Punch Card Research: Interview With Mr. Geoff Gannon of Focused Investing

I started the interview by telling Mr. Gannon that unlike most investor interviews I read, I had no interest in his background or his investing journey. Instead, I jumped right in by asking key questions about his largest holding, a Texas bank called Cullen/Frost Bankers (CFR).

(The interview was conducted over three days via email. It has been lightly edited and condenses to improve readability.)

Punch Card (PC): What is your investment thesis for Frost in 500 words or less?

Geoff Gannon (GG): Frost has a low cost of funding. When asked about his investment in Wells Fargo, Buffett said: “They get their money cheaper than anybody else. We’re the low-cost producer at GEICO in auto insurance among big companies. And when you’re the low-cost producer — whether it’s copper, or in banking — it’s huge … The key to the future of Wells is continuing to get the money in at very low costs, selling all kinds of services to their customer and having spreads like nobody else has.”

Frost actually gets their money cheaper than Wells. In every year from 1991 through today, Frost had a lower cost of liabilities than Wells. Wells is better at lending their money, so their spreads are better. But, Frost has lower costs because Frost has grown deposits per branch by 4.7% a year for the last 20 years. Frost has around $200 million in deposits per branch (and I estimate about $120 million of this is in deposits that receive no meaningful interest) versus maybe $135 million per branch at Wells. Other banks have less deposits per branch than Frost. And other banks also pay more interest just to get less deposits per branch. Frost just focuses on customer service in place of paying interest. So, that’s the buy and hold investment case for Frost.

The average bank should – if held forever – provide an acceptable compound return. Frost is the low cost producer, so it should provide more than an acceptable compound return. The logic is really the same as what Buffett laid out with the lowest cost auto insurer, copper mine, etc. In the long-run, the shares of the lowest cost producer should compound at a higher rate than the shares of the other companies in the industry. That’s the investment case for Frost.

It earns a little under $5 a share now. If it trades at 20 times earnings, that’s a $100 share price. I’d say Frost is worth $100 if today’s interest rates are the interest rates we’ll have forever. Frost is the low-cost producer of deposits in the banking industry. Texas grows 1% faster than the nation. Those two facts make a P/E of 20 reasonable. So, $5 in earnings times 20 is a $100 share price if interest rates never go up. The speculative part of the situation is that – because it’s the low-cost producer – Frost is more interest rate sensitive than other banks. The higher interest rates are, the more Frost earns. I think interest rates will be higher in 5 years. So, I think Frost will earn something like $10 a share in 5 years (instead of the less than $5 it’s earning right now). So, the investment case is that Frost can return 10% a year as a buy and hold investment if interest rates never rise from here. The speculative case is that – if interest rates rise – the stock could be worth $200 within 5 years and it’s at $90 now.

PC: With any lending business, I get nervous about underwriting standards declining. That is, will they start underwriting riskier loans in a misguided attempt to increase revenue? How did you get comfortable with Frost in that regard? To continue the GEICO analogy, will Frost send home their loan officers when the credit cycle turns?

GG: There are better lenders than Frost. However, Frost is conservative. They lend less and make fewer types of loans than most banks. Frost doesn’t do any mortgage lending or credit card lending. They survived the 1980s Texas banking crisis that wiped out 9 of the 10 biggest banks in Texas (Frost is the only big Texas bank that made it out of the 1980s both solvent and independent). Frost survived the crisis, because as the company’s CEO at the time said: “I was taught that just because you got deposits, it didn’t mean you had to lend the money.” Coming out of that crisis in 1991, Frost was only lending 39% of its deposits. That’s how it survived.

