Back to the Old School

 | May 11, 2012 | 4:30 PM EDT
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I am intrigued by yesterday's screen, which showed that adding Piotroski F scores to my bank research is a worthwhile idea. I will be playing around with incorporating that measure into my regular research efforts, but deep in my heart I am still old school.  I have had a great deal of success over the years buying banks on the basis of a few basic criteria.

When I look at banks, I look for a price below tangible book value, excess capital and a strong balance sheet. I also pay close attention to make sure the bank has set aside adequate reserves for loan losses. I have a preference for those that are fully reserved or even over-reserved. Buying these has turned out to be profitable most of the time.

Most of the banks on my list are way too small to write about on Real Money. The average market cap of my core bank stock portfolio is probably around $50 million right now, and several names price well below even that level. But a few of my close-to-perfect banks make the cut, and I will share them with you as a representation of old-school bank stock selection.

Heritage Financial Group (HBOS) operates as the holding company for HeritageBank of the South. The Albany, Ga.-based bank has locations in its home state and in Florida, and it just purchased a branch in Auburn, Ala., as its initial excursion into that neighboring state. The company is growing organically but also completed two FDIC acquisitions last year of smaller failed banks in its core markets.

The stock is cheap right now at just 80% of tangible book value. The tangible-equity-to-asset ratio is over 11, so it has plenty of capital to fund growth, dividends and stock buybacks in the future. The loan portfolio not covered by FDIC sharing agreements is in sound shape, with nonperforming loans at just 2.24% of total loans. In all, nonperforming assets are just 1.27% of total assets.

The bank just increased in its dividend by 33% in February and has more than 400,000 shares remaining on its buyback authorization. This is a perfect example of a community bank that is safe and cheap. It may not be exciting, but it has the characteristics to be a wildly profitable investment over the next decade.

Another example of a solid bank with long-term profit potential is located in the booming metropolis of Stroudsberg, Pa. Essa Bancorp (ESSA) is a stock that was first mention by the folks at FJ Capital when we talked with them about bank stock investing last year.

This is a 17-branch bank that sticks to banking basics and prospers as a result. The shares are cheap, trading at just 80% of tangible book value. The equity-to-assets ratio is a rock-solid 14, so it has more than enough capital. Nonperforming assets are just 1.515 of total assets, so the bank's loan portfolio is in good shape. Essa is completing an acquisition of another bank in the region that will add to its growth potential as the region continues to recover from the recession.

Neither of these banks is horribly exciting. You probably won't see them on the financial news networks as hot investment prospects, but you also won't see the CEO discussing a multi-billion dollar trading loss either. These are basic banks with conservative lending and management practices. They may not be sexy, but for long-term, "old school" value investors, these kinds of stocks have historically been incredibly profitable.



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