Last night, as I sat watching the Yankees bounce themselves out of the playoffs in an eerily familiar October scenario, my thoughts wandered toward bank stocks and the banking industry. That happens a lot these days as banks are quickly becoming one of the cheapest assets in the financial world. We have covered all the reasons for this countless times. The credit crisis, a changing regulatory environment and fiscal policy have delivered a series of crippling blows to the industry. Unquestionably banks, especially smaller regional and community banks face a hard time for the next few years. Equally true however is that given the pricing of many of these issues, if the world does in fact survive long term investors who can deal with the probable volatility in the sector can make an enormous amount of money over the next decade.
As I watched A-Rod strike out with the bases loaded -- ending my hopes of a Yankees-Phillies World Series -- it occurred to me that there is another way to make money off the weakness in the banking industry. When I was a broker, my firm made a market in dozens of these community banks -- and for a long time, we had the marketplace pretty much to ourselves. As banks were beginning the merger wave following the savings-and-loan (S&L) crisis and changes in interstate banking laws, it was profitable -- and to be honest, a lot of fun. In the 1990s, a competitor began to slowly but surely take business away from us in the bank stocks. It had a larger research department and its focus on investment banking in the sector eventually gave the company the control of regional bank stocks that had been ours. Although they have stumbled and struggled since the 1990s, FBR Capital has survived and is still a strong presence in the bank stock sector.
FBR Capital (FBRC) is the leading book running manager of deals in the financial services sector of the market. It makes markets in over 1,500 stocks, many of which are smaller regional and community banks. The firm's asset management division includes two Financial Services Funds that focusing primarily on bank stocks. They are run by David Ellison -- a stock picker for whom I have a lot of respect. Both the large- and small-cap bank stock funds have held up much better than one might expect, given the carnage in the industry. Although FBR does have research, trading and investment banking operations in other market sectors, it is still very much leveraged to the banking industry. A recovery and renewed mergers and acquisitions wave in the sector could well be an enormous boost to the top and bottom lines over the next 10 years.
Reflecting the weakness in banks, specifically, and capital markets in general, the stock is cheap at current levels. As the pace of mergers-and-acquisitions (M&A) activity has slowed in the sector, FBR's investment banking revenues have declined. At some point that will change and the firm will see strong revenues from the bank and financial services as a merger wave is inevitable in my opinion. Commission revenues from institutional clients also declined in the quarter. Again, at some point, the markets will firm up, so that should climb higher over time.
The shares currently trade at just 50% of tangible book value. Management thinks the stock is cheap, as not only have they been buying stock back on a regular basis, but they have also just completed a tender offer for more than 6 million shares of stock. There is a potential home run buried in the balance sheet as well. The firm has $25 million invested in two private firms that were formed to acquire banks at distressed levels and do a roll-up into a larger bank. Given the prices paid for troubled banks right now, this could provide huge gains for the firm and its shareholders over time.
Some fairly smart outside investors, including Invesco and Royce Funds, also have established large stakes in the stock. For those of us who are looking for ways to profit from the eventual recovery of the banking industry, owning a few shares in FBR might be a nice complement to our bank holdings.