My Trade of the Decade Is Very Much Alive

 | Jun 15, 2012 | 4:30 PM EDT
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In the midst of all that has been going on in the markets, I have not talked much about small banks. Last night, an associate asked how that Trade of the Decade was developing and if I still believed in my thesis for the sector. The trade is going just fine, so far. We have been nibbling and picking at cheap small banks for some time and, overall, the portfolio is more than holding its own. The long-shot banks that were bought by private equity firms have been about as volatile as predicted, with a few huge wins and a few that have just been disasters. I have no intention of selling any of these semi-distressed gems, so I don't worry too much about the price gyrations. If little banks like Flagstar (FBC) and Hampton Roads Bankshares (HMPR) work over the next decade, they will make me a lot of money. If they go under, I will lose a relatively small amount.

My core holdings of small banks with lots of excess capital and low loan losses trading below tangible book value is doing just fine. If you look at the First Trust Nasdaq ABA Community Bank Index (QABA), you can pretty much tell what's going on in the sector. The little banks roared about 40% higher after the September bottom and have since pulled back a little over 10%. Investor caution towards the sector is growing, given the continued pressure of low-interest margins, higher regulation and the latest news that small banks would be subject to the Basel III capital requirements.

I mentioned these concerns to one of the better small-bank investors around, Martin Friedman of FJ Capital. As always, the small bank veteran had a sharp eye on the sector. The firm has been running a hedge fund investing in small banks since 2008 and has far surpassed the overall stock market, as well the sector. So far this year, they are up more than 10% amid all the market fireworks and confusion.

Friedman said, "The historic low bond yields coupled with lack of good loan demand is leading to ongoing compression on margins. Having said that, we continue to see market share gains as community banks are out servicing the middle market. We have anticipated higher capital standards for all banks, which lowers the return potential and makes it harder, especially for smaller banks, to earn their cost of capital. Lastly, all these issues and others will accelerate merger and acquisitions as cost rise, revenue is challenged and earnings remain under pressure. We are seeing an uptick in M&A as banks understand the new normal operating environment might be with us for longer than expected."

That is pretty much in line with view of the small-bank sector right now. The headwinds are strong and that will limit near-term earnings. But if you look beyond the headlines and read the reports from these little banks, you can see that the balance sheets are improving rapidly, and they are gaining market share at the expense of their larger brethren.

Every day that goes by, it becomes more apparent that merging with like-sized and like-minded institutions makes sense and will allow for better expense control and growth opportunities. Larger banks will be buying the little guys to gain access to a quality deposit base and a sound loan portfolio.

Banks such as Fox Chase Bancorp (FXCB), Capital Federal Financial (CFFN) and Heritage Financial Group (HBOS) are not setting the world on fire, but I remain highly confident that this sector will fund my retirement in 10 years.

The Trade of the Decade is still very much alive.

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