The other day I visited FJ Capital, a hedge fund in McLean, Va., and spent an enjoyable afternoon talking about banks stocks and the trade of the decade with Martin Friedman and Andrew Jose, two principals of the firm. They recently updated their white paper on the opportunities created by the merger-and-acquisition cycle in small banks, outlining their thesis for investing in small banks. It is well worth reading.
Although we are seeing some M&A activity in small banks, the pace remains below previous years. In 2011, we saw just 159 deals, down from 175 the previous year. That is more than the 143 transactions completed in 2008 but still well below the number of deals during the last banking crisis in the 1990s, when there were more than 500. Given the low valuations in the group, there's a very large one-day premium as merger prices more accurately reflect the values of the banks than the depressed market price. On average, deals were done at a 69% premium to the previous day's market close in 2011.
We have a very similar situation today. Nonperforming assets are historically high and price-to-tangible-book-value ratios are historically low. Prices are recovering before the loss cycle has returned to normal. Loan losses are improving across the small-bank sector, though they are still historically high. These losses seem to be priced into bank-equity prices, and it would be reasonable to expect the price-to-book-value ratios of these institutions to move higher soon.
FJ Capital's white paper looks at current valuation vs. historical deal multiples, which reveals the size and scope of the small bank opportunity. The SNL Micro Cap U.S. Bank Index trades at roughly 70% of tangible book value. Deals today are in the 100% to 125% of tangible-book-value range. During past recessions and periods of weak economic growth, deal multiples for small banks averaged about 125% to 150%, and it is reasonable to expect them to get back to that range before long.
Although the move from 70% of tangible book to 150% is an attractive return, the real opportunity comes from solid, well-managed banks that are able to grow book value even in tough times. If a bank grows book value by 0% a year and it is acquired a few years later at 150% or more of book value, the return to investors who bought at today's deeply discounted price is extraordinary.
The white paper also looks at the forces pushing banks and their boards to consider mergers. New costs from regulatory measures such as the Dodd-Frank Act crush the profits of smaller banks and are best dealt with by joining larger rivals. Loan growth is difficult to achieve in a slow economy with so many banks chasing the same customers. The same holds true for deposit growth.
Many banks suffer from what the white paper calls "management fatigue." The past five years of falling residential and commercial real estate prices, loan losses and intense regulatory pressure has been exhausting and for smaller banks -- the fight has been too difficult for too long. Managements are looking for an exit in the form of a merger transaction.
The opportunity is huge, according to FJ Capital, and I agree. There are more than 1100 banks and thrifts with less than $250 million of market capitalization in the U.S., and almost all of them are M&A candidates. An enormous amount of money could be made by investing in small banks over the next five years and beyond.
