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

Small Banks Are the Gems

Difficulting in banking is creating an opportunities for small banks.
By TIM MELVIN Oct 21, 2014 | 02:00 PM EDT
Stocks quotes in this article: HTBI, ESSA, BAC

My reading of the Beige Book this weekend didn't really change my world view, but it did reinforce my view on the banking sector. Last month, the general trends in banking were favorable once again. According the Fed, "In most Districts, banking conditions continued to improve relative to the previous Beige Book, with net increases in loan volumes reported in a number of Districts."

The credit problems are fading away, and we are returning towards some level of normalcy in banking activity. The Fed mentioned that there were no reports of deterioration in credit quality in any of the districts, and credit standards generally remained unchanged.

Business loan and commercial real estate demand were the real drivers of bank loan growth during the month. Mortgage demand remained weak in virtually all of the districts. The Philly Fed said there was a very low level of demand for new mortgages and negligible demand for refinancing loans. Competition for new mortgage loans was fierce. Banks are currently looking towards commercial customers and other products, such as auto lending, to drive loan growth.

As earnings season unfolds, net interest margins will continue to be a problem for most banks. Looking at the reports that have come in so far, the majority of them are reporting yet another small decline in net interest margin. Coupled with the small growth in loan volumes, it is still tough to make money in banking. Organic growth at a pace that would satisfy shareholders is difficult to come by. Along with the rising costs of regulatory compliance, this situation is going to continue to drive merger activity in the banking sector.

The smaller regional and community banks that are healthy are going to fall into one of two categories over the next few years. They will either be acquired by another bank looking to buy growth in assets or earnings, or they will become survivors that can compete against and take market share form the big banks that dominate the industry. This is a win-win for banking stock investors.

HomeTrust Bancshares (HTBI) of North Carolina could fall into either