I spent part of last evening reading over a new white paper form my friends at FJ Capital up in McLean, Virginia. You may recall that FJ Capital is an investment firm that specializes in the small regional and community banks, and is on board with the trade of the decade theses in a big way. The firm has put up some decent numbers, as they buy the small banks that are part of the fast-developing merger and consolidation wave that is just getting started in little banks. A weak business environment, combined with spiraling regulatory costs, make it pretty much necessary for many of the smaller banks to seek out a partner to deal with the compliance costs. This trend could make investors an enormous amount of money over the next decade.
FJ's paper looked at the current state of the bank M&A market. As expected, we are seeing deal activity pick up in 2014. In the second quarter there were 75 announced transactions, with a total value of $3.4 billion. In the first quarter of the year we saw 58 deals with a value of $2.7 billion. In the second quarter of 2013 we saw 52 mergers with about $2.7 billion of total value -- so there is plenty of activity going on in the small bank space.
Multiples are starting to climb as well. The average price to book value of a deal this year is 145%, compared to just 124% on average in 2013. Acquiring banks are willing to pay up for quality right now; the banks with above-average returns on equity are getting book multiples of almost two right now. The average one-day increase after the announcement is currently at about 32%, so bank investors are making decent gains on their little bank holdings.
The geographic breakdown of merger activity is interesting as well. Most of the deals announced in the last quarter have been in the Midwest and Southeastern portions of the country. There has been surprisingly little activity in the Northeast and Mid-Atlantic regions, and I think that has to change sooner rather than later. The DC-Boston corridor is one of the most over-banked, competitive sections of the country, and consolidation is inevitable in my opinion. There was very little activity in the Eastern region of the country as well. California in particular should also see a lot more deal making during the rest of the year.
That's not to rule out continued strength in the Midwest and Southeast. In the Midwest I still see a lot of cheap little banks that are attractive merger candidates. HopFed Bancorp (HFBC) is a Midwestern bank with 18 offices located in Middle Tennessee and Western Kentucky that needs to be sold to a larger competitor. Earnings for the first half of the year are down compared to a year ago and the bank had underperformed its peers. It has attracted the attention of activist investors and Joseph Stilwell has representation on the board. I cannot imagine he is satisfied with the results and I think he will push for a sale of the bank at a decent premium to book value. With the stock trading at about 90% of book value, there is a lot of upside from the current price to the average deal premium. At 140% of book value, investors buying today could see gains of 50% or more if the bank is sold in the next year.
Charter Financial (CHFN) in the Southeastern US is doing a lot of things right, but they have an attractive footprint, with 16 branches in Georgia, Alabama and the Florida panhandle. So a takeover would be less than a surprise to me. Charter is seeing solid results this year and has been aggressively buying back stock -- so the shares could go higher even without receiving a bid. At 90% of book value the shares are cheap enough to merit consideration as a trade of the decade opportunity.
In its white paper, FJ Financial says: "our research indicates that scale is necessary to handle the ever-increasing regulatory burden facing banks. What size is needed? While not scientific, we believe $3 billion to $10 billion in assets is necessary to handle the increased cost of regulation." That leaves a lot of small banks with less than that amount of assets that are going to need to find a buyer. More than 6,000 banks in the US are under that threshold. That is a huge opportunity for investors to buy these little gems at a discount to book value.