Focusing on Small Banks

 | Aug 31, 2012 | 4:00 PM EDT  | Comments
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I was lounging around Chez Melvin this week contemplating the Orioles' playoff chances when the Voo-Doo Professor sent me a spreadsheet of small banks with less than a billion dollars in assets, one of his latest projects. Dr. Mark McNabb, assistant director of the MS Finance Program at the University of Texas at Dallas, has apparently been looking at the same set of facts that I used to establish my Trade of the Decade thesis. Increased compliance costs are going to make it difficult for these banks going forward, so they are going to have to seek merger partners soon.

"With the writers of Dodd-Frank favoring the same industry leaders that required a bailout," McNabb said, "the small banks will become targets as they will find it easier to sell out than comply with the weight of regulatory excess and loss of business discretion and judgment to pursue opportunities in the marketplace."

I also spoke to the good folks at FJ Capital on this subject. The firm runs a hedge fund focused on community bank stocks, and they view the market the same way. Managing Director Scott Cottrell told me that many shareholders of community banks with a billion dollars in assets or less will likely get better returns on their money from a sale of the bank. In many cases, he said, the returns that these banks post on equity will be in the single digits or worse, which for many investors is insufficient for the risk they take as equity investors. Returns, he continued, are going to be lower because many banks are being squeezed from all angles: higher regulatory costs and higher capital requirements, compressed net interest margins, slow loan growth, still-elevated credit costs, and regulatory opposition to higher fee income.

"While there is definitely a group of smaller banks that will be able to reinvent themselves or survive due to lack of competition or a unique business niche, many smaller banks will be faced with the choice of delivering high returns to shareholders through a sale or paltry-to-dismal returns to shareholders by remaining independent," Cottrell said.

There is another solid reason to focus on the smaller banks. Earlier this week, many of the same concerns led the board of Hudson City Bancorp (HCBK) to approve a takeover by M&T Bank (MTB) at a price below tangible book value. The deal should work out in the long term because it is a good fit for both banks. As a shareholder, however, I made pennies where I should have made dollars. The directors and officers, as well as members of the local community, of the smaller banks tend to have a significant portion of their net worth invested in their banks and are less likely to accept a take-under offer. These small deals should be done at a multiple of tangible book value, not at a fraction.

Comparing the Voo-Doo Prof's list of little banks of safe and cheap banks to mine, I found many shared names. One of the more intriguing names is Berkshire Bancorp (BERK). The bank has 11 branches in the New York Metropolitan area and about $880 million of assets. Insiders own 80% of the outstanding shares so no deal that doesn't fit their objectives will ever get done. The bank is incredibly healthy, with an equity-to-assets ratio north of 14 and a nonperforming assets ratio of just 0.06% -- one of the lowest I have seen since the banking crisis began. There will be interest in acquiring the bank, but insiders will want a premium. It is very well run, so it may be one of those smaller institutions able to grow its way into dealing with higher costs and increased regulations. Either way, with the stock trading at just 88% of tangible book value the shareholder should be rewarded with a much higher price over time.

Most of the banks that meet my selection criteria and have less than $1 billion in assets are too small to mention on Real Money. As part of constructing portfolios for the Trade of the Decade, I have been buying community banks with market caps of as little as $10 million. The average capitalization of our merged list looks to be less than $50 million.

Your best research is best done at the local Chamber of Commerce's happy hour, not on Wall Street. You can also use the information available at FDIC.gov to check the latest financials and ratios for small banks. Community banks may not be the most exciting investment, but they may be the most profitable over time.

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