Bank on the Community Names

 | Aug 21, 2012 | 3:30 PM EDT
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It seems that size has been an insurmountable issue when it comes to today's mega banks. No matter how many times we read that Bank of America (BAC) is one of today's great bargains, as the shares are trading at 40% of book value, Mr. Market is simply not interested. Despite the fact that Goldman Sachs (GS) has grown per-share book value by an average of 10% to 15% since its IPO and shares now trade at one of the lowest price to book ratios in the company's history, investors are not interested.

Banks are the vital backbone of capitalism. From time to time, environments become frothy and the subsequent pullback can be very painful for the entire economy. But that doesn't change the fact that banking plays an insurmountable role in the development and growth of a market based economic system.

But banking is not confined to the headline making mega-banks. While names such as  JPMorgan (JPM) get raked over the coals, there are super small banks such as Malaga Financial (MLGF) operating the five branches of Malaga Bank in southern California. Nearly 50% of the company is owned by its board of directors. The bank was recently rated as one of the safest 349 banks in the U.S., out of survey of nearly 8,000 banks, based on a complex measure known as the Texas Ratio, a formula developed in the 1980s that measures a bank's non-performing assets, loans, and bank owned real estate against equity and loan loss reserves. Measured as a percentage, the lower the ratio, the better. As a rule of thumb, many banks start to fail when the ratio approaches 100%. Malaga's ratio is perfect, or 0%. Its return on assets exceeds 1% while return on equity (ROE) exceeds 10%. On top of that, investors get a 3% dividend yield.

If you thought banks couldn't have large stock prices, you probably haven't heard of Farmers and Merchants Bank (FMBL), a $570 million market-cap stock with a current share price of $4,375. But a stock price is arbitrary; what matters is the value received. FMBL currently has a per-share book value of more than $5,200. Over the past five years, its loans have grown by 6% a year while its net income has grown by a respectable 5% a year. These numbers are even more impressive when you account for the fact that FMBL employs very little leverage: Its equity stands at $690 million against total assets of $4.7 billion. The company trades for 9x earnings and also yields 2%.

Because banking is such a hated sector today, the entire banking industry is being neglected. The fear is based on the uncertainty of the balance sheet: Analysts don't trust the value of the assets residing in the coffers of today's mega banks. Community banks are a different story -- they have extremely transparent balance sheets and it is a simple exercise to determine profitability. The fact that many of these banks have paid uninterrupted dividends throughout this entire time speaks volumes. If it is visibility you are after, look no further than some of today's well-run community banks.

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