approach of mass market banks. And, second, it’s a wealth manager. Customers use Truxton for wealth management of their net worth. Truxton does – I think – do some discretionary management of bond and stock portfolios. But, the company isn’t a wealth manager in the same way as a big fund manager like Blackrock, Schroders, or Fidelity. It holds the direct relationship with the customer, who has a brokerage, retirement, etc, account with Truxton. But equally, it’s not really a broker like Schwab, Interactive Brokers, or even a full service traditional stockbroker either. It’s performing a service that is more like what a financial adviser (what I’d think of as an independent financial adviser – an IFA – here in the UK) would do for an affluent client, but aimed at genuinely high net worth individuals. And, it would encompass a wider set of services than an IFA would provide. Truxton’s services include things like managing and administering trusts and foundations established by the client (hence the name, Truxton Trust), providing tax and inheritance advice, administering a client’s estate after their death, and advising on overall portfolio composition. Truxton takes a fee – essentially 1% of AUM, maybe a bit more – for these services.
It’s important to understand that there are these two separate parts of Truxton’s business. But, the reality is that the key to Truxton is that it has a wide relationship with its key customers encompassing both their banking arrangements and their wealth management. Something like having the personal and business checking accounts for a business owner, the time or CD deposits of that customer, accounts for his or her family, trust and investment brokerage accounts with the vast majority of that customer’s investments, and loans to that customer secured on their business, their investment properties, or similar. Basically, the private bank and wealth manager together are intended to have high share of wallet of the bank’s customers – really all of that customer’s business, or a very high share of it – and those customers are on average very wealthy (so, the average customer has high account balances).
Truxton’s proposition to its clients is that it’s a full-service private bank that is focussed on customers in one market – wider Nashville – and focussed on long-term, high quality, personal relationships, rather than referrals, cross-selling and short-term fee maximisation.
It’s also – although it’s a very small bank compared to the major regional or statewide (never mind national) banks, at c$400m in earning assets – a quite extreme example of earning returns through economies of scale. There’s nothing about Truxton that suggests it really minimises expenses – after all, it’s a full service private bank – but, it has only one full branch and (as a private bank) it has a high average account size per customer. This combination – high average account size and very high (c$400m) deposits per branch allows Truxton to earn a high return on equity because non-interest costs as a percent of total deposits are very, very low. Truxton’s total costs (that is, interest plus net non interest costs) per client must be high. But, because those clients have high average balances, the costs are low as a percent of total assets, deposits, loans, etc. This is really the key to understanding why Truxton is attractive. It doesn’t (unlike, say, Frost) pay particularly low interest. And it doesn’t (unlike, say, Prosperity – or, back in the history of Berkshire Hathaway, Continental Illinois) really minimize expenses. But, it still has a low all-in cost of funding because of its very high deposits per branch (and per client) and the fees it charges as a wealth manager – as well as a very low – essentially zero – rate of loan losses. The first two of these qualities should be persistent. The level of charge-offs may be higher in future (though it should still be low compared to most banks).
Durability
Truxton is – like private banks generally – a durable business in a durable industry
Truxton has a durable business. This is mostly, if not entirely, just an industry thing. Banking overall is a durable industry. The business of taking deposits from the public and lending them out – acting as intermediary between savers and borrowers and creating credit – is a core function in the economy that only banks can perform at scale. There are some challenges to banks from non-bank financial companies – particularly on the lending side of the business. And the gradual move away from cash and towards electronic payments may have some impact on the returns banks can earn (both positively and negatively – it’s hard to say what the net effect will be). That’s obviously an area of potential change that introduces some uncertainty. It does seem credible – though not by any means certain – that there’ll be increased competition and more commoditisation in the lending banks do. That may also be true to some (although lesser) extent of their deposit taking. But, banks should be a key part of the economy in 100 years. Some of the oldest companies in existence are banks. And the durability of banking as an industry should be as good as the durability of, say, farming.
