A Vote of Confidence for the Small-Bank Trade

 | Oct 28, 2011 | 12:45 PM EDT  | Comments
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I spend a lot of time thinking about banks. I have been talking about the Trade of the Decade since 2008. Given the damage done to the banking sector over the past three years, this trade is inevitable. It has also been frustratingly long in developing. Eventually, the small regional and community banks are going to see substantial consolidation at much higher multiples of tangible book value than where they are currently trading.

In the short run, there are still a lot of obstacles in front of the group, and you must be patient enough to wait for the trends to assert themselves in the sector. Yesterday I decided to check my premises on the group. I spoke with Martin Friedman of FJ Capital, a Virginia-based hedge fund that specializes in small bank stocks.

We last spoke with Friedman in December of 2010. At the time, he was as bullish on the group as I was and was a believer in the Trade of the Decade. He and his shop are still just as bullish on the long-term outlook for the smaller banks. He pointed out that small banks have not done much of anything so far this year. But by falling a lot less than their larger competitors, they have outperformed substantially.

The SNL Securities Microcap Bank Index is down less than 1% so far this year. Compare that with the KBW Bank Stock Index (BKX), which has declined by about 25%. The small bank stocks are certainly cheap. The median stock in the index trades for just 72% of tangible book value.

Friedman does see substantial headwinds for the smaller banks in the short run. The combination of lower long-term interest loans and decreased loan demand is not friendly for bank earnings. The combination is pressuring net interest margins, and the firm sees small bank margins at the low end of its expectations. Friedman warns that this could go on for some time, as it is unlikely that we will see the Federal Reserve allow longer-term rates to rise anytime soon.

The answer to loan demand is simply jobs. Once the employment situation improves, loan demand will begin to rise and allow net interest margins to rise somewhat. Regulatory uncertainty and expense are also still relevant issues for the smaller banks. Many of the regulations that were meant to restrain the larger banks are harmful to their smaller brethren, and while we know there is additional regulation on the way, no one knows what the form or cost will be.

Oddly enough, according to Friedman, this could work in investors' favor by pushing us closer to the start of the merger-and-acquisition wave in the sector. Smaller banks that have been reluctant to sell may be looking at several quarters, if not years, of difficult operating conditions and decide it is time to go ahead and sell. I believe this may be particularly true of institutions where the average member of the board of directors is over 60. They are more likely to take a profit and move on than a younger institution, in my opinion. Larger banks will look ahead and realize that the only path to growth is going to be through acquisition. We are seeing some signs of this, with 85 bank deals being done so far this year.

Friedman named a couple of stocks that he believes are well positioned to take advantage of the conditions in the market for smaller bank stock sector.

Sterling Financial (STSA) is based in Spokane, Wash., and operates in several northwestern states. The bank did a reorganization, and private-equity investors provided much of the capital needed. Thomas Lee and Warburg Pincus, combined, own about 50% of the bank right now. The bank will able to add back a $5 deferred tax asset to its balance sheet next year, and that, along with the add-back of some excess reserves, will make book value closer to $20. Credit losses at the bank have also been improving. Friedman said that the numbers are all going in the right direction and pointed out that Sterling Financial just beat Wall Street estimates with earnings of $0.11 a share, compared with expectations of $0.11 for the third quarter.

Rockville Bank (RCKB) is a Connecticut-based bank that did a conversion from being a thrift back in March. The shares came public at $10 a share and currently trade just below that level. This is a classic thrift conversion with lots of excess capital and very low loan losses and few problem assets. The stock currently trades at 85% of tangible book value, and the tangible-equity-to-assets ratio is close to 19. It is a classic safe and cheap bank stock.

Freidman says that the M&A wave may be delayed, but it is coming. Owning small-bank stocks really will be the Trade of the Decade.

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