Small Banks Offer Golden Opportunities

 | Jan 18, 2012 | 1:30 PM EST
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Continuing with my week of columns devoted to banks, while everyone else on Wall Street is focusing on the reports from the big banks, I am much more interested in searching for stocks that fit my "trade of the decade" theme. I do not really care how much the big guys made from  trading, restructuring mortgages or investment banking. They may bounce when the economy recovers, but they will not provide the many multiples of purchase price returns I think we can get from their smaller brethren. Today I want to talk about the core of my strategy for profiting from the small bank recovery and mergers-and-acquisitions (M&A) boom I see developing and playing out over the next decade.

There are several different ways to play the small banks but the core of my portfolio is devoted to finding what I like to call perfect banks. First and foremost I want banks that trade below tangible book value. As Marty Whitman of Third Avenue Value and others have pointed out, buying otherwise solid banking institutions at 80% of tangible book value is a profitable investment activity most of the time. I want these banks to be solid with enough capital to make it through the tough times. I want banks with a tangible equity to asset ratio above an absolute minimum of 5 and the higher the better. It has been a tough few years but smart bankers with good underwriting practice have edged many of the bad loan bullets. I want banks that have loan losses well below the national average and focus on those with non-performing loans less than 2% of total loans. Last I want a bunch of conservative folks running the bank who hate to lose money and reserve more than enough capital to deal with potential losses.

The vast majority of banks that fit my "perfect" profile are too small to talk about here on Real Money. They are the banks with just a few branches where the bank officers know everyone in town and who is a good risk and who is not. I call them Jimmy Stewart Banks as they tend to resemble the Bailey Savings and Loan of It's a Wonderful Life fame. However, there are a few that fit the bill and large enough to talk about here.

Westfield Bank (WFD) is an 11-branch bank located in Massachusetts. The bank has $1.2 billion of assets and appears to be a very well-run institution. Westfield has been in business since 1853, so it would appear it has learned something about surviving banking crises and recessions along the way. The company has plenty of excess capital with an equity-to-assets ratio (at the end of the third quarter) of a little above 17. The loan-loss ratio is just 0.51% and it is over reserved for loan losses with a reserve of 243% of non-current loans.

The shares currently trade at a little less than 90% of tangible book value. Management has been smart with the capital buying back stock under book value and rewarding shareholders with a 3.2% dividend. In December, the board authorized an additional 5% share buyback.

Among the larger regional banks, Huntington Bancorp (HBAN) comes closest to being a "perfect bank" under my definition. The stock has rallied a bit since the end of the year and now trades just above tangible book value of $5.52. This Midwestern regional institution has 600 branches and more than $53 billion of assets, making it, by far, the largest stock considered for the core portfolio. Credit and asset quality for the bank are well above its peers with just 1.45% nonperforming loans and loan loss reserves of 180% of NPLs.

Huntington is seeing strength in commercial and industrial loans, as well as in home equity and other consumer loans. The strength of its balance sheet and loan portfolio is going to give it an advantage over their competitors as the economy and real estate markets begin to recover. Bank stocks have rallied since December and are due for a bit of a pullback, so I would be looking for an opportunity to buy this high-quality regional at a better price. The company is set to report earnings on Thursday, and any shortfall of the always highly accurate Wall Street analysts' estimates may also create a buying opportunity.

Most of the perfect, or close to perfect, small banks are microcap in nature. One of the best investments you can make is to find out who the most respected bankers in your area are and arrange to meet with them. They know far better than Wall Street which depressed bank stocks can build your net worth over the next decade.

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