Significant merger activity has had a positive effect on our community bank investments this year (see below). The following table updates our holdings in community banks. OceanFirst (OCFC) is shown in the third row, adjusted to include our estimate of the pro-forma impacts of the CBNJ acquisition that closed May 2nd.

Anabatic -- 2Q16 letter REDACTED

Price data as of 6/30/2016. Sources: SEC filings, Call Reports, Bloomberg, FactSet, Anabatic estimates. Figures adjusted/estimated as applicable to reflect current annualized levels.
1 Market price divided by tangible book value, as reported
Non-performing assets (non-performing loans + foreclosures / other real estate owned) divided by total assets, as reported
Tangible common equity divided by tangible assets, as reported
Estimated percentage of the company’s current shares outstanding likely to be repurchased under existing buyback authorization
Net interest margin, adjusted and annualized
Return on assets, adjusted and annualized
Return on common equity, adjusted and annualized
Market price divided by earnings per share, adjusted and annualized
Efficiency Ratio = non-interest expenses divided by the sum of net interest income and non-interest income, as reported
10 Mutual holding company conversion — the year in which the company converted to public ownership

The early May closing of OceanFirst’s acquisition of Cape Bancorp was several months ahead of schedule. OceanFirst is proving to be an adept acquirer, an opinion shared by the regulators who approved the deal more quickly than expected. As noted previously, we received approximately 15% of the proceeds in cash and the rest in shares of OceanFirst. I remain impressed by OceanFirst’s operations and management and I find the valuation compelling.

[On July 13, 2016] OceanFirst announced the acquisition of Ocean Shore Holding (OSHC), a smaller peer in southern New Jersey and another of our holdings (shown in the second row of the table above). This deal was a logical and somewhat expected outcome for both banks. (It also explains OceanFirst’s timing of its prior acquisition.) When we made our investment in Ocean Shore in 2015 I thought it was a likely acquisition target, particularly after its long-standing CEO suffered a health scare just over a year ago.

The announced purchase price of $22.47 per share, consisting of $4.35 in cash and 0.9667 shares of Ocean First, represents 132% of tangible book value, 20x trailing earnings, and a 4.9% core deposit premium.

There is substantial geographical overlap between the two companies and OceanFirst expects significant cost savings that I believe are attainable. If realized, OceanFirst is paying less than 10 times its estimate of Ocean Shore’s 2017 earnings. Despite issuing equity for roughly 80% of the purchase price, OCFC’s tangible book per share will be diluted by a modest 3.1% with a projected earn-back period of 3-4 years. OSCH’s deposits will add to OCFC’s already substantial low-cost funding base, and OSHS will add high-quality residential loans to OCFC’s asset mix.

I also want to mention that Ocean Shore may have lacked efficient scale but it was always a well-managed bank. Ocean Shore’s net charge-offs never exceeded 16 basis points of average loans at any point in the past decade, despite being a mostly residential mortgage lender in southern New Jersey faced with the housing crisis and the Great Recession, the collapse of many Atlantic City casinos, and Superstorm Sandy, among other problems. That is exceptional credit quality and exactly what I hope to find in a bank. Sound underwriting combined with a stable base of low-cost deposits is a recipe for success.

Another of our banks, the first on the chart shown above, is also under increasing pressure from shareholders to find a merger partner. Stay tuned for further updates.

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The Brexit vote and the decline in interest rates sent shockwaves through many markets, and many large financial stocks were notable for their declines. WFC fell but the market didn’t assign a negative time value to the warrants as it did briefly in the first quarter.

In Wells Fargo’s case, I believe the impact of the recent macro shakeup will be manageable. Wells Fargo is primarily a domestic operation with little business directly exposed to the worst of the turmoil. There could be spillover effects in the U.S. economy but Wells is in excellent shape to navigate the problems as they arise. The company has plenty of capital, in excess of $30 billion of pre-tax earnings power per year, and it remains one of the world’s best managed banks with a preeminent deposit gathering franchise. To that point, WFC’s deposits grew at 7-9% per year each of the past three years, and as of 1Q16 they cost 10 basis points per year. Asset yields may decline marginally, and loan growth is far from booming, but this doesn’t change the overall picture very much.

