A Midwestern Bank Is Becoming a Value Pick

 | Aug 23, 2011 | 1:57 PM EDT
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Today I want to continue searching through the rubbish pile that is the bank stock universe. I started the morning looking at charts of the bank indices I track. I looked at charts of the KBW Bank Index (BKX) and the First Trust Community Bank ETF (QABA). In a word, they looked pretty terrible.

I asked Bob Byrne and Tim Collins to look at them, and their reply was along the lines of "expletive deleted." Bank stocks are at new lows, and all the moving averages and trading bands have rolled over and are pointing straight down. There is no logical price support level in sight on either of these charts. Naturally, since I'm a very contrarian long-term value investor, this attracts my interest in a big way.

I am continuing to look at the Midwestern banks today. I believe the banks in the Midwest have fewer credit and toxic securities problems than those in the major East Coast and West Coast financial centers, and I am intrigued by the possibility that they could grow into other markets at the expense of the bigger money-center banks. Many of these banks in the center of the country had stubbornly traded above tangible book value, and I could not buy them using my standards for buying banks. Now, after the apocalyptic behavior of banks stocks this month, several of them have fallen close to bargain levels.

A bank that has been on my "want to buy" list for some time is TCF Financial (TCB). The Minnesota-based bank has traded above tangible book since putting in its lows back in 2009 and had gotten close to 2x tangible book value. Now the stock has fallen sharply, and the stock trades at just 90% of TBV. There are some good reasons for the decline. TCF Financial has derived almost 30% of profits from debit-card fees and other fess that were curtailed by recent bank legislation. The bank is looking for new revenue streams to replace that lost income.

Credit metrics are also starting to improve. Delinquencies and charge-offs fell last quarter, on a quarter-over-quarter basis, for the first time in two years. Nonperforming assets peaked at $506 million in the third quarter of 2010 and have since fallen to $458 million, or less than 2.5% of total assets. Unlike a lot of other banks, TCF Financial has not been releasing loan-loss reserves. In March, the company took steps to build capital levels by selling $200 million of stock at $15.25 per share, well above the current quote. The ratio of tangible equity to assets now stands at 8.71%, up from less than 8% a year ago.

There is a lot to like with this bank, although the tangible-equity-to-assets ratio is a little lower than I like. The bank has been profitable for 65 consecutive quarters. It has a strong and growing base of low-cost deposits. Since the depths of the financial crisis in 2008, the bank has grown deposits by more than $3 billion. The average cost of these deposits was 0.36% as of the end of June. The inventory floor plan business has grown by more than 100% since 2009, with miniscule losses. The equipment leasing and finance business has also been very strong. I believe the bank will easily overcome the loss of fee income by expanding these and other markets.

As I mentioned, the bank is trading at 90% of tangible book value right now. I like to start scaling into my purchases at 80% of TBV so I can wait for further declines. My chart-reading and tea-leaf-reading friends tell me this is highly likely to occur. Of course, although I am patient after I buy, I can sometimes be a little impatient when it comes to buying stocks I really want to own. Rather than relax my standards, I can turn to my good friends in the options market for assistance. I can currently sell the January 9 puts for $1. That puts me in right at 80% of the bank's tangible book value if the options are exercised. If they are not exercised, I keep the premium for a 25% annualized return.

I am well aware of the financial and regulatory issues that banks are facing this year. However, I do not believe the world is ending, and it makes sense to start scaling into these stocks at 80% of tangible book value. I am highly confident that five years from now, these stocks will show returns in multiples, not percentages of the current stock prices.

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