2016 was an interesting year for financials, to say the least. Expectations were low – always a good sign – and fundamentals supported slow, steady appreciation. Yet after opening the year in a nosedive, the sector shook off a brief Brexit-related decline and then soared in the fourth quarter. Expectations are now higher for the sector, but I believe there are still significant opportunities in individual companies.

The industry is at an interesting crossroads in 2017. The regulatory burden has been increasing for years, resulting in higher expenses that have, along with more capital and lower net interest margins, reduced returns on equity. Will that really change in 2017 or beyond? Regulatory omelets are often difficult to unscramble, capital isn’t going to be deployed overnight, and interest rates need to rise further before banks will see a big impact. There are other potential positives, however. Will a reduction in the corporate tax rate be enacted? Will loan demand grow? Will consolidation accelerate? These are important questions with imprecise answers. I think about them often but usually “upside down” – I want to know how the answers to these questions could hurt us. As always, there are no certainties and we’ll take a probabilistic view of what could happen.

**************************

On November 30th OCFC completed its acquisition of OSHC.[1] OCFC completed the transaction ahead of schedule – just as it did with its CBNJ acquisition earlier in the year – and the numbers are playing out as expected.[2]  OCFC is now positioned as a leading community bank in central and southern New Jersey with a low-cost deposit base, a conservative and diversified loan book, peer-leading efficiency and profitability, and about $350 million of excess cash to deploy if lending conditions improve.

Looking back on our investment, this path of consolidation was one that we saw as more likely than not when we made and then held our investments in CBNJ/OSHC/OCFC. The timing was somewhat less predictable, but these were attractive, low-cost deposits; conservative, well-underwritten loan portfolios; experienced, competent, and rational management teams; and companies that were ripe for consolidation. The downside was well protected by asset value and earning power, and the upside was considerable.

Regarding our current investment, recall that we started out with individual investments in CBNJ and OSHC before they were acquired by OCFC. We now own the same loans, the same customer relationships, the same low-cost deposits, in a consolidated, more efficient holding company. Granted, our investment is now lined up behind one management team (that we believe is excellent) and its decisions will be magnified across one bigger enterprise instead of two smaller ones. But is our investment riskier than it was when we held two separate securities? Conventional security analysis and portfolio theory would say yes, but I’m not sure. We did sell a small portion of our shares in December but we hold our remaining shares for now. OCFC still has room to grow into its new operations and it offers a favorable mix of upside and downside. And at some point in 2017 or beyond, OCFC itself may become an acquisition target.

The following table reflects our holdings in community banks as of December 31, 2016. OCFC is shown pro forma for the OSHC acquisition which closed November 30th. Bank A is still undergoing an exploratory process that we hope results in a sale of the company. Bank F was a new investment in 2016, but we never got to our targeted 5-6% size before the price shot up.

**************************

The price of the Wells Fargo TARP warrants increased from $12.48 on September 30th to $21.33 on December 30th as the gloomy overhang from the unauthorized accounts scandal in September and October shifted to an optimistic view based on higher interest rates, less regulation, more growth, etc. I would not diminish the importance of either set of events but it is worth highlighting the large swings in price, as they may or may not correspond to value.

I remain less than impressed by management’s response to the unauthorized accounts scandal. The overall strategy and tone has not changed much at this point but it will take time to see any effects. On the other hand, monthly metrics tracking Wells Fargo’s customers have already started to stabilize. New account growth has slowed, but total accounts and balances have continued to increase. Deposits, which are the ultimate driver of Well Fargo’s success, have increased steadily through 2016 just as they have for decades.

Since 1966, Wells has seen core deposits decline on an annual basis just seven times (and in some of those cases the company was intentionally running off deposits). [3] Over five decades, WFC’s core deposits have grown at a compounded rate of more than 12% per year. In “bad” years for the economy or the stock market WFC’s core deposits still grew: +8% in 1973, +16% in 2001, +7% in 2008.[4] Even in the slow-growth recovery of 2010-2016 the company’s core deposits have grown at almost 7% per year. And the average cost of deposits was 0.12% as of 4Q16.

Such a powerful deposit-gathering machine is hard to stop, although it’s worth noting that the large acquisitions that spurred some of that growth are no longer possible. If we ever do see a slowdown in deposit growth it will be time for a dramatic reconsideration of this investment. But as of 2015, 20% of all American households and 10% of all U.S. small businesses have relationships with Wells Fargo.[5] Even as new relationship growth slows those existing relationships are quite profitable. The low-cost deposit base – now back in vogue with interest rates having ticked up – will provide the raw material for future profits, so long as management can avoid bad loans or regulatory scandals.

Valuation is, of course, trickier. It will be important to monitor any change in price, the ongoing response to the unauthorized accounts, any new information pertaining to the overall culture, the regulatory relationship and the macro environment.

[1] As discussed in prior letters, during 2015 we made investments in CBNJ and OSHC, both of which have since been acquired by OCFC. The shares of OCFC we own today were received as compensation in those deals.

[2] To highlight management’s strategy and execution, consider CBNJ’s deposits and loans. OCFC targeted CBNJ’s sticky, long-term core deposits, but even the best deposit base turns over a little bit in an acquisition. OCFC planned for $190 million of deposit run-off at CBNJ but has experienced zero deposit outflows. The credit marks on the loan portfolio have proven conservative as well, matching expectations almost dollar for dollar.

[3] Core deposits are in-market, relationship-based deposits (noninterest bearing deposits, interest-bearing checking accounts, savings accounts, etc.) excluding certificates of deposits, brokered deposits, and most foreign deposits. These figures were pulled from WFC annual reports but may contain transcription or other errors. 2016 figures are as of Sept. 30, 2016.

[4] Average core deposits (i.e., excluding the Wachovia acquisition that closed 12/31/08) increased 7.3% in 2008. Including the Wachovia deposits the year-over-year change in core deposits was +139%. Source: 2008 Wells Fargo annual report.

[5] Source: Wells Fargo 2015 annual report and 3Q16 earnings call transcript

[us_separator]

The above commentary is excerpted from a 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.

[moi-video-phil-ordway]

[us_separator]

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 FOR INFORMATIONAL PURPOSES ONLY. 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. 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. 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.