Truxton, of course, is a private bank. However, that doesn’t really affect the analysis. Two of the oldest banks in the world – Coutt’s and C. Hoare & Co, both in the U.K. – are exclusively private banks. And Northern Trust, which is probably the most comparable large U.S. bank to Truxton, is now 130 years old. There will always be a market for personalised, high-touch private banking aimed at very wealthy individuals with complex needs who are not well-served by mainstream banks. In fact, as banks increase in size through growth and consolidation, it may become increasingly difficult for them to satisfy these customers – because increased size means they become more bureaucratic, more process-driven, and less personal – to the advantage of focussed private banks. The wealth management side of Truxton’s business should be at least as durable as the private banking side – the need for wealth management services has seemingly perfect durability. It may be that technology will change – to some extent – how wealth management is delivered. But, that’s always going to be a change in distribution, not a change in whether the industry is necessary. And there’ll always be a personal, human side to wealth management – particularly for wealthy clients with complex personal, financial, tax and administrative needs – that will be poorly served by commoditised, technology- or statistically-driven providers. The nature of Truxton’s client base, and the service Truxton provides, are such that commoditised, passive, automated wealth management should have little to no impact for the foreseeable future.
So – overall Truxton is in an industry with very high durability in terms of the need for its services far into the future. Durability is very high. The questions of what returns the company will earn and how competitive the industry will be, of course, are very different issues.
Moat
Truxton’s relationship based business model and niche focus on wider Nashville gives it high customer retention and thus a wide moat
Truxton’s moat is broadly the same as the moat of any other bank or wealth manager – very high customer retention.
Truxton has little to no moat on the lending side in terms of the price it gets for making loans. This is the same as most banks. There is one important difference here: it’s a private bank. And private banks do appear to have some advantages over mass market banks – basically, their customer base is richer and more liquid than most banks, so they can lend more safely and suffer fewer loan losses. This is important – it could be a difference of as much as say a 0.25 – 0.5% per year lower rate of charge-offs per year. So far, Truxton’s loan losses (after recovering on collateral) – in its entire history – are zero. They’re clearly not going to be zero forever. But, they should continue to be low. So, Truxton has a somewhat limited, but nonetheless real, advantage over most banks in suffering lower loan losses over time. That’s just an industry thing to do with being a private bank rather than a retail and commercial bank. You may not say it’s a moat. But nonetheless it’s a real advantage.
So, the moat on the lending side is really just limited to potentially lower loan losses over time. On the deposit and wealth management side, it’s very different. Truxton’s moat is that it has high customer retention in both its deposit taking and its wealth management businesses, and that these two sides of its business work together to increase customer retention and customer economics in a symbiotic way. In large part the moat is the same as most banks and wealth managers. Customer retention isn’t something Truxton publishes statistics on. But generally, banks have customer retention rates of 90% or more on seasoned customer relationships, at least where the bank is not just relying on paying high interest rates to attract hot money. And wealth managers – particularly those, like Truxton, that own the customer relationship (rather than say running a mutual fund) – also have very high retention rates. Behavioural reasons mean that client relationships of this type should be very long lasting. Truxton might lose a client because they annoy or anger the client (basically, because they make a mistake) or because the client moves, dies or gets divorced. But they are unlikely to lose clients due to competition generally and price competition specifically. You can see this in the length of relationships that established private banks have with some of their customers. These relationships can last for decades and decades – spanning multiple generations of a wealthy family. Truxton itself is only 16 years old. So you can’t see that in Truxton’s case – yet. But reading about established private banks (like Hoare, Coutt’s and Northern Trust) this aspect of the private banking industry is very apparent. Private banks in general have the potential for longer lasting customer relationships than the average retail or commercial bank and, therefore, wider moats.
And then, the wealth management business is in an industry that has customary pricing. It’s an established norm for wealth managers to charge a percentage of AUM (usually a low percentage, like say 1%) for their services. So it’s not – or at least it historically has not been – a price competitive industry. There are parts of the industry where that’s no longer the case. For example, index funds tied to major indices are in an open price war, with fees being cut in a race to the bottom. And the mutual fund industry in general is under severe pricing pressure and disruption from the rise of indexing and cheap quantitative strategies. Whereas the private investment management industry (so private equity, broadly defined) appears to have very strong market power. But undifferentiated mutual fund management appears to be quite far from what Truxton does. Apart from anything else, Truxton (unlike a mutual fund) owns the overall client relationship and advises on portfolio construction, tax, allocation, administration, etc. There’s no sign of Truxton’s services being commoditized. And there’s no sign that customers search frequently or are particularly price sensitive. So, competitors’ ability to take business from Truxton – in particular based on price – is just very, very limited. And then there is the location advantage. Truxton is a focussed company that concentrates on the Nashville market and is well connected there. It doesn’t have national or international scale and presence (unlike competitors such as SunTrust and Northern Trust). But, equally, those competitors (or any major regional or national bank) cannot position themselves as a local company grounded in Nashville.
