Beaten-Up Banks Can Be Bargains

 | Oct 05, 2011 | 1:00 PM EDT
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Banks are the group everyone loves to hate right now. So far this year, they have been getting beat on like Joe Frazier in the "Thrilla in Manila." In addition to the ongoing loan loss issues, they now have to deal with a harsh regulatory environment and the Fed's Operation Twist, which promises to squeeze interest rate margins. As unpopular as the sector has been, when I look at the technical charts (don't tell the other value guys. I might get kicked out of the club!), it appears that they could well go lower before they find support and begin to work higher, as the levels seen at previous major banks stock bottoms have not been reached. In spite of the potential weakness, I am always looking for cheap bank stocks because I believe they will be long-term investments that offer tremendous returns for patient investors.

Given the recent selloff in the group, I decided to look back at the second-quarter 13HF filings. I looked for bank stocks that had been purchased by some of the world's best value and distressed managers that might be on sale at current levels and worth investigating. I found a few banks that are owned by successful investors that seem to have extraordinary long term potential.

Central Pacific Financial (CPF) has been one of the most volatile stocks in the market in since August. The price has moved up and down by double-digit percentages on several occasions in the past month. Seth Klarman of the Baupost Group purchased 1.8 million shares earlier this year at higher prices. The stock bottomed at $9.65 this week and then proceeded to rally by 17% on Tuesday. Given the volatility, I would wait for the next down move before buying the shares, but they do appear to merit consideration.

The bank provides services to individuals and businesses in Hawaii and currently has 37 branches in our 50th state. The bank was founded in 1954 by Japanese-American World War II veterans and is the largest residential mortgage originator in the state. The real estate crisis has taken a toll on its business, but the bank has recapitalized this year with help from private equity firms Carlyle Group and Anchorage Capital. The bank named John Dean, an experienced turnaround manager, as CEO last year and it appears to be back on a path to profitability. Since 2010, non-performing assets have fallen from almost $500 million to less than $300 million. Since non-performing assets peaked in the last quarter of 2009, NPA's have dropped by more than 50%. In addition to Klarman's purchases, insiders have been accumulating shares of the stock since August.

I also pay close attention to investor Michael Price's actions -- especially when he buys bank stocks. I have done very well by cloning some of his bank stock selections over the past 20 years. In the second quarter, he purchased 600,000 shares of Franklin Financial (FRNK), which has eight branches in and around Richmond. Following its mutual-to-stock conversion and stock offering earlier this year, shares of Franklin Financial now trade at just 60% of tangible book value. Insiders have been steady buyers of the stock since the offering was completed. At just above 4%, non-performing assets are higher than I like to see, but the capital ratios more than compensate for this. The tangible equity-to-asset ratio is above 23, which is one of the highest in the industry. The stock has sold off with the rest of the sector and I think long-term investors could start to buy the stock now.

Bank stocks are unloved right now. They may still have some room to go lower before they turn to the upside, but buying at these levels has historically been very rewarding for patient investors.

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