Community Banks Grab the Limelight

 | Apr 26, 2013 | 3:00 PM EDT
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While bank stocks have moved higher during the past year along with the rest of the market, there are still plenty of cheap community bank stocks available.

Many are institutions that have struggled to remain profitable and to rebuild the balance sheet. They are attracting the attention of activist investors. I remain as enamored of the sector's long-term future and have seen in the past the type of returns available from piggybacking on activists.

One of my favorite bank stock investors to track is the folks at PL Capital. They have been shooting the lights out with their combined value and activist approach to bank stocks, and I have made money with their stock picks. They recently filed a 13D on a small bank in Muncie, Ind., announcing an 8% stake in MutualFirst Financial (MFSF), a 31-branch bank with $1.4 billion in assets.

In their filing, PL Capital said the shares were undervalued, and if necessary, they would assert their shareholder rights. This could be a difficult struggle for the hedge fund as officer and directors own 18% of the stock and related entities, including an employee stock ownership plan and a foundation, own an additional 8.7% of the stock.

The bank recently reported results and earnings were up 47% on a year-over-year basis. The bank has been letting wholesale deposits run off and selling most of their mortgage production into the secondary market, so the balance sheet shrank in the quarter. Management is trying to rebalance the mix of assets by reducing the residential portfolio and adding loan exposure in commercial and consumer lending. Nonperforming assets were 2.25% of total assets and tangible book value for the bank is $15.40. The bank does appear to need to build its capital base as the equity-to-asset ratio is just 7.72.

It will be interesting to watch this situation as PL Capital attempts to unlock the full value of the shares. The stock has run up a little but in recent weeks, so I would wait for a pullback to be a buyer. A sale of this bank as a result of activist pressure is not going to surprise me. The loan portfolio is heavy in residential real estate, and they could use a capital injection. Officers and directors own a lot of stock and are fairly young. If this goes to a full activist proxy fight, it will be interesting.

Joseph Stilwell is another activist investor with a bank stock focus that has provided me with some profitable ideas over the years. Stilwell has run Stilwell Value Partners since 1993 and has been an activist in many of his investments. The fund targets banks and insurance companies and I have made some very profitable investments by following him into share of these institutions.

One of his latest investments is in HopFed Bancorp (HFBC). The bank has 18 branches in Tennessee and Kentucky and has a total of about $960 million in assets. Stilwell recently filed a 13D disclosing ownership of 7.4% of the bank and in his accompanying letter expressed his displeasure at management decision. He is particularly unhappy with the board's decision to buy a smaller competitor instead of buying its own stock back below book value. The stock currently trades at just 65% of book and Stilwell (and I) feels the money would have been better spent on a large buyback.

The decision to buy another bank was not the only shortcoming pointed out by the activist fund manager. In his somewhat scathing letter he emphasized that the return on equity was below 3% for the past four years and that the 2010 capital raise had diluted existing shareholders by 25%. He took CEO John Peck to task for a record of 12 consecutive annual pay raises despite poor performance and for selling shares of his bank for less than tangible value. Stilwell suggests that if the current officers and directors cannot perform with their own bank, shareholders should not let them buy another one. He closes with a strong suggestion to sell the bank.

Stilwell makes a strong case. I like the stock and will be a buyer at this level, around $11. Management appears to have done a less than spectacular job of running the bank, the stock is cheap and they are geographically attractive to many potential buyers.

The community bank space is going to see a surge of merger-and-acquisition activity over the next few years. Tracking activist investors in this sector can help identify potential targets and find stocks with large upside potential and with a catalyst for cash out.

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