I wouldn’t say Frost is a great lender. I’d just say it’s always extraordinarily liquid and it tries to limit lending to a few categories it knows and just the one state it’s in. The Great Recession wasn’t hard on Texas, so it wasn’t much of a test for Frost. However, in 2009, Frost charged off 0.58% of its loans. In 2010, Frost charged off 0.52% of loans. And in 2011, Frost charged off 0.54% of loans. Many banks were charging off more than 2% of loans a year in each of those 3 years. The bigger test for Frost came when oil dropped from about $100 a barrel in April of 2014 to about $30 a barrel in January of 2016. Frost is a big energy lender. It was making 16% of its loans to the oil and gas industry when oil prices started that huge two-year drop. Charge-offs increased. The company’s allowance for loan losses and its non-performing assets have both been around 1% to maybe 1.5% since the oil bust. However, Frost is still only lending about 45% of its deposits. So, even with a 70% drop in the price of oil, non-performing assets have stayed at maybe 0.75% of assets or so. I

think Frost is a conservative lender. But, honestly, their biggest competitor, Prosperity, always charges off even less than Frost. Unlike banks in the rest of the country, I don’t think Texas banks have been severely tested in a quarter century. In terms of Frost’s safety, I’d call their lending “good” and their liquidity “great”. I think that adds up to a safe combination.

PC: Lending is a commodity service. How can there be true sustainable competitive advantages in this industry? Can’t Frost’s customer service model be copies? It is not like Frost has a structural, business model advantage like Geico’s direct sales model.

GG: There are two sides to a bank.

The lending side of banking is a commodity business. In fact, Frost puts more money into bonds than loans. So, they are clearly just a commodity provider of money. In a commodity business, the lowest cost of production wins. Everyone gets the same “price” for their money, but everyone has a different “cost” on their deposits. Deposit gathering is a bank’s cost of production. The more deposits you gather relative to your expenses, the lower your non-interest expense. And the less interest you pay relative to your deposits, the lower your interest expense. U.S. banks have no advantages over hedge funds, mutual funds, insurers, etc. when it comes to making loans or buying bonds. The only thing they have is a lower cost of production. Customer deposits are a sticky, permanent source of funds. If you net out fees versus both interest and non-interest expenses, you get an operating cost of 1.4% of deposits for Frost. So, they’re effectively borrowing at 1.4% interest. If we’re talking about a stable funding base, you aren’t going to have a lower cost of funding than Frost in any given year regardless of what type of institution you are.

So, the lending side of banking is a pure commodity business.

The deposit side of banking is the complete opposite. It’s as non-commodity and non-competitive as a business gets. Customer retention is very high in this industry. For example, Frost retains about 92% of customers from year-to-year. Considering the bank is only in Texas and that people move and die and get divorced and married and so on – that’s effectively as close to complete customer retention as you can get. And unlike insurers, banks tend not to have problems retaining customers even when they offer interest rates that are clearly lower than their cross-town rivals. I think a bank can “lose” an existing depositor to another bank. I’m not sure a bank can “take” an existing depositor from another bank. A satisfied depositor never really enters “search mode”, so they aren’t going to be stolen away as long as the bank they’re at treats them right. Deposit share shifts are glacial and close to infinitesimal even when one bank clearly has a better service than another bank. So, the deposit side of U.S. banking just isn’t a competitive industry. Banks keep the depositors they have out of habit and those depositors add to their accounts every year. That’s where almost all growth comes from. And it’s not growth banks have to compete for.

PC: Financial services are highly capital-intensive. They are a spread business with no real free cash in it. Banks must continually grow equity to grow assets to make more spread.

GG: Frost’s long-term average return on equity is about 15% after-tax. It’s only making 10% now. However, in the future, it should make close to 20% a year if interest rates were ever to return to pre-2008 levels because non-interest expenses are now much, much lower relative to deposits than they were when the bank was smaller. Over the last 25 years, Frost has cut its leverage ratio in half and paid out 50% of its earnings in dividends while also growing faster than the GDP of Texas. I’d estimate that Frost can grow earnings, deposits, book value, etc. all by up to 7% a year while still paying out at least half of its earnings as dividends. The average U.S. public company can’t stretch much beyond that. Companies that grow faster than 7% have low dividend payout ratios. And companies with high dividend payout ratios don’t grow that fast. If a bank like Frost grows slower, it’ll pay out more. You can look at another bank with huge deposits per branch – Bank of Hawaii (BOH) – to see this. BOH is now in a no-growth Hawaiian market. So, the corporate top line just inches along at inflation type growth rates while the stock pays very close to 100% of its earnings out in dividends and buybacks. Banks like Frost, Bank of Hawaii, and Wells Fargo really aren’t capital intensive at all. I don’t see how any of them could end up in a position where – outside of periods where interest rates were very close to zero – they consistently earned a return on equity below 15%. Unlike railroads, bank’s reported earnings are virtually the same as cash earnings. A business that normally earns 15% a year cash-on-cash after taxes isn’t capital intensive at all.

