The biggest takeaway for my recent conversation with John Allison, Chairman of Home BancShares (HOMB), was that his approach to growing his Arkansas-based bank is a total validation of my process in picking small-bank stocks.
Allison told me that the way to make money was to buy the broken and underperforming banks, fix them up and increase their profitability. That's almost exactly what we are trying to do as investors.
We are looking for underperforming banks trading at bargain prices with the intent of profiting when they begin to grow assets and earnings, or as is often the case, throw in the towel and sell to a larger financial institution. Both outcomes are profitable for us as outside investors, and we try to tip the odds further in our favor by focusing on those names that have activist investors pushing for profit and stock price increases or a sale of the bank.
When I look at this approach and crunch the numbers it is by far the most effective method for individual investors to use when investing in bank stocks. Buying banks with a lower-than-average return on assets (ROA) when the shares trade below book value outperforms the market over the five-, 10- and 15-year periods.
During the credit crisis this approach outperformed by being primarily in cash. At the end of 2007 there were almost no banks trading below book value. Bank deals were taking place above 2.5x book value, credit conditions were deteriorating and any bank investor with an ounce of prudence, caution and common sense was in cash. Since the crisis returns have accelerated and I expect that trend to continue as the pressure to grow or sell becomes even more intense.
When I ran a screen looking for banks with below-average ROAs that trade below book value, there are still plenty of candidates for a "trade of the decade" portfolio. My most recent purchase, Green Bancorp (GNBC), has bumped up a little in price but still remains attractive. The Houston-based bank has an ROA of just 0.43% and the shares are trading at just 95% of tangible book value. Green has private equity ownership of 13% and I can promise you that the three firms that control that 13% are looking to get paid off with a much higher stock price over time. CEO Manny Mehos has started, grown and sold a bank before and I suspect that is his eventual end game for Green as well.
I have owned Eastern Virginia Bancshares (EVBS) for a while and been pretty pleased with the results. It hasn't been spectacular, but EVBS has provided a solid return and it has done a nice job of expanding its presence in both the Tidewater and Richmond markets. The bank has made some smart acquisitions and is working to get asset levels to the point it can achieve the scale needed to increase profitability. And EVBS has plenty of incentive to keep growing or consider selling as Wellington, FJ Capital, Castle Creek Partners and PL Capital are all significant shareholders.
The bank is making solid progress. In its most recent earnings release CEO Joe A. Shearin pointed out that "For the first quarter of 2016, as compared to the same period of 2015, we are reporting an increase in net income available to common shareholders of 60.3%, an increase in annualized return on average assets of 22 basis points to 0.70%, and an increase in annualized return on average common shareholders' equity of 271 basis points to 8.34%." The stock is still a bargain at just 91% of tangible book value.
When I ran this screen I came up with 123 candidates. But only 20 of them have market caps of more than $100 million. To participate in the big gains I see developing in community bank stocks you have to think small. It is the smaller banks that will sell out at a profit, so you need to give up any high-tech dreams and medical miracle expectations you might have when trading larger-cap stocks in order to participate in the trade of the decade ( I may need to change this to trade of the half-century).
There are no sure things in investing but buying a small bank in sound financial condition with a lower-than-average ROA and at least one activist shareholder is about as close as I think we will ever get.