Dust Off the Fleas From Small Banks

 | Jul 02, 2013 | 12:00 PM EDT
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It was brought to my attention that no banks were mentioned in last week's articles on the cheapest stocks. I assure you this was intentional on my part.

As part of my ongoing efforts to avoid anything remotely resembling frolicking here at the beach, I have spent my time calling everyone I ever met to discuss weighty and lengthy business matters. I also set aside several matters that would require in-depth arduous research and consume as much of the daylight hours as possible. While the others are engaging in traditional beach activities I am on the deck, considering bank stocks over a cup of coffee.

While the larger regional banks caught fire last week as investors realized that higher interest rates could actually be good for them, this really did not trickle down to the smaller community banks. These stocks are not attracting much investor interest. They are too small for most institutional investors and individual investors. They have moved up off the lows but their valuations do not reflect the vast improvement in their balance sheet and financial condition. The returns from these stocks over the next five to 10 years will be breathtaking in my opinion

The bank stocks that rank among the very cheapest on a price-to-book value basis have some ongoing problems that have caused the extremely low valuations. Some are still dealing with credit and loan loss issues while others will need to raise capital. Others are simply struggling to remain profitable due to low net interest margins and higher regulatory and compliance costs.

As a result, these banks have a few proverbial fleas on them. If these banks are able to dust off the fleas and clean up their act, their stock prices should rise by several multiples of the current prices.

I am a little constrained by market cap and liquidity issues as the very cheapest bank stocks are too small and illiquid to write about. The cheapest of those large enough to mention, however, is actually the largest bank on the list. I have discussed Synovus Financial (SNV) and will not reinvent the wheel here. The bank is rapidly cleaning up its act, however, and the stock is very cheap at just 60% of tangible book value. They sold off some distressed assets and bit the bullet and charged off others to clean up the balance sheet. The stock may not get back to its pre-crisis highs of above $30 a share, but even halfway back would be a six bagger.

Intervest Bancshares (IBCA) is hitting new highs but the stock still trades for less than 70% of tangible book value. I confess to missing the boat on this one as the stock did not fit my strictest guidelines. And I missed the 13d filings by several sharp bank activists.

The bank has cleaned up its act and is no longer operating under restrictions from the Office of the Comptroller of the Currency, although the holding company is still bound by an agreement with the Federal Reserve that restricts some activities. They were recently successful in buying back some TARP securities from the Fed. It may take some time for nonperforming assets to get back to the level of their peers, but the upside is tremendous if they continue to have success.

MutualFirst Financial Inc. (MFSF) is also on the list of cheapest bank stocks. This stock first came to my attention when the guys at PL Capital filed a 13d on the stock earlier this year. The activist firm owns 8% of the bank but has not put forth any activist proposals so far. The bank is not setting the world on fire but conditions are improving steadily. Nonperforming loans are 2.52% of all loans, roughly in line with its peer group. The equity-to-asset ratio is 10, so they have adequate capital right now. The return on equity and return on assets are well below their peer group, but that should improve. If it doesn't get better, look for increased pressure to sell the bank. A sale would be well above the current 70% of tangible book value.

Several of our old favorites are still on the list as well. Berkshire Bancorp (BERK) has not done much in the last year but it is still cheap at 80% of tangible book value. Pacific Mercantile (PMBC) is still at less than 80% of tangible book value as well. The super cheap banks may take some time to see their price improve, but the greater risk for long-term investors is in not owning these trade of the decade stocks.

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