PC: I have not spent any time on Frost’s 10-K but in the past I have found the reporting by banks very difficult to get my arms around. Do you have any concerns about hidden liabilities on the balance sheet or similar issues?

Frost is funded by depositors and shareholders. So, it has almost no other liabilities. I don’t have concerns about hidden issues. I can see where the problems would be. On the asset side of the balance sheet, Frost has four main exposures: 1) businesses generally, 2) Texas specifically, 3) oil, and 4) interest rates. Frost is a pretty typical bank, except it is 100% Texas, it’s about 50% business (it takes deposits from households and businesses, but only really lends to businesses), it’s about 10% oil, and it owns a lot of marketable securities. Frost’s bond portfolio will decline in market value when interest rates rise. However, the bank is exempt (since it’s not a giant bank) from having to include these mark-to-market losses for capitalization purposes. There is no risk to cash flows from higher rates. The bank’s marked-to-market balance sheet will look worse as rates rise, but its cash flows will improve. I care about the cash flows not the reported results. So, losses in the bond portfolio won’t bother me. Oil was a risk when it was $100 a barrel. Now, oil is at a reasonable price, so I’m no longer worried. New loans to oil producers don’t assume anywhere near $100 a barrel anymore. Loans are now being made assuming a market price for oil that’s honestly not that far above the cost of production. So, these new oil loans are safe. Texas is a strong economy. And businesses are at a strong point in the economic cycle. So, I’d say Frost’s loan losses will get worse at some point in the cycle when Texas isn’t doing as well and business borrowers aren’t doing as well. But, I use 28-year average charge-offs for my expectations about losses.

Honestly, I think Frost’s a pretty simple bank. It buys Texas municipal bonds, makes business loans in Texas, and lends against the value of already producing oil wells in Texas. If you add those 3 asset categories up, that’s most of what matters. And I think those areas are easy enough for me to understand given how stable Frost’s funding base is. That’s the key. I don’t need to guess whether there will be a day when the rest of the world is afraid to lend to Frost. Frost is 86% funded by depositors and 10% funded by shareholders. So, it relies on the rest of the financial system to finance 4% of its assets. It won’t matter if – during a panic – the rest of the world refuses to do business with Frost as long as its customers keep banking with it. To me, I’m always more concerned about the safety of a bank’s funding than the safety of its lending. Banks get in trouble by relying on outside money that’s likely to be pulled at the exact moment it’s most needed. Frost has a system in place that allows it to rely solely on its own customers to keep it funded through a crisis.

PC: I get the stickiness of customer deposits. It’s like my brokerage account. It would be a major pain in the ass to switch providers for a very limited upside. But, what did Frost do to bring in the customer in the first place? In a nutshell, what is the secret to Frost’s deposit-gathering skill? How are they able to outmaneuver their competitors?

GG: Historically, Frost had basically been a business bank. The bank targets Texas businesses with sales of more than $10 million and less than $100 million. That’s the bank’s core customer group. Frost talks about a typical banking relationship as being one that is usually with a Texas business doing between $10 million and $100 million in sales where Frost is the bank with the business’s primary checking account, a credit facility, and 3-4 consumer accounts (with officers of the company). This is almost certainly why Frost does some sideline things like a very small amount of home equity loans. It wants to increase the number of deposit, lending, and fee relationships it has not just with the business as a business – but with the officers of the company too.