From a broader perspective, the past decade has clearly been a difficult one for any bank, yet Wells Fargo has been profitable in each and every year, posting an ROE lower than 10% only in 2008 (4.8%) and 2009 (9.9%). More of the same seems likely. The problems are real, but so is the progress. Interest rates have continued to fall – the 10-year U.S. Treasury recently hit an all-time record low – and the yield curve has flattened. That is certainly not helpful to most banks, although as the nation’s largest mortgage lender some of WFC’s pain might be offset by an increase in refinancings. Non-interest (fee) income is also nearly as large as net interest income.

I expect Wells Fargo’s earnings to be roughly flat compared to the past year or two. Compared to 2012 – the last time interest rates were in this ballpark – pre-tax earnings are about 15% higher. (The improvement is even greater on a per-share basis due to buybacks, and book value per share has grown roughly 22% in the three years ended December 31, 2015.) So despite low interest rates, despite the energy/commodity price declines, despite fintech, despite Brexit, and despite ongoing regulatory and capital pressure, Wells Fargo is still likely to produce a return on assets well above 1% and a low-double digit return on equity. At just less than eight times my estimate of pre-tax earnings, I think it remains a sound investment.

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The above commentary is excerpted from the 2Q16 quarterly letter of Anabatic Investment Partners LLC. The fund’s Managing Principal and Portfolio Manager is Philip C. Ordway. Please note that the complete text of the disclaimer included with the fund’s quarterly letter is also reproduced below.

Gross Long and Gross Short performance attribution for the month and year-to-date periods is based on internal calculations of gross trading profits and losses (net of trading costs), excluding management fees/incentive allocation, borrowing costs or other fund expenses. Net Return for the month is based on the determination of the fund’s third-party administrator of month-end net asset value for the referenced time period, and is net of all such management fees/incentive allocation, borrowing costs and other fund expenses. Net Return presented above for periods longer than one month represents the geometric average of the monthly net returns during the applicable period, including the Net Return for the month referenced herein. An investor’s individual Net Return for the referenced time period(s) may differ based upon, among other things, date of investment. In the event of any discrepancy between the Net Return contained herein and the information on an investor’s monthly account statement, the information contained in such monthly account statement shall govern. All such calculations are unaudited and subject to further review and change. For purposes of the foregoing, the calculation of Exposure Value includes: (i) for equities, market value, and (ii) for equity options, delta-adjusted notional value.

