I have been preaching the small-bank gospel for some time now. I first discovered this sector back in the 1990s as a broker when I realized that one older fellow at my new firm was making a ton of money in spite of the fact that he really didn't work very much. He slid into the office at 9:25 every day, was one of the last faithful practitioners of the three-martini lunch and was never late for happy hour in the almost 20 years I worked with him. I spent a little time talking with him, picked up a few super-sized bar tabs and got the secret of his low-work, high-pay approach to life.
Our firm made a market in every small bank in the Mid-Atlantic region, and he was socially connected to all the developers, Realtors and bankers in town. For years, my friend had handled all their buying and selling of the small banks in the area and had become the go-to guy for community bank stocks.
As I investigated the little banks we traded for our customers, I realized this was indeed a gold mine. They all traded below book value in the aftermath of the savings-and-loan crisis in spite of being fairly healthy banks. I added small banks to my repertoire and the rest is history. It has been my favorite investment sector and I have made more money for myself and others in small banks than in any other sector over my career.
I am familiar with all the ridiculous objections to investing in small banks. They are illiquid and hard to trade is one of the biggest objections I here. They are hard to buy and can be even harder to sell. Of course, Roger Ibbotson's study has proven that illiquid, undervalued stocks are far more profitable than large, liquid-growth stocks, but some people just seem to need the action.
I happen to think the illiquidity is one of the main reasons people do so well with these stocks. Large liquid stocks are like a coffee can full of money that you can dip into any time you choose. You can even move it to another can several times a day but you will drop some coins each time you do. Illiquid community banks are a stack of money in a safe with a 19-digit combination wrapped in barbed wire. As a bonus, the money is growing at a decent rate and every once in a while someone will want pay you a $1.50 for the $1 bills you have in there. It is hard to get the money out and takes time, forethought and preparation. As a result, you tend to leave it in there and let time and the long-term bank consolidation trend do their job.
The other complaint is that they just are not exciting. That is very true. They do not trade a lot. They are not in the headlines every day and no one at the cocktail party wants to talk about your position in Hamilton Bancshares (HBK) or ASB Bancorp (ASBB). They are not shiny or exciting, they have no drugs in clinical trials that cure nose condensation and only cause minor anal leakage and heart attacks, you can't wear their products on your wrist like Dick Tracy and they don't even have a decent search engine. They take deposits and make loans and that's about it. They are very boring and they trade like bunny rabbits. They sit still for long periods of time and only jump when things like dividend increases and new buybacks are announced. Of course, when a 13D is filed by an activist or a takeover offer is made, they take off like a magic money bunny to bring you outsized profits.
The long-term math of small-bank stocks is exciting. If we buy them right, math and time are ever in our favor. As the economy just sort of grinds along, the book value of these banks is growing every year. Community bank earnings grew by 12% year over year, according to the FDIC quarterly report released last week. A lot of that will be reinvested and grow the value of the bank. As time goes by, the premium larger banks are willing to pay to buy a smaller one will grow as well. Since 2011, the growth rate of the takeover premium has increased by about 5.5% and is now at 1.35x book value.
Let's put the math to work for us. Let's say we buy a bank stock with a $10 book value and we pay my preferred price of 85% of book value. Over the next three years, management grows the book value by reinvesting profits and buying back stock by about 7% a year. That's what Chris Marinac of FIG Partners, a community bank research and trading firm, tells me he thinks community banks will grow in book value over the next few years on average. Let's say the takeover premium continues to grow by 5.5% a year, and at the end of three years a larger bank buys your bank for 1.6x book value. You cash out with an annualized return of 33.01%. If the takeover premium just stays the same, your return slips all the way to just 24.85% a year.
What if management doesn't perform and book value just stays the same? Assuming the takeover multiple grows as expected, buying the bank at even 90% of book value and then selling to a larger bank in three years, your return is a paltry 14.47% a year. That's only a little more than 40% better than the long-term return of the markets and 95% or so of all money managers and hedge funds, so why would you bother? After all, according to the research firm Dalbar, you could mirror the average individual investor's account, chase hot stocks and earn less than 3% annually without ever owning these boring little banks no one ever heard of or cares about.
We are in the early stages of a long bank consolidation wave. Regulatory costs are soaring as a result of post-credit crisis legislation. Technology costs for things like cybersecurity and mobile banking will also continue to grow. It is harder for smaller banks to go it alone, so they will be looking for merger partners. Larger banks will be looking to buy growth in a low-growth economy. There are larger pools of banks that will need to sell and an equally larger pool of banks that look to buy to grow assets and earnings.
Investors who buy smaller banks at a discount to book value and sell at a premium over a few years are going to make an enormous amount of money. They are not liquid and they are not exciting. But they can make you rich if you are disciplined and patient.