Anyway, the bank says it has about 17% of the market for Texas business with between $10 million and $100 million in sales. However, it focuses its salesmanship on a subgroup of this market. For example, Frost did a study of its customer list to find business client relationships that had lasted 25-30 years on average. It then applied a screen to a list of over half a million business customers in Texas that it could approach and narrowed that list to about 25,000 (so just 5% of the list) prospects that it believed cared most about a personal relationship approach to banking. The bank’s relationship managers then worked through that smaller list. It also does things like have an “onboarding” program where it works extra hard to retain customers in the first year. It contacts new customers more than other banks do. U.S. banks may retain 90% of seasoned clients on average but they only retain like 70% of their first year business. I think higher retention rates and higher share of wallet with existing customers had explained all of Frost’s growth up to the financial crisis.

Frost then made a slight shift though. It started pushing the bank’s name as a brand more.

It didn’t advertise heavily in the past. After the financial crisis, though, Frost started advertising heavily – it doubled ad spending from $15 million to $30 million in the years 2010 to 2014 – and it signed up partners to get ATMs all over Texas. Today, Frost has the second largest number of ATMs in Texas despite being only the fifth biggest bank in the state. It uses its brand to win household accounts – 50% of deposits are from households but only 10% of loans are to households – and it uses relationships to win business accounts.

PC: How do you feel about management at Frost? In general, how do you go about evaluating management in general?

GG: I think Frost has the best culture of any Texan bank. But, honestly, I think Prosperity (PB, Financial) has the best management of any Texas bank. Frost was founded in 1868. I think it’s had a total of 6 CEOs in its history. The first 4 were members of the Frost family. In fact, the bank was run by a Frost family member from 1868-1996. It’s only the last 20 years where that has changed. The President of Frost Bank is a great-great-grandson of the company’s founder. He’s on the board too. I don’t want to make it sound like a family company. This is a big public company. But the cultural continuity is still pretty high.

As far as management goes, they’re good. There’s two areas where they don’t stand out: 1) They aren’t value investors and 2) They aren’t cost cutters. So, you just have to accept that when you invest in the bank. The acquisitions they’ve done have all been excellent from a cultural fit / quality of the acquired bank perspective. But, the prices have sometimes been good and sometimes not. And they’ve sometimes issued stock to do a deal. This is also not the bank to own if you want serious cost cutting. They’re big on customer service and they’ve really not pushed two areas: 1) fees and 2) expenses as hard as other banks do.

Someplace like Wells Fargo is always looking for more fees to charge customers. Frost isn’t. And someplace like Prosperity is always looking for more office expenses to cut. Frost isn’t. Frost is looking to add relationships it thinks will stay with the bank for 20 or 30 years. One thing to point out is that Frost has been very disciplined on acquisitions as far as fit though not necessarily as far as price. Frost is the correspondent bank for a lot of Texas banks. So, it knows many of them well. Prosperity’s management also once mentioned that Frost has often gotten a call – on a particular acquisition offer – probably before Prosperity has. When it comes to acquisitions, I’d say Frost is focused really on cultural fit. Prosperity is focused on what it can fix at the bank it takes over. Prosperity takes over other Texas banks and then immediately cuts costs and improves the loan book. They’ve shown that they can run the banks they acquire with both lower costs and lower loan losses than anyone else would. So, I can’t rank Frost’s management as number one among Texas banks. But, I think the culture is solid.

I’m not great at evaluating management. I look at what they’ve done in the past. And, more importantly, what they haven’t done that others did do. I compare them to peers and look at past behavior. Other than that, I’m really just looking for candor, an owner orientation, and a customer orientation – not necessarily in that order. I want them to be very blunt and to think like an owner while caring about customers more than employees.

PC: How did you find Frost? What is your typical search process? Do you maintain a watch list of attractive companies?

GG: I can’t remember when I first read about Frost. It’s a name I’ve known for a long time. After the financial crisis, a friend of mine told me that his sister wanted to take money out of her bank (not Frost) and literally put it under her mattress. He thought that was crazy. She lives in Texas. And, so, he asked me what the safest bank in Texas was. Without hesitation, I said “Frost”. So, he was able to tell her I said put your money in Frost – it’s safe. Based on my memory of that episode, I guess we can say that way back in 2008-2009 I knew enough to feel Frost had the best balance sheet of any bank with branches in Texas.

