It should come as no secret to most readers that I am very involved in the small banking sector on pretty much a daily basis. Not a day goes by where I am not screening bank stocks and reading FDIC reports to keep up with what's going on in small community banks. In addition to the large amounts of money to be made, one of the neat things about this space is that it is small. So, you eventually you get to know most of the people engaged in the space.
I have kept track of the activities and reports from PL Capital, the manager of several banks stock hedge funds, and last week I had a chance to speak with them and gather their thoughts on community banks.
The principals at PL Capital, Richard Lashley and John Palmer, bring an interesting approach to investing in bank stocks. They started out as auditors and consultants to the banking industry, not as investment managers. They have both been involved in advising banks and thrifts on day to day business activities, merger and acquisition proposals and restructurings. They started their funds back in 1996 to put their expertise to use as investors using a deep value and activist approach in the small bank sector.
Few activist investors exist in the small bank space. Most activists avoid the space because it is simply too small to matter for their multi-billion dollar funds. So PL Capital's extensive expertise and deep understanding of community bank operations gives them a huge advantage over competitors. As Lashley said last week, "When we show up at a bank, the principals know it is because we know they are not being properly run. If we file a 13D on a bank, we have identified some factor limiting returns and have the specialized knowledge to correct the problem." The target bank can either choose to work with PL Partners to improve returns and build shareholder value or face a proxy fight for board seats or an attempt to force a sale of the institution.
One of the biggest problems in the small bank space, according to the partners, is that far too many local bank executives are more worried about their W2 income than their stock price performance. Management teams and the boards of the smaller banks can be very entrenched and are usually well respected in their community. The employees can be very loyal and happy with their position. However, as Palmer pointed out, just because a company is a good place to work does not always mean it is a good place to invest.
But, according to the two fund managers, that attitude has been changing recently. It is extremely difficult to be a community or regional bank space right now. The regulatory environment is increasing compliance costs. In a weak economy, it is very difficult to grow a bank right now. Shareholders have lost quite a bit of money in many of these stocks and are starting to complain. Bank executives are tired of the hassle and costs of running the business. According to the guys at PL Capital, pretty much every small and mid-size bank in the U.S. is probably for sale right now. It is just a matter of time and price. The election and fiscal cliff prospects may have slowed takeover talks, but they will begin again in earnest as the year progresses.
The two fund managers also provided an interesting stock idea that is a little different than the normal cheap bank with operating problems they usually favor. Horizon Bancorp (HBNC) is a 22-branch bank in Michigan City, Ind. that has $1.8 billion in assets. The stock trades at a small premium to book after the recent 3-for-2 stock split. The bank should earn around $2.14 a share this year and next, according to Palmer and Lashley, so it trades for about 9x earnings. The bank is so well run that they referred to CEO Craig Dwight as one of the very best in the business.
The bank will be an acquirer, not a seller, during the consolidation wave and will grow to appoint where it is large enough to attract significant institutional interest. Earnings are improving at a rapid clip for the bank and credit issues are behind them with nonperforming loans at just 2.08% of the total loan portfolio. The return on equity is 13, which is one of the best in the industry. As the bank grows and is included in more of the larger indices, institutions will be pretty much forced to buy and increase their ownership well above the current 38% level.
The fund also has about 15% of its assets in the larger bank space. It owns shares and warrants of the larger banks, including JPMorgan (JPM), PNC Financial Services (PNC), Comerica (CMA) and Capital One (COF). According to Palmer, the big banks have put their credit problems in the rearview mirror and are just too cheap. The partners consider the TARP (Troubled Asset Relief Program) warrants for these banks to be incredibly cheap and have huge potential payouts.
For obvious reasons, we couldn't talk about their small positions or those where they are on the board or engaged in a proxy fight. It is worth your time to search the Securities and Exchange Commission (SEC) filings to identify those stocks. The fund has adopted a value-based activist approach to the small banks that is working very well.