Truxton doesn’t have the same advantages that some successful U.S. banks (like Frost, Bank of Hawaii, Wells, and Bank of America) have in terms of a very low-cost funding base from an interest cost perspective. While Truxton does have a reasonable amount of non interest bearing deposits, a very large proportion of Truxton’s funding comes from large accounts of $1 million or more. It’s unrealistic to pay no, or very low, interest on those accounts. So, as and when interest rates rise – so will Truxton’s funding costs. However, offsetting that is Truxton’s very, very low net noninterest costs. These are driven by wealth management fees and Truxton’s one-branch business supporting a very high level of deposits (over $400m) as well as Truxton’s high average account size supporting low operating costs per dollar of deposits (even though costs per customer are probably quite high). What this means is that fixed costs – occupancy and staffing in particular – are spread over a very large deposit base. So Truxton’s all-in cost of funds is very low – much lower than average. Although Truxton’s interest costs in themselves are unlikely to be much better than average, so long as it can retain customers from year to year it’s very hard to see how the company won’t have a persistent, durable all-in cost advantage over almost all U.S. banks. Combined with Truxton being a private bank lending to wealthy, liquid customers, meaning loan losses should be lower over time, Truxton has a deep moat as a low cost producer. This moat will persist for so long as Truxton only grows within its niche – operating few branches in areas it knows well, providing services only to wealthy customers, and combining private banking with wealth management.
Quality
Truxton is a high quality bank primarily due to its low noninterest expenses per dollar of deposits and possibly due to low loan losses over time
Truxton’s quality is high – substantially higher than that of the average bank – and it all comes from factors discussed above. The key things are:
- High level of deposits per branch
- High average account size per customer
- Low loan losses in private banking
- Substantial wealth management business, and
- More broadly, a relationship-based business model with high retention rates over time
All of these factors mean that Truxton has high returns on equity, despite being very conservatively capitalised (by the standards of U.S. banks generally). And there is the potential for Truxton’s returns to improve over time if it can increase assets, deposits, AUM, loans, etc, at a faster rate than it adds staff and increases fixed costs. Basically, Truxton’s quality comes from (a) the fact that it earns high noninterest income due to its wealth management business, and (b) when your average client account size is high – say, $1m – you can afford to spend a lot more per client on customer service, and yet still be spending less – a lot less – than your competitors or peers on a per dollar of deposits basis. Truxton actually has a really high average salary per employee – much, much higher than most banks (something like $150,000 per employee, versus a peer group average of around $80,000). It seems to have a quite different employee base compared to retail and commercial banks – with what seems to be a higher proportion of well-credentialed, experienced staff used to advising and dealing with wealthy, complex clients. But, due to its high average balances per client (both in the private bank and the wealth management business) it is still much more efficient than most banks.
Truxton’s wealth management business is a huge part of its business quality. Wealth management revenues have grown from c$2m in 2009, to nearly $10m in 2018 – while AUM has grown from $200m to $870m at year end 2018 (and probably over $1bn currently). And while Truxton must have had to add some expenses to support this growth – particularly to the extent it’s come from adding new clients – underlying growth in client portfolios (which could easily average 5 – 7% per year essentially forever) is totally free. It’s not growth Truxton has to pay for at all. So, if all the wealth management business does is retain its existing client base, you can expect revenues, profits, and cash flows to grow at say 5 – 7% per year essentially indefinitely – at least for so long as the industry’s customary pricing (charging a percentage of AUM) remains intact. And frankly – for the kind of clients Truxton has, and the kind of services it provides, that pricing really should remain intact.
Then there’s the likelihood that Truxton’s business, as a private bank, means it should have low loan losses over time. So far, certainly, this has been the case – Truxton has had no credit losses (after recovering on its collateral). There are some risks here. For all of its history to date, Truxton has been lending into a hot Nashville real estate market (most of its loans are secured on real estate of some description). And some – a very few – loans have gone bad – it’s just that Truxton has managed to recover its debts via the security it had taken. It’s possible, given what the company did to recover on these loans, that it genuinely does have some level of differentiated lending skill (basically, renovating a property that had been pledged as security and selling it at a profit, rather than immediately selling it like nearly all – if not all – large banks would do). There are a few other signs that the company is a relatively conservative lender. It hasn’t made lots of loans in risky categories like property development. It doesn’t do any large-scale, statistical lending (things like mass market mortgages, credit cards, etc). Its mortgage lending is largely customized, closed-end non standard mortgages (which does present some different risks, discussed further below). And, given Truxton is seemingly largely lending to its own private banking and wealth management customer base (which is normal for a private bank) the company’s loan officers should be aware early on of potential problems and have better security for their loans than most banks do. There’s nothing concerning in Truxton’s loan history – if anything, the opposite – but basically, the quality here comes mostly from industry factors. It comes from the fact that Truxton is a private bank with rich customers. This can be illustrated by comparing an average household with a private banking customer’s household.