THE INFORMATION PROVIDED HEREIN IS CONFIDENTIAL AND PROPRIETARY AND IS, AND WILL REMAIN AT ALL TIMES, THE PROPERTY OF ANABATIC INVESTMENT PARTNERS LLC, AS INVESTMENT MANAGER, AND/OR ITS AFFILIATES. THE INFORMATION IS BEING PROVIDED SOLELY TO THE RECIPIENT IN ITS CAPACITY AS AN INVESTOR IN THE FUNDS OR PRODUCTS REFERENCED HEREIN AND FOR INFORMATIONAL PURPOSES ONLY. THE INFORMATION HEREIN IS NOT INTENDED TO BE A COMPLETE PERFORMANCE PRESENTATION OR ANALYSIS AND IS SUBJECT TO CHANGE. NONE OF ANABATIC INVESTMENT PARTNERS LLC, AS INVESTMENT MANAGER, THE FUNDS OR PRODUCTS REFERRED TO HEREIN OR ANY AFFILIATE, MANAGER, MEMBER, OFFICER, EMPLOYEE OR AGENT OR REPRESENTATIVE THEREOF MAKES ANY REPRESENTATION OR WARRANTY WITH RESPECT TO THE INFORMATION PROVIDED HEREIN. AN INVESTMENT IN ANY FUND OR PRODUCT REFERRED TO HEREIN IS SPECULATIVE AND INVOLVES A HIGH DEGREE OF RISK. THERE CAN BE NO ASSURANCE THAT THE INVESTMENT OBJECTIVE OF ANY SUCH FUND OR PRODUCT WILL BE ACHIEVED. MOREOVER, PAST PERFORMANCE SHOULD NOT BE CONSTRUED AS A GUARANTEE OR AN INDICATOR OF THE FUTURE PERFORMANCE OF ANY FUND OR PRODUCT. AN INVESTMENT IN ANY FUND OR PRODUCT REFERRED TO HEREIN CAN LOSE VALUE. INVESTORS SHOULD CONSULT THEIR OWN PROFESSIONAL ADVISORS AS TO LEGAL, TAX AND OTHER MATTERS RELATING TO AN INVESTMENT IN ANY FUND OR PRODUCT. THIS IS NOT AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY AN INTEREST IN A FUND OR PRODUCT. ANY SUCH OFFER OR SOLICITATION WILL BE MADE ONLY BY MEANS OF DELIVERY OF A FINAL OFFERING MEMORANDUM, PROSPECTUS OR CIRCULAR RELATING TO SUCH FUND AND ONLY TO QUALIFIED INVESTORS IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW. ALL FUND OR PRODUCT PERFORMANCE, ATTRIBUTION AND EXPOSURE DATA, STATISTICS, METRICS OR RELATED INFORMATION REFERENCED HEREIN IS ESTIMATED AND APPROXIMATED. SUCH INFORMATION IS LIMITED AND UNAUDITED AND, ACCORDINGLY, DOES NOT PURPORT, NOR IS IT INTENDED, TO BE INDICATIVE OR A PREDICTOR OF ANY SUCH MEASURES IN ANY FUTURE PERIOD AND/OR UNDER DIFFERENT MARKET CONDITIONS. AS A RESULT, THE COMPOSITION, SIZE OF, AND RISKS INHERENT IN AN INVESTMENT IN A FUND OR PRODUCT REFERRED TO HEREIN MAY DIFFER SUBSTANTIALLY FROM THE INFORMATION SET FORTH, OR IMPLIED, HEREIN. PERFORMANCE DATA IS PRESENTED NET OF APPLICABLE MANAGEMENT FEES AND INCENTIVE FEES/ALLOCATION AND EXPENSES, EXCEPT FOR ATTRIBUTION DATA, TO THE EXTENT REFERENCED HEREIN, OR AS MAY BE OTHERWISE NOTED HEREIN. NET RETURNS, WHERE PRESENTED HEREIN, ASSUME AN INVESTMENT IN THE APPLICABLE FUND OR PRODUCT FOR THE ENTIRE PERIOD REFERENCED. AN INVESTOR’S INDIVIDUAL PERFORMANCE WILL DIFFER BASED UPON, AMONG OTHER THINGS, THE FUND OR PRODUCT IN WHICH SUCH INVESTMENT IS MADE, THE INVESTOR’S “NEW ISSUE” ELIGIBILITY (IF APPLICABLE), AND DATE OF INVESTMENT. IN THE EVENT OF ANY DISCREPANCY BETWEEN THE INFORMATION CONTAINED HEREIN AND THE INFORMATION IN AN INVESTOR’S MONTHLY ACCOUNT STATEMENT IN RESPECT OF THE INVESTOR’S INVESTMENT IN A FUND OR PRODUCT REFERRED TO HEREIN, THE INFORMATION CONTAINED IN THE INVESTOR’S MONTHLY ACCOUNT STATEMENT SHALL GOVERN. NOTE ON INDEX PERFORMANCE: INDEX PERFORMANCE DATA AND RELATED METRICS, TO THE EXTENT REFERENCED HEREIN, ARE PROVIDED FOR COMPARISON PURPOSES ONLY AND ARE BASED ON (OR DERIVED FROM) DATA PUBLISHED OR PROVIDED BY EXTERNAL SOURCES. THE INDICES, THEIR COMPOSITION AND RELATED DATA GENERALLY ARE OWNED BY AND ARE PROPRIETARY TO THE COMPILER OR PUBLISHER THEREOF. THE SOURCE OF AND AVAILABLE ADDITIONAL INFORMATION REGARDING ANY SUCH INDEX DATA IS AVAILABLE UPON REQUEST.