Two Small Banks With Big Potential

 | Jul 01, 2013 | 11:00 AM EDT  | Comments
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Friday marked the last day of trading for the second quarter. Although the market could not duplicate the double-digit performance of the first quarter of the year, it turned in a solid showing.

Despite the increased volatility of the last six or seven weeks, the S&P 500 posted nearly a 2.5% gain in the recently completed quarter. In my columns this week, I will seek to highlight and profile stocks and sectors that I believe should outperform the overall market in the second half of the year.

One of the core facets of the second quarter was the rapidly rising interest rates that dominated the headlines during the last two months of the quarter. The 10-year government yield moved from just over 1.6% in early May to over 2.6% in late June before falling back to 2.5%. This has caused junk bond yields to jump from 5% to about 6.75%, the consumer staples and utilities sectors to perform poorly and mortgage rates to move up a point.

I don't expect the same volatility in interest rates in the third quarter, but I do believe the 10-year Treasuries should remain solidly above 2%. One area that should benefit from these higher interest rates is the banking sector. Higher yields should improve the sector's net interest margin, which is a key driver of earnings. I prefer the smaller banks as they should not be as burdened by some of the onerous regulations aimed at their bigger brethren. In addition, I think there could be significant consolidation in the space, such as the recently announced merger in Arkansas between Home BancShares (HOMB) and the privately-held Liberty BancShares, which drove HOMB more than 20% higher.

Here are two small banks I like right now:

OceanFirst Financial (OCFC) is a small financial concern based in New Jersey that operates 24 branches. The stock yields 3.1% and is priced at just over 20% book value. The shares sold for about $25 a share prior to the financial crisis and its branches are located in zip codes with levels of income that are much higher than national averages. Stern Agee recently upgraded the shares, noting that the price could hit $20-$21 if the company becomes an acquisition target; that would be substantially above its current price of $15.50 a share.

My other selection also comes from the same region of the country. Northfield Bancorp (NFBK) operates 30 branches in the New York City boroughs of Staten Island and Brooklyn, as well as in New Jersey's Union and Middlesex counties. It converted over from a thrift bank earlier this year and the stock currently yields 2%. However, with the more than $300 million the company raised in its thrift conversion, it could easily increase that in the near future.

Trading for around 95% of book value, which is 10% to 15% lower than its peers, the stock looks cheap on this basis. It has also has a substantially higher loan loss reserve (over 2%) than its peer. Some of that excess reserve level should drop to the bottom line in coming quarters as the economy continues its tepid recovery.

In addition, the bank's net interest margin of just under 3% is a bit lower than peers, so it has some opportunities there. Approximately 50% of its loan book consists of residential real estate, primarily multi-family properties. Northfield looks poised to benefit from the continued housing recovery. Finally, given its locations and an enterprise value of less than $1 billion, a larger player may eventually target the bank as a small, strategic acquisition.

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