The average household in the UK – and it’s somewhat similar in the U.S. – is quite illiquid, even very illiquid. This is true even of relatively wealthy households. For example, a relatively wealthy household may have a mortgage of, say, $250k, on a house worth $450k, a car on finance, some sort of pension savings, and then maybe (but far from always) some sort of cash buffer. That’s a household with a net worth of over $200k – potentially a lot more than $200k if the pension savings are meaningful. But, if the main earner or earners lose their jobs – the monthly mortgage payment is immediately in serious danger, and the lender is heavily reliant on the value of the collateral if it’s to recover on the loan.
Compare this to the customer of a private bank. They may have a mortgage of say $2.5m on a house worth $4.5m (so, the same proportionate level of debt). But on top of the house – they may have an investment portfolio, an investment property (or even several investment properties), an interest in a private business, etc. They’re simply richer, more liquid, have more diverse net worths (less reliant on the value of their main residence), have more sources of income and capital, and frankly also less borrowing as a percentage of their total net worth. They are all round better credit risks. This is even truer to the extent that you can – as Truxton says it does – take pledges over other assets they own and that you manage as a wealth manager (and, therefore, have detailed knowledge and oversight of).
There are other advantages that come from combining wealth management (of the type that Truxton does – so, administering the overall portfolio, advising on allocation, inheritance, drawdown, tax, trusts, etc – not necessarily stock-picking) and private banking. First, it’s possible that combining these in a specialist firm such as Truxton leads to better service and better advice more closely matched to the client’s needs. Secondly – it’s very clearly going to deepen the client relationship, and by a lot. You might change your bank, and you might change your wealth manager, but you’re not likely to change both at the same time. So, this should result in Truxton having deeper, stickier, longer-lasting customer relationships. They should also be more profitable over time because Truxton is well-placed to get a high share of wallet at its customers. They’re very well placed to service new customer needs as and when they arise. Cross-selling does not appear to be a focus of how Truxton do business – indeed exactly the opposite, they focus on “doing the right thing” (as they put it) rather than cross selling. So pushing cross-selling would actually be a really, really bad idea. But it’s just likely that – given the relationships it has with at least its biggest customers – it’s well placed to meet new needs of existing customers over time.
Finally, the integrated banking and wealth management provides a defence against losing clients through staff attrition. Private banking and wealth management are businesses based very much on personal relationships. And – certainly on the wealth management side – there’s the risk that staff could leave, either to set up on their own or to go to a competitor – for more money, greater autonomy, more responsibility – in fact, this appears to be a key driver for Truxton’s own recruitment of key staff from SunTrust and other rivals. If Truxton were just a wealth manager, they may well take their customers with them. This can create a bad dynamic as regards staff costs. But in this case many customers would have to move both their wealth management and their banking. They’re just less likely to do that, particularly if they’ve pledged assets that Truxton administer against loans Truxton have made to them. So, the integrated business model here is crucial for scale and financial returns – but, also for the overall durability and safety of the business.
So, having said that – what does quality look like here? Well firstly, Truxton has been scaling up over the past decade. So, returns have improved a lot over that period. Pretax returns on equity – which are still trending up – have been in the mid-teens and higher since 2012. This year pretax return on equity will likely be over 18% and post-tax will be over 16%. And Truxton is overcapitalised; it has a very conservative leverage ratio compared to most U.S. banks. The company itself appears to recognise this as in its most recent results, it also declared a special dividend – and if it had a similar leverage ratio to the typical U.S. bank it would likely have an ROE of over 20%.
And – as I said – Truxton isn’t achieving that ROE by using a lot of leverage (compared to other banks). Its return on earning assets is over 2%. That is an exceptional number for a bank, especially such a small – one branch – bank. On most of these measures, Truxton is better quality than huge, well positioned, banks with high levels of deposits per branch, national scale, etc, such as Wells and Chase.
