Tap in to Burgeoning Growth

 | Feb 05, 2013 | 4:00 PM EST
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Early this month, the Milken Institute released its study of the best-performing U.S. cities and metropolitan areas. The study ranks cities on things like job growth, wage growth, technology output and local gross domestic product growth for the year -- and the information certainly offers some real value for investors. Strong economic growth in a particular city leads to population growth, as well as an increase in city and local tax revenue.

In addition, property values stabilize and begin to recover much quickly in parts of the country with strong economic performance. Builders with a strong presence will do better than their peers around the country. Infrastructure contractors will see an uptick in contract awards, and their top and bottom lines will rise faster than at many national companies. Finally, real estate investment trusts with a solid presence in strong market will see higher occupancy rates and lease rates. An astute investor, therefore, can use the information in the report to find all sorts of investable opportunities.

It occurred to me this morning, as my coffee kicked in, that the report is probably most useful to those of us who follow and invest in the smaller regional and community banks. A healthy, growing job market means the region is set to experience income and job growth. This means higher deposits, more loan demand and improving collateral value. The business community will be looking for business financing, and contractors will be borrowing to build homes in order to meet new demand. It's the start of the sweet spot in a recovery for banks; larger banks will want to expand in the region, and often the easiest way will be to just buy a smaller competitor. If we combine the Milken report with the Trade of the Decade in small bank stocks, we could come up with banks poised to see huge potential returns.

The No. 1 region last year was San Jose, Calif. Business spending in information technology is starting to pick up there once again, and apps for smartphones and social media are exploding -- and this helped the region jump 50 spots to claim the top contender. The largest bank in the region is SVB Financial (SIVB) with more than $20 billion in assets. The bank's strong presence and reputation in the valley means the shares are not cheap: Shares trade at 1.6x tangible book value. It has great relationships with the major players in Silicon Valley, however, including the leading companies and venture capital firms.  The stock only trades below book in severe banking selloffs, such as that of the early 1990s and in 2008 -- but, when it does, the stock should be bought.

Heritage Commerce Bank (HTBK) is a smaller institution in the region that does not demand the same valuation premium. This stock trades right at tangible book value, and it has solid financials. The equity-to-asset ratio is a healthy 12.1, and nonperforming assets are at just 1.56% of total assets. The bank also has $1.14 billion in deposits spread among its 11 branches in the area. Heritage projects itself as a community bank started by businesspeople, for businesspeople, and this is reflected in its loan portfolio. More than 80% of its loans are commercial and industrial or commercial real estate loans.  While this might be a red flag in a weaker region, this is actually a positive factor in a growing region such as Silicon Valley.

Heritage has been working to further strengthen its balance sheet and enhance its future prospects. It redeemed its preferred stock in 2012, and it also paid off subordinated debt prior to maturity. In the third quarter, the bank had 13% deposit growth and posted its ninth consecutive quarter of profitability. Given the strong growth potential in the region, the stock is cheap enough to buy -- and, perhaps, to scale into even more cheaply over time.

Apparently I am not the only one who thinks this is the case. Two insiders were accumulating Heritage shares back in August. Value-investing legend Michael Price, of MFP Advisors, owns almost 5% of the bank. Charles Moore's Banc Funds is also a large shareholder of the bank. In the third quarter of last year, 24 institutions increased or initiated a stake in the bank.

It is worth noting that, for those willing to do the work, there are several microcap banks operating in the region with cheap shares, as well as strong balance sheets and loan portfolios. They are far too small to mention here, but some legwork could pay off for bank-stock buyers willing to do engage in it.

Combining the Milken list of economically strong cites with the basic concepts of the Trade of the Decade strikes me as a very worthwhile activity. On Wednesday, I will continue our search for safe and cheap banks in high-growth regions of the country.

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