Choosing Small Banks for a Big Trade

 | Jan 17, 2012 | 2:00 PM EST  | Comments
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Today, begins what I think may be one of the more interesting weeks of the year. It is not about playoff week, although with the Baltimore Ravens in the final mix it is certainly exciting around Chez Melvin as we don the purple. It is not Shark Week on the Discovery Channel, although that is one of my son's favorite weeks of the year. I have decided that this holiday-shortened trading week will be bank week in my Real Money columns in this.

The small banks that I follow are trading at some of the lowest valuation ratios in decades, and 'back up the truck' time quickly approaching for investors. I consider the small bank trade to be the trade of the decade and intend to retire (or have the option to retire as I do not golf and hate shuffleboard) on the proceeds from small bank investing over the next 10 years.

By now, we all know what happened to the banks over the past few years. The collapse of real estate prices caused a historic credit crisis, and loan losses mounted as collateral values fell. The use of highly leveraged derivatives at the bigger banks made the situation even worse. The damage spilled over into the economy causing a severe slowdown and job losses. Banks saw the value of underlying residential and real estate collateral plummet, and losses piled up on the books. Naturally, stock prices fell as losses grew.

While the big banks received all of the attention over the past few years, the real opportunity to profit from the carnage exists in the regional and community banks Most of these institutions did not do a lot of complex trading or deal in toxic mortgage derivatives. To be sure, they suffered as real estate collapsed and businesses slowed, but many were able to side step most of the potholes that basically destroyed their competitors. Smaller banks that aggressively played the subprime and liar loan markets to boost profits are now either gone or on the troubled bank list and will be gone by year-end. The regionals and community banks that have survived the worst of the crisis should thrive over the next decade.

While an improving economy and rising profits are a solid part of the story, a merger-and-acquisition (M&A) wave will eventually hit the industry, and this is what appeals to investors. However, in a typical 'one size fits all' move, the new financial regulations that have been passed to prevent further industry meltdowns apply to all banks -- not just the larger ones that created much mortgage mess. About 5500 pages of new regulations will take effect, and the cost of compliance will be enormous. In fact, it will be more than many smaller banks can pay no matter how well run they may be. The regulations will also reduce or eliminate many of the fees that banks can charge, which further complicates matters for many of the smaller banks. Roughly 7000 banks have less than $1 billion in assets in the U.S., and most of them will become takeover candidates in the next several years.

The other driver of M&A activity will be regional banks seeking to expand. At current prices, it is far cheaper to grow by taking over smaller banks than it is to grow your branch network naturally. Since many quality banks with solid loan portfolios are trading well below tangible book value, it just makes sense to expand via the stock market rather than by opening branches. Banks with less-than-perfect loan portfolios can quickly improve by purchasing a smaller rival with a high-quality portfolio of local loans. This occurred in the aftermath of the S&L crisis and short recession of the late 1980s and early 1990s; this time, the bank consolidation wave will be much larger and will last a lot longer. We should be able to buy banks at a fraction of book value and sell them for multiples of that number earning outsized profits along the way.

Investors have several different ways to play the trade of the decade. Which one you use will depend on what type of investor you are and your time frame. This week, I'll discuss how to find and invest in what I call perfect banks, turnaround candidates and I will compile a portfolio of banks that provide above-average income streams from dividends. I believe that 2012 will, at last, be the start of the banks stock trade of the decade; so, it's time for bank week.

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