This quality largely comes from having low net noninterest costs per dollar of deposits. Truxton’s interest costs have – like any bank – been low in recent years. But its customers do expect interest. It’s not realistic to pay no interest on really large accounts. So, in higher rate environments it won’t have a big advantage on interest cost. But it should still have low operating costs per dollar of deposits because it has such a huge level of deposits in one full branch served by such a relatively small number of staff. It also comes from the economics of being a wealth manager charging a percentage AUM. This is a business that scales very, very well. So, yes, you probably have to increase expenses as you increase the number of clients you’re serving (although there can still be economies of scale here). But the growth that comes from increases in value of client accounts through appreciation in value and additional savings over time is essentially free. That growth is unpredictable and varied, of course. But it could be as high as say 7% a year. The implications of this are that, if Truxton does no more than maintain its existing client base (and historically, it’s grown that client base substantially) returns on equity should nonetheless grow. Return on equity isn’t going to double again, or anything like that. But, it could certainly head up towards the mid-20s over time. That seems a realistic – even likely – outcome here.
Capital Allocation
Truxton is likely to generate substantial excess capital over the next decade which it will pay out as dividends
Truxton has been a fast-growing company for its entire existence to date. That means it has not faced particularly difficult problems of capital allocation. Because it has been growing its balance sheet – deposits, loans, earning assets, etc – at a 10%+ rate, and because it’s been increasing scale rapidly over this period, most of its earnings have been used up to fuel growth.
It does now appear that Truxton is generating some surplus capital – enough to initiate a regular dividend (which is growing at low double digit rates) and approve a share buyback program (though Truxton’s very low liquidity means that it can’t really buy back shares). And, as mentioned above, Truxton announced a special dividend with its latest quarterly earnings explicitly because “Truxton has been fortunate to generate return on average shareholder’s equity (ROAE) higher than our recent and expected asset growth rate. Even with our regular dividends, the Corporation has seen capital ratios grow increasingly conservative, allowing us to pay this special dividend”.
So, capital allocation is very important here because it’s clear that Truxton is already generating excess capital, and it’s likely that – if Truxton can achieve further scale and increases in its ROE – it will generate excess capital at an even higher rate in future. Basically, the big risks here would either be Truxton simply sitting on cash, or perhaps making very risky investments (there isn’t much sign of that) or, more likely, Truxton buying or merging with another bank. This would be a risk because the company might overpay. It would also become more operationally complex. And – critically – a merger would put the company’s focus and culture at risk. Truxton is a very high return bank, and its niche, customer- and relationship-focussed culture, small size, personal touch, and a very high level of scale at the branch level, are really critical. If Truxton generates excess capital – which it almost certainly will – then it’s much better if it pays that out as dividends than uses it to make acquisitions. Nothing about management reads as if acquisitions are likely. Critically- the fact that the company still only has one full branch (when it clearly had the resources to open more) is a good sign of management being focussed on tending to their niche rather than seeking rapid expansion.
The company does have a wealth management office in Athens, Georgia – and it will be very interesting to see how – if at all – the company seeks to expand out of Nashville. That’s relevant to growth, of course. But it’s also important from a capital allocation perspective, because one of the biggest risks here is that Truxton make big, risky moves to expand. Really, it’s far better if – as they’ve done so far – they stick to their geographical and customer segment niches, even at the cost of growing more slowly.
Nothing in Truxton’s capital allocation suggests there are any problems in this area – if anything, it’s the opposite. But this is an area that needs to be watched carefully over time if – as I expect – it generates increasing amounts of excess capital.
Growth
It’s unlikely that Truxton’s growth rate will be below nominal GDP and it could be as high as 10%
Truxton has grown rapidly since it was founded in 2003. Net income growth has been extremely rapid – because Truxton has gone from a sub-scale company to one with high economies of scale (due to its high deposits, loans, and AUM per branch). And then, it has benefited from the corporate tax cut. The tax cut is obviously a one-time benefit. And although Truxton can probably achieve further economies of scale by growing assets, deposits, loans, etc faster than fixed costs like occupancy, salaries, etc, those economies will not be anything near as great in the future as they have been to date. They can certainly be valuable – growing AUM, earning assets, etc, at 10% while expenses grow at say 7-8% is a recipe for increasing earnings by a lot over the years. But that would imply say a 12-13% growth rate, not a 20% growth rate.
So, what sort of growth should we expect? Well, average (mean) growth rate from 2008 – 2018 was (roughly) as follows:
Deposits: 11.44%
Loans: 12.46%
AUM: 20.36%
These are probably on the high side of what to expect in future – particularly the AUM figure. But, there’s no doubt that – measured over time (all these categories have an element of cyclicality to them) Truxton has grown consistently. It seems there’s two sources of this growth. First, Truxton has won new clients. And, secondly, it can grow along with its clients over time. The second source of growth is easier to predict.