Around 2012 or so, I moved to Texas. I doubt I would have thought of buying Frost if I hadn’t moved here and started getting their ads looped to me on Pandora and Hulu and such. But, I still hadn’t thought about it as an investment at that point. Then, in 2013, I started a newsletter with Quan Hoang. We picked a stock each month. However, we had avoided financial stocks. We dipped our toes in with a couple. One of which was the auto insurer Progressive (PGR). What was interesting about Progressive is how much less it was now reporting in earnings because interest rates were low. We could see how Progressive had grown market share, had been a good underwriter, etc. and yet profit was so flat. We knew earnings would go up when rates went up. So, we thought if we can analyze Progressive we can analyze Frost. That’s when we decided to analyze Frost. Over time, we ended up writing reports on Frost, Prosperity, Bank of Hawaii, Commerce Bancshares (CBSH, Financial), and BOK Financial (BOKF, Financial). We also researched Wells Fargo (WFC, Financial) and UMB Financial (UMBF, Financial) although we chose not to write reports on those. The research we did on all those peers convinced me that I could understand banks and that I was most comfortable with Frost. So, I decided to put all my eggs in one basket and instead of putting 5% of my portfolio into each of 5 banks – I put 25% into Frost.

My typical search process is to talk stocks with a lot of people. I give them ideas. They give me ideas. Once I find a stock that might be interesting, I like to study the entire industry – at least 5 of their closest peers – at once. I do maintain a watchlist of companies I plan to research next. That list right now includes: Under Armour (UA, Financial), Howden Joinery (a U.K. company), Car-Mart, Grainger, and Omnicom. I know Howden well. And I’ve already written reports on Car-Mart, Grainger, and Omnicom. So, those are really re-visits. I’d say most of my good stock purchases have coming from buying a stock I was already familiar with for some reason.

PC: What do you hope to achieve with Focused Compounding?

GG: I’ve been writing about investing since I was 19. That was 12 years ago. And, more than once, I’ve found myself thinking along the lines of a famous Henry Ford quote, which – like all good quotes – is probably apocryphal: “If I had asked people what they wanted, they would have said faster horses.” I know what readers want is a regular flow of actionable stock ideas. You know: new stuff to buy now. However, I’ve gotten to know my readers well enough to know that what they need is not more ideas. They have enough ideas. Most of them even have enough good ideas. What they don’t have is the returns they should be getting from those ideas. So, I want Focused Compounding to be a support group for value investors where we help each other do two things. One: Help each other to always bet bigger on our very best stock ideas. And two: Help each other to always hold on longer to our very best stock ideas. I saved an email I sent to Andrew (my partner in Focused Compounding) right after I’d gotten done talking to a potential new member.

What I said was:

“This email from (name of person) is a good example of the kind of thinking we have to guard against in our members. We should learn from the experience that (name of another person whose website membership spiked and then crashed) had and make sure that we stress the long-term nature of our stock picks, the rarity of good ideas, and especially the importance of ignoring the market. Focused Compounding should not be in the idea generation business as much as it should be about getting the most out of your best ideas. And, more than anything, it should be in the ‘ignoring the market’ business. Whether the market is going to make 4% or 14% over the next 10-15 years, it should always be our goal to find the kind of ideas that can return 10% to 15% a year over 10-15 years regardless of what the market does – and to make sure our members stick with those ideas.”

I saved that email, because I think that’s what folks like us who write about investing should be trying to do. We should be trying to help people find ways to build the habits needed to make 10% to 15% a year over any given 10 to 15 year period. If members do that, they will achieve all the financial goals they have. We shouldn’t be in the business of trying to find ways to provide alpha this year. Individual investors should never need to worry about this year. And they should never need to worry about the market. They should only need to worry about whether they are doing the kinds of things that are going to let them compound their money at double digits over the next decade or two. I think I can teach that. And I think a group of like-minded members can stick to that. But, I know I can’t keep coming up with a constant flow of ideas. So, there has to be a better basis for a value investing community than just spitting out new stock ideas every week. We’re trying to find that better basis at Focused Compounding. That’s what I want to achieve.

This article originally appeared here.