Prosperity Bancshares is trading at nearly 10-year low valuation (NYSE:PB)

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Due to the ongoing bear market, most investors are wondering how they should position their portfolios, especially given the headwind of inflation soaring to a 40-year high. Financial stocks are attractive candidates because they are among the few beneficiaries of the Fed’s aggressive interest rate hikes and resulting net interest margin expansion. However, as the risk of an upcoming recession has risen sharply, investors should be particularly cautious and focus exclusively on banks that have proven resilience to recessions.

Prosperity Bancshares, Inc. (NYSE: PB) certainly fits this description. This disciplined bank has proven to be resilient to recessions on several occasions and is currently trading at a low price/earnings ratio for almost 10 years. Therefore, investors should consider buying this stock around its current price.

Company presentation

Prosperity Bancshares was founded in 1983 as a community bank, but has grown significantly since then through organic growth and the acquisition of smaller banks. It currently operates 258 full-service banking locations in the greater Houston area and some neighboring counties in Texas, as well as 14 branches in Oklahoma.

Prosperity Bancshares benefits from some key characteristics of Texas, which is the second largest state in the United States, with 29 million people. This state is characterized by higher economic growth than the rest of the country and has been ranked the top state for business for 9 consecutive years. It is also the state with the most Fortune 500 headquartered companies, with 53 companies this year.

Prosperity Bancshares has a key competitive advantage over most financial companies, namely its exemplary management. Thanks to the disciplined strategy of its management, the bank has proven to be exceptionally resilient to downturns. Certainly, during the Great Recession, when most banks suffered excessive losses and sharply cut their dividends, Prosperity Bancshares increased its earnings per share by 29% and continued to increase its dividend.

The bank has also shown resilience throughout the coronavirus crisis. Despite the fierce recession caused by the pandemic in 2020 and the almost unprecedented interest rates that prevailed in 2020-2021, Prosperity Bancshares increased its earnings per share by 10% in 2020 and an additional 1% in 2021, to a new all-weather high.

Prosperity Bancshares’ conservative business model causes the bank to grow at a slower pace than its peers during boom times. Financial companies that use a lot of leverage are in principle able to grow at a rapid rate during good economic times. However, whenever a recession hits, these banks experience a slump in profits as Prosperity Bancshares remains highly profitable thanks to its conservative strategy. Overall, investors will struggle to identify a more disciplined and defensive bank than Prosperity Bancshares.

Thanks to its conservative strategy, this bank has posted a record of consistent growth. It has grown earnings per share at an average annual rate of 6.4% over the past decade and at an average annual rate of 7.3% over the past five years.

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Prosperity shares growth (Investor Presentation)

The company has steadily increased its results through organic growth as well as a series of acquisitions of smaller financial companies. It should also be noted that insiders own 4.2% of the bank’s shares and therefore their interests are aligned with the interests of shareholders.

While the Fed is aggressively raising interest rates in an effort to cool the economy and bring inflation back to normal levels, the economy has already slowed and is likely to enter a recession over the next of the next quarters. In such a case, most banks are likely to significantly increase their loan loss provisions.

On the contrary, thanks to its disciplined approach, Prosperity Bancshares is not susceptible to major loan losses. Its non-performing loans, which have remained negligible for several consecutive quarters, currently represent only 0.07% of total assets. As the bank has repeatedly proven in previous recessions, it has a high-quality loan portfolio and therefore its loan losses should remain limited even in a recession. Even better, the bank will benefit greatly from the rate hikes put in place by the Fed. Due to the headwind of depressed interest rates, the company posted a low 10-year net interest margin in 2021.

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Prosperity Bancshares Net Interest Margin (Investor Presentation)

Fortunately, Prosperity Bancshares should soon start benefiting from rising interest rates and will therefore likely improve its net interest margin significantly over the next few quarters. This will provide a strong tailwind to the company’s earnings.

Signs of this tailwind have already appeared in Prosperity Bancshares’ results. In the second quarter, the bank sequentially increased its net interest margin from 2.88% to 2.97% and thus increased its earnings per share by 5%, from $1.33 to $1.40. Further improvement is expected on this front, as the bank has only recently begun to profit from rising interest rates. Analysts seem to agree on the promising outlook for Prosperity Bancshares, as they expect the company to increase earnings per share by 3% this year and 10% next year.

Evaluation

Prosperity Bancshares is currently trading at a nearly 10-year low price-to-earnings ratio of 12.6, which is below the stock’s 10-year average of 14.3. It’s also worth noting that the stock is currently trading at just 11.3 times its expected earnings in 2024. Additionally, the company hasn’t missed analysts’ earnings per share estimates for 17 consecutive quarters. As a result, it is reasonable to expect the bank to meet or exceed analyst estimates in 2023 and 2024.

The reason for the cheap valuation of Prosperity Banc shares is the effect of inflation on the valuation of most stocks, as inflation reduces the present value of future cash flows. However, the Fed is more determined than ever to bring inflation back to its long-term target of 2%. True, the central bank is raising interest rates at an unprecedented pace in order to cool the economy. The Fed is well aware that its policy is likely to cause a (hopefully mild) recession, but it has prioritized bringing inflation down to sustainable levels. Whenever inflation begins to subside, Prosperity Bancshares’ valuation will likely return to its historical average and the stock will therefore benefit from significant tailwinds. Nevertheless, as inflation has persisted for much longer than originally expected, a great deal of patience may be required for the investment thesis to materialize.

Dividend

Prosperity Bancshares has increased its dividend for 18 consecutive years and currently offers a nearly 10-year high dividend yield of 2.9%. As the bank has a strong payout ratio of 38% and has proven resilient to downturns, investors should be confident that the company will continue to increase its dividend for many years to come. The bank has increased its dividend by an average of 8.9% per year over the past five years and by an average of 8.3% per year over the past three years. Overall, Prosperity Bancshares is currently offering a lackluster dividend yield, but it is likely to continue to increase its dividend significantly for many years to come.

Risks

A potential risk is the adverse scenario of a severe recession. As the Fed has adopted an aggressive stance on inflation, the possibility of a severe recession cannot be completely ruled out. In such an event, Prosperity Bancshares is likely to incur significant loan losses. However, thanks to its disciplined approach, the bank has always endured declines more easily than most of its peers and so investors will just have to be patient until the subsequent recovery in such an adverse scenario.

The other risk is the scenario of persistently high inflation for years. In such a case, Prosperity Bancshares will benefit from high interest rates but the valuation of its stock is likely to remain under pressure for a long period. Therefore, great patience will also be required in such a scenario.

Final Thoughts

Prosperity Bancshares is an exceptionally managed bank that has proven to be resilient to recessions on several occasions. As the stock is trading at a nearly 10-year low valuation, it should greatly reward long-term investors. On the other hand, due to the pronounced economic downturn and the sharply negative market sentiment currently prevailing, investors should be aware that a great deal of patience may be required for the investment thesis to materialize.

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