The Calm During the Storm: Finding Yield in Community Banks

 | Sep 02, 2016 | 12:00 PM EDT
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The first hurricane in a few years has come and gone from Florida, and here in central Florida all we got was some wind and lots of rain from the outer bands of Hermine. The rain was quite heavy at times, which means DirecTV didn't work much, so it was a good evening for sitting around reading and thinking. I have been thinking about income investing and banks most of this week and it occurs to me that we can combine the two to find an alternative solution for yield-starved investors.

Community banks have historically been pretty generous with dividends to shareholders. Many of them have a local shareholder base that is made up of many of their friends, neighbors and customers, so sharing the wealth via dividends is a good way to keep shareholders happy and lessen the risk of your house being TP-ed on a regular basis. Many had to reduce and even eliminate the payout during the credit crisis, but we have seen payments resume and grow as the banking industry has gotten better over the past seven years.

It is a simple matter to find smaller banks with generous payouts to include in an income portfolio. While I don't think you need to be as strict about valuation as we are in a Trade of the Decade portfolio that's more focused on capital appreciation, you do need to make sure you are buying yield at a reasonable price. Paying too much over book value, or too high a PE for small banks, can be a recipe for disaster, so some caution is suggested.

One of my favorite community bank income picks is BCB Bancorp (BCBP) . The Bayonne, N.J., bank has 15 branches with about $1.7 billion in assets in the northern New Jersey and Staten Island, N.Y., markets. While there are some concerns about New York metro area real estate prices, the bank has a nonperforming assets ratio of just 2.07% and appears to be doing a good job of underwriting and managing the loan portfolio so far. The shares are trading at about 90% of book value and yield 5.08% at the current price. While neither have large positions that would require a 13D, I do see that both Lawrence Seidman and PL Capital have a stake in BCB Bancorp as of the end of the second quarter. Insiders own about 10% and have been buying all year, so management has some skin in the game.

I count 14 small banks that trade for book value or less and have yields of 3.5% or more. Another 13 have a yield above the 3.5% threshold and fetch less than 1.2x book, which would be my upside cutoff for a community bank income portfolio. Most are too small to mention here, but interested investors can find them using a stock screen rather quickly.

There is another way to find income in the community bank sector. StoneCastle Partners (BANX) is an investment firm that specializes in community banks. The firm has been around since 2003 and is one the largest investors in community banks and I have stolen some profitable ideas from them over the years. Their asset management division advises a closed-end fund that is focused on providing income by investing in preferred equity, subordinated debt and common equity investment. The fund invests in banks that they think have experienced management teams, stable earnings, sustainable markets and growth opportunities.

I went thought their portfolio this morning and I am familiar with most of the banks in it and own common equity in many of them. The current portfolio mix is 38% in preferred, 23% in credit securitizations, 21% in trust preferred securities, 15% in term loans and other debt securities and the remaining 3% in common stock and other securities, with most of their investment carrying a rating of BBB or better from Kroll Ratings, an agency that specializes in financial institutions.

The fund shares are trading at about a 13% discount to net asset value right now. The fund just raised the quarterly payout to $0.37 a share, so the yield is 8.03%, which is a very attractive alternative to most other income alternatives today.

Using community banks and a closed-end fund specializing in community bank income securities to round out an income portfolio makes a great deal of sense to me. Community banks remain the most attractive sectors of an overheated market and income investors should not hesitate to buy community bank income-producing investments.

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