HarborOne And East West: Bank On This Pair Trade (NASDAQ:EWBC)(NASDAQ:HONE)

Historic buildings of Wall Street in the financial district of lower Manhattan, New York City

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The market outlook for 22/23 is uncertain at best. Against a backdrop of global tensions led by Russia’s invasion of Ukraine that has ushered in a period of high energy & food prices, H2 2022 will reflect tighter financial conditions as rising rates impede growth.

The Fed’s dream of a soft landing in which we avoid a recession and rein in inflation seems more and more remote. With this in mind, employing a strategy that’s agnostic to market direction seems an appropriate course of action.

This is one of the main benefits of Pairs Trades that can perform well regardless of market direction.

With healthy loan demand and the potential for meaningful NIM expansion, we see the banking sector as one of the most likely to provide market beating returns despite economic slowdowns and looming recessions.

On a fundamental basis, EPS growth and Multiple expansion moves stocks. So, we looked at the banking universe and selected stocks with the greatest (least) opportunity based on expected EPS growth (shrinkage), multiple reversion and potential upside (downside) from common factors.

We’ve chosen NASDAQ:EWBC and NASDAQ:HONE as two bank stocks with very different expected trajectories in terms of EPS growth & stock price development.

EPS Growth

Below we break down the first component of our valuation, EPS Growth.

EPS Growth Table

Author Table

HONE

HarborOne Bancorp, Inc. provides financial services out of their two segments, HarborOne Bank and HarborOne Mortgage.

The stock is only down 5.25% YTD so it hasn’t felt the wider market sell off nearly as much as its counterparts, however we expect this to change imminently.

Higher rates have hindered the pace of Mortgage Applications and the industry has slowed significantly in 2022 with the Mortgage Bankers Association Market Index is down 45% YTD.

MBa Market Index

Trading Economics

HONE derive a third of their revenue from Mortgage Income which could be a huge issue given the drop in applications.

We expect a > 30% decline in Mortgage revenue leading to a > 10% fall in revenue and a 15-25% drop in Net Income with much of the variability coming from Non-interest expense.

EWBC

EWBCs most recent quarter brought beats on the top and bottom line, accompanied by raised expectations for the future.

We’ve earmarked EWBC as one of the fastest growing Banks (1st Quartile) in terms of EPS with potential for further upside from Fed rate hikes.

EWBC raised their revenue guidance due to increases in loan growth expectations and the increasingly asset-sensitive nature of their portfolio. They raised income guidance without meaningfully raising expenses in FY22. We can now expect 200bps more from loan growth, 500bps additional NII (assuming 2.5% Fed Funds rate at YE).

With 13-15% core loan growth in FY22, leading to Net Interest Income growth of 25%, we expect Revenue growth of 27% to outpace Expense growth, leading to an improvement in the efficiency ratio towards 38.5%.

Trading Multiples

By examining trading multiples against historical averages, we see that EWBC is trading at levels significantly below its long-term average, while HONE is trading above its historical average.

If we expect multiples to mean revert, this could translate to a +44% move for EWBC and -5% for HONE, all else remaining equal.

See relative PE Spreads below.

PE Forward Spread (EWBC/HONE)

Author Chart (Data: Yahoo)

In addition to their relative valuations, we also picked these stocks for their potential to beat and miss earnings (or raise and lower guidance) due to their exposure to Interest Rates.

Common Factor Upside: Interest Rate Sensitivity

A Fed Funds rate of 2.5% by YE 22 seems to be the Goldilocks level for economists who see this threshold as one that will neither significantly impact economic growth but could still bring inflation under control. However, recent forecasts released in June project a 3.25% – 3.50% Fed fund rate by YE 22.

What does this mean for the banking sector stocks?

Banks lay out their interest rate exposures with reference to different scenarios, including the magnitude of the movement (100 or 200bps etc.), and the speed of the hikes (gradual or immediate shock).

With the expectation of higher rates, investments channeled towards bank stocks with higher levels of asset sensitivity to interest rates should yield outsized returns to the sector.

Our analysis of Regional Banks shows that EWBC is a top quartile name when it comes to Interest sensitivity while HONE find itself in the lowest quartile.

At HONE, a 100bp increase in interest rates would yield a 0.50% increase in NII in 2022 and 2.9% in 2023, our model shows that this could increase NI by only 2-3%.

Interest Rate Sensitivity

HONE Accounts

HONE Accounts

On the other hand, a similar increase in rates would have a much more pronounced effect on EWBC, raising NII by 4% in 2022.

Interest Rate Sensitivity

EWBC Accounts

EWBC Accounts

Relative Opportunity

Cointegration between 2 stocks implies that the mean and variance of their spread remains constant over time.

This is important for the Pairs Trade in order for us to rely on their mean reverting properties.

We used Portfolio Visualizer to confirm that EWBC and HONE are cointegrated (between 2020 and 2022).

Cointegration Results

Portfolio Visualizer

Great, there’s a high degree of cointegration so we can feel comfortable that the spread mean reverts. But does the spread currently present an opportunity?

Since the beginning of 2021, the EWBC/HONE spread has been trading between 6.37x and 4.56x with an average of 5.41x. The spread is currently right at the bottom of this trading range at 4.66x, meaning that there is a clear opportunity for the spread to mean revert back towards 5.41x.

This will occur should the stocks reach our 2022 valuations.

Valuation input

Author Table

Putting it all together, we expect EWBC to generate EPS of $7.10 and for HONE to produce $0.95 in FY22. When applied to their Trailing 12-month average PEs we get a valuation of $90.80 for EWBC (+40%) and $11.50 (-14%) for HONE.

Entry Points

In order to find the right entry points, we normalised the spread between EWBC and HONE producing a Z-Score. This chart allows us to view the spreads mean reverting tendencies by plotting its distance from the mean (0) in terms of standard deviations.

We find that going long EWBC and short HONE whenever the normalised spread hits 2 standard deviations from the mean.

Normalised Spread

Author Chart

With this entry point and a 3-month holding period, a trader could have pocketed 17% between March and May 2020 (Annualised: 87%) and 11% between June and August 2021 (Annualised: 51%). Not a bad return, and that’s without taking into account their differing fundamental picture and potential valuation, not to mention the extra upside potential from their asset sensitivity to Fed rate hikes.

We recently hit 1.97x in late June and prices haven’t moved significantly since. We see this as an opportunity to make c.15-25% in Q3 with potential for additional returns in Q4 should the Fed raise rates more aggressively, without much of the market risk associated with traditional long only exposure.

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