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

Run for Shelter in Community Banks

It's unlikely that they will be hit by Europe or the Ebola scare. 
By TIM MELVIN Oct 16, 2014 | 12:00 PM EDT
Stocks quotes in this article: NFLX, WMT, ABBV, ESSA, PBIP

Another day, another opening swoosh for stocks. The usual suspects still hold sway, including weak Europe, Ebola and falling oil prices. They're all influencing the down move in stocks. Bad earnings reports from leaders like Netflix (NFLX) were not helping this morning. Wal-Mart (WMT) is lowering its sales forecasts, which would seem to put the lid on any optimistic economic forecasts. Risk arbs are getting hurt pretty badly as the AbbVie (ABBV) deal falls apart. There is not a lot of good news anywhere, and investors are starting to realize that the global central banks may not be able to solve all our problems.

While I own the energy and resource names that are getting absolutely blasted right now in this market environment, I am hoping we continue to see prices fall. Coming into all this, I have been holding lots of cash, especially in a newer portfolio like the "don't lose my money or I'll kill you in your sleep" IRA rollover portfolio we started for my wife earlier this year. I have been staying small and moving slowly, and that strategy could be about to finally pay off.

Cash is the worst asset on earth, until it is not. I have heard a lot of flack this year as people wondered how I could suggest keeping large cash balances in a zero-rate world. Now it's a buffer against dropping prices and valuable ammunition to load up on bargains. I view my portfolio as three separate accounts. In the international portfolio I am about 40% in cash and my domestic account is over 50%. If and when stock prices continue to fall, I will be in a great position to buy safe and cheap stocks at bargain prices. Over the next several years, that should pay huge dividends for me.

We have not created any new inventory just yet, but we are getting close. I ran a screen of almost-but-not-yet-there stocks last night. I found that here in the US 169 stocks are safe, pay dividends and are profitable, with sound balance sheets. They have dropped more than 10% in the past month and now trade between 90% and 120% of tangible book value. Internationally, 197 stocks are safe and almost cheap enough. That's a huge potential bargain bin for deep value investors.

The third section of my portfolio is about 25% cash, and that just because I have not been filled on all my limit orders to buy these very illiquid mid-cap stocks. If they all went off at once, I think I would actually be about 10% levered in this part of my portfolio. Most of the time, these stocks are somewhat exempt from broad market moves.

A community bank stock is not going to move in reaction to an Ebola scare, unless a case breaks out in the lobby. As a rule, events in Europe won't have much impact on a little bank like ESSA Bancorp (ESSA) in East Stroudsburg, Pa. Falling oil prices are probably a net plus for depositors and shareholders of Prudential Bancorp (PBIP), as folks in Philadelphia will have a little extra cash to deposit.

I have outlined the case for community banks often. The wave of regulations in the aftermath of the credit crisis has caused regulatory and compliance costs to soar. Low interest rates have compressed net interest margins, and it doesn't look like that is going to improve any time soon. Loan demand is better than it was, but a long way from great. There is a combination of factors that are going to push these smaller banks to merge with larger institutions. Those banks that do not merge will be these small banks that dominate their local marketplace and are financially strong and highly profitable.

My trade of the decade portfolio is full of small banks that are well capitalized, with equity to asset ratios over 10. Their loan portfolios are solid, with most of them having non-performing asset ratios below 2. I bought most of them around 80% of tangible value and in some cases less. Currently the average takeover multiple is around 1.3x tangible book, so there is plenty of upside in these stocks. Many of them have activist investors pushing to unlock shareholder value and sell the bank at a premium. These banks are increasing dividends, as well as buying back stock, and rarely respond to market movement.

Yes, the beating I am currently taking in energy, resources and European banks is a bit painful. However the enormous holdings of lots of cash and community banks give me a huge cushion without giving up upside potential. As a bonus, if we keep falling I have dry powder to take advantage of bargains.

If you are not invested in the trade of the decade in community banks, you should be. It is the make money and sleep at night investment opportunity.

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At the time of publication, Tim Melvin was long HFBC, PBIP.

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

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