New client growth is important to Truxton’s future. But, it’s probably going to be harder to achieve new client growth in future than it was in the past. That’s just because Truxton itself is bigger – so, each new client makes less of a difference – and then, Truxton is dependent on referrals – from existing clients, professionals it or its clients work with (accountants, lawyers and so on). That is a good source of growth but unlikely to be a very rapid one. And – at the moment – Truxton isn’t expanding by entering new markets. Client growth is probably likely here over time provided Truxton tends to its niche carefully. It should retain its customers year over year and add gradually to them. But it’s not something we should expect to be rapid.
What about growth in the average balances per client of deposits, loans, and AUM? This is easier to predict. Provided Truxton’s clients are spending less, year on year, than their growth in wealth (generally a reasonable assumption for a wealthy family), their balances with Truxton should grow. This is very likely a safe assumption. Truxton’s client could easily be growing their wealth – on average over time – at say a 7% rate. That’s less than the long-term return in the stock market (though perhaps a more realistic rate in a low-inflation, low-return world). There’s little, if any, reason to believe that – if Truxton maintains its competitive position – it should grow any slower than this 7% rate.
Another key question mark relating to growth has to do with whether Truxton will open new branches. It already has a small (two person) wealth management office in Athens, Georgia. So, it’s possible that management will seek to expand that office over time. It’s also possible that Truxton could establish branches elsewhere in Tennessee – Memphis for example – or in other states. The risk here is that this would be expensive, and potentially unsuccessful. Truxton is very well connected in Nashville (through its management and founders). It has deep connections in the Nashville business community. That sort of reputation and network would be very hard to establish outside of Nashville – or, at least, outside Tennessee – so more risks would have to be taken to grow the business. Riskier clients, flightier money, less deep relations, and more reliance on the personal connections of staff recruited in new markets. So for these reasons, growth outside of Nashville and wider Tennessee is to be watched carefully. You really want any such moves to be slow, careful, cautious and well thought through.
The value in Truxton comes from the predictability of growth tied to a low cost of growth – not a very high rate of growth in and of itself.
Misjudgment
Major areas of potential misjudgment are credit and particularly interest rate risk
The key risks of misjudgment for an investor in Truxton are the following:
- Credit risk
- Liquidity and interest rate risk
- Limitations on growth – in particular, management responses to those limitations.
Credit risk has already been addressed above. To a large extent, the investor’s defence against credit risk is an industry wide one – it’s simply safer to lend to wealthy customers of a private bank than it is to lend to the average household. Truxton’s particular risk is that it’s concentrated in Tennessee, and particularly in Nashville. So, a downturn that affected Nashville badly would potentially hit Truxton hard. That’s particularly true of lending secured on Nashville real estate. A high proportion of Truxton’s loan book is secured on property, presumably a lot of which is in Nashville. And it does seem that the Nashville economy and property market have been hot over the last decade – particularly at the higher end of Nashville real estate, which is where Truxton’s lending is concentrated. So, this is a risk. It’s true that Truxton wasn’t really affected by the financial crisis. But it was much smaller back then. Nashville’s economy doesn’t appear to be over reliant on a single, cyclical industry (oil, autos, or the like) and there are undoubtedly areas in the U.S. with higher real estate prices. So – there are counter arguments here. But, this is a risk – there’s no doubt about it. The best defence is almost certainly that lending to private banking customers generally is a good business. It’s not the collateral Truxton has. Nothing about the loans – or the collateral – looks risky now. But that could evaporate quickly. It would be easy to misjudge.
Liquidity – and more specifically interest rate risk – is a real concern, though. Truxton makes more loans, and holds fewer securities, than some other U.S. banks. And it certainly makes more longer-dated, fixed-rate mortgages than the vast majority of U.S. banks. I don’t want to overstate this. As of June 2019, Truxton had c$400m in deposits and c$332m of net loans – so, roughly an 83% loan-to-deposit ratio. The problem really relates to interest rates. Given that Truxton is making a lot of fixed-rate, long duration loans, a significant rise in interest rates would cut its net interest margin, potentially by a lot. How serious that would be depends on three things: the speed at which rates rise; the speed and extent to which Truxton’s deposit costs rise as a result; and the speed at which Truxton’s deposits and loans are growing or shrinking. The worst case would be a rapid rise in rates matched quickly by Truxton’s deposit costs at a time when Truxton isn’t growing, or is shrinking. This would be a problem because Truxton would be trapped in a large amount of fixed-rate mortgages and yet potentially (if the rise in rates were fast enough) would be receiving a lower rate of interest on these mortgage loans than the company was paying on its deposits – because the deposits would reprice quickly whereas the loans are fixed rate and so only reprice at the end of their term. On the other hand, if this scenario were to arise when Truxton were growing, the problem would be less severe because the underpriced loans would be a continually shrinking part of Truxton’s balance sheet.
There’s another defence here as well – Truxton’s high return on equity. Of course, if there is a rapid rise in rates, the company’s return on equity would suffer, as a result of the compression in its net interest margin. But still, the fact that Truxton has a high return (the economics of the wealth management arm should be broadly unaffected by this save that higher rates would presumably mean AUM reduced due to potentially lower valuations) means that it should be well placed to earn its way out of any problems – and also of course have a bigger buffer before any net interest margin compression starts to cause real problems. The worst case scenario seems far fetched right now. And really the exposure here isn’t higher rates in future – it’s a rapid rise in rates. Still, it’s important to realise how this could affect the company. I’ve tried to analyse this by looking at Truxton’s call reports submitted to the FDIC. It’s hard – for me, at least – to get a clear picture here. Something like 48% of Truxton’s loan book is over three years in duration. I’ve tried to model this out with various assumptions. It takes some quite extreme assumptions to see how this could really damage the company in a permanent kind of way – something like the Fed Funds Rate rising to 10%, while Truxton retains a significant amount of loans on its balance sheet yielding like 4 or 5%. That would be a very bad situation – but also quite extreme. It could happen – the Fed Funds Rate rose from 3.5% to over 10% in two years in the 1970s, and also from c.4.6% to well over 10% from 1977 to 1980. And of course, you don’t get advance warning of these things. However – even if rates do rise this rapidly – it’s still not an immediate thing. Loans will be maturing and Truxton’s loan book repricing during this period. A rapid rise in rates would still be bad news for Truxton in the short term. But – longer term – it shouldn’t cause really serious risks to the company.
Other serious risks relate to culture and growth. Truxton’s success depends on its ability to tend to its niche more responsively than large, relatively unfocussed competitors. There are two angles to the risk here. First – this is a niche strategy. So, will Truxton reach the limits of that niche? Yes, it might. That isn’t – in itself – a huge problem. The stock isn’t really expensive at all. And even if Truxton doesn’t grow client numbers (so achieves no real unit growth) it should still have some nominal growth from growth over time in line with client balances. So Truxton could just grow at inflation or GDP-type rates and pay out all its earnings – basically, adopt capital allocation policies similar to Bank of Hawaii’s. The question is – would it? Or would management seek to make risky moves to keep growing? There’s no suggestion at present that they would. But, if they did, that would be a reason to sell out completely.
Then there’s the risk that, if it grows too much, Truxton will lose its culture and personal touch. Again – this is a risk. It’s one management seem keen to avoid. And it should be possible to maintain Truxton’s culture for some while yet. The company does not have many employees, and there are far (far, far) bigger companies that have managed to sustain distinctive cultures. There’s little reason to believe that, at twice its current size (in terms of employees), Truxton’s culture would be at risk. And, of course, a doubling of Truxton’s employee base should support more than a doubling in assets, deposits, and AUM. In fact, it could potentially support a lot more than a doubling of those things. So, there’s little need for this to be a risk. The thing to watch out for here is probably an overlay rapid rate of expansion, as opposed to the absolute amount of the expansion. It doesn’t appear to be a risk at present – but, it could become a risk in future. At the moment, all the company has done is open a small (two person) wealth management office in Athens, Georgia, which is exactly the way investors should want to see the company grow. But of course Truxton has been growing well in Nashville. Potentially there could be – at some point, presumably, there will be – a limit to this growth. And this risk is more likely to manifest itself if Truxton’s growth in Nashville slows. So, this is a real risk over the medium term. Now, Truxton’s executives, founders, and other key staff were in many cases employed by large, conglomerate banks. And they don’t want to recreate that at Truxton. The company’s CEO talks about the “50-year journey” of Truxton Trust, which isn’t so ridiculous now the company is 16 years old. Really, the risks here all boil down to how management will manage growth, capital allocation and company culture. Truxton is likely to do better for shareholders if it grows at a steady – even relatively slow – rate but pays out capital to shareholders, than if it really seeks to grow rapidly.
Value
Whichever way you look at it, Truxton is cheap provided it can maintain its return on equity and grow at something like 6-8% per year
There’s basically three ways of looking at value. One, you can look at what sort of ROE Truxton can earn, what sort of growth it should expect, and then what sort of P/E it should trade at if it’s going to roughly match the market over time. Two, you can value the private bank and wealth manager separately on a standalone basis. And then, thirdly, you can look at what sort of annualised return the stock should deliver if bought today and held forever.
Let’s first look at what Truxton’s growth rate and ROE mean in terms of what P/E it should trade at to match the market. For these purposes – it’s really on the conservative side – we’ll assume an ROE of 16% and a growth rate (in assets, loans, deposits, AUM, and earnings) of 8%. So – if EPS were $1 – Truxton would have to retain $0.50 to fuel its growth. The other $0.50 would be available to pay out. (This is always the case where the growth rate is 50% of the ROE.) So – logically – if Truxton can grow at an attractive rate, like 8%, forever, while paying out 50% of earnings (which would always be the case where the ROE is at least 16% – the difficult part to predict here is the growth rather than the ROE), it could have a payout – in practice, a dividend – yield of 1% to match the market (because a 1% yield plus 8% growth equals 9% total – which is likely to at least match the market over time). This seems a bit silly – even if it’s logical – because it results in a P/E of 50x. So, say it could have a yield of 2% (which in fact should lead to a higher total return than the market over time). This means – assuming a 50% payout ratio – that Truxton should trade at a P/E of 25x, to give an earnings yield of 4% and a dividend yield of 2%. That would lead to a 10% “hold forever” return, which honestly is likely to beat the market over time. The 16% ROE here looks pretty reliable – in fact conservative. The difficult part is growth. But 8% growth for say 10, even 15, years is hardly outlandish. If Truxton can maintain 8% growth in earning assets for 15 years, it will at the end of that period have earning assets of around $1.5 billion. That’s a big increase, obviously, but – assuming say 2% inflation – it’s only a 6% per year real growth rate. Far from outlandish – it just requires Truxton to grow at something like 2-3% ahead of nominal GDP. This probably requires some growth in customer numbers, but not a lot. Growth in existing customers’ accounts will probably achieve a lot of it.
The second way to look at this is to value Truxton on a divisional basis – appraising the private bank and the wealth manager separately. Logically this is not the correct approach because the two businesses work well together – and deliberately so. However, it’s still a useful method to employ as a method of corroboration.
You can look at this by saying that Truxton can earn, say, an 11.8% return on average assets, and earning assets basically equal deposits. So – on $430m of deposits, Truxton can earn $7.7m pretax in its private banking division. The private bank is a good, growing business that should be worth at least 13 times EBIT in today’s environment. So the private bank should be worth at least $91m. Then there is the wealth management business. It has around $1bn of AUM and a fee rate of around 1% – it’s actually a bit higher – so, around $10m of revenue per year. Truxton does not break out a separate margin for the wealth management business. So it is difficult to assess what the margin should be. Something like a 30% EBIT margin doesn’t seem unreasonable to me though for a one branch wealth manager with over $1bn of AUM. That would mean around $3.3m of pretax earnings. If you value this at the same 13x EBIT multiple, that leads to an appraisal value of $43m which is around 4% of AUM – not in any sense excessive. So together with the private bank, that gives a sum of the parts valuation of $134m.
The final method is to look at what – on an annualised basis – the stock should return at today’s price. At $47 per share, the P/E is around 13x (just annualising the last quarter’s results, which is reasonable here as there’s no meaningful cyclicality). If the company grows at say 8% with an ROE of 16%, it needs to retain 50% of its earnings. A 13x P/E is a 7.7% earnings yield. Half of that – 3.8% – has to be retained to finance growth. And maybe 0.5% will go to staff each year as an incentive. The rest will be paid out. So, you’re getting a 3.35% payout, plus 8% growth, for a total return of just over 11% per year. This is pretty conservative. Growth in earnings could be higher than growth in assets, loans, etc, for at least the next few years. And it seems like Truxton’s ROE on its core business is already over 16% really – it’s just that the ROE has been depressed because Truxton has accumulated excess equity. It seems likely that Truxton’s ROE could get up to the 18-20% range.
Conclusion
Truxton looks extremely attractive provided you are comfortable with the credit and interest rate risk and the low liquidity in the shares
There’s little more to say here. If Truxton can maintain anything like its current return on equity and growth rate it’s very hard to see how it could return less than 10% per year for a long time to come.