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  1. Home
  2. / Investing
  3. / Financial Services

3 Stocks Even a Small-Bank Evangelist Would Avoid

Valuation is the key to successful investing in banking, and this trio is just too richly valued to own at current levels.
By TIM MELVIN Jun 13, 2016 | 01:00 PM EDT
Stocks quotes in this article: OZRK, WAL, HOMB, GE

Before everything turned upside down here in Orlando, it had been a pretty bank-focused weekend.

On Saturday morning I did a 90-minute teleconference with an investment group in Virginia about the community bank sector and how to select winning small-bank stocks. I spent most of the afternoon putting together my monthly community bank letter and researching small-bank stock ideas. In one of my last "normal" conversations of the weekend, an associate asked if there were any bank stocks I would avoid owning right now. While I am something of an evangelist when it comes to community bank stocks, there are some stocks that I think you should avoid and even consider shorting in the current environment.

I always have considered it a mix of optimism and insanity to buy stocks in an industry at earnings and asset multiples higher than the current M&A levels for the group. I have found this to be especially true in bank stocks.

Paying attention to growth rates in lieu of valuation can be deadly. The only way to grow a bank today is via acquisition, and a string of deals means you are diluting your own tangible book value per share and eventually the piper will get paid. Currently, the average bank deal is done at about 1.35x book value and 18x to 20x earnings. Paying much more than those figures for a bank is probably not a great idea, especially after seven years of rising prices for the market and the sector.

Shares of Bank of the Ozarks (OZRK) have been falling since research firm Muddy Waters put out a short thesis on the bank earlier this year. Looking at the valuation of the stock right now, it has further to fall in my opinion.

Bank of the Ozarks has done a great job of growing assets and earnings, but the stock is trading at a ridiculous price-to-tangible-book-value ratio of 2.5 and a price/earnings multiple of 17x trailing earnings. In addition, as Muddy Waters noted, it is far too concentrated in construction loans and unfunded commitments to developers that are not on the books yet and that can have a very unhappy ending.  Construction lending is one of the first loan classifications to turn sour if things slow down, and OZRK's loan book is heavily exposed. The high valuation and higher-risk loan book has the potential to be a toxic mix, and I think the stock goes lower from here.

Western Alliance Bancorporation (WAL) is another bank that has been a great growth story since the credit crisis, but the stock is now trading at what I think is an unsustainable valuation. The bank is trading at 2.8x tangible book value and, simply put, banks are not worth 2.8x book.

The high growth rate is showing signs of slowing, and WAL also has a higher-risk loan book than I like to see. Nonperforming assets are very low for the bank right now at just 0.39% of total assets, but it just acquired a $1.34 billion hotel franchise loan book form General Electric (GE) and it has $3.1 billion in commercial and industrial loans. Bill Moreland of Bankregdata.com has warned that C&I loan quality is starting to turn, and it is highly likely that we will start to see rising delinquencies. Western Alliance is not a bad bank. Indeed, it appears to be a very good one, but the stock price is just too high at current levels.

Home Bancorp (HOMB) of Conway, Arkansas, is another bank that has grown by the art of the deal. It likes to buy other banks and it has done a fantastic job of it over the past two decades. Since the end of the credit crisis, HOMB stock has risen fourfold and assets have more than tripled. It has been a fantastic story and a great stock to own over that time period.

Today, however, the shares fetch a mind-numbing 3.8x book value and 20x earnings. It is just hard to see much upside form this level, and a fall back to even 2x book would create a loss of more than 50% for shareholders.

Everything can have too high a price, and that's true for banks as well. While the "trade of the decade" in community banks is still very much alive, valuation is the key to successful investing in banking, and some banks are just too richly valued to own at current levels.

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At the time of publication, Tim Melvin had no positions in the stocks mentioned.

TAGS: Investing | U.S. Equity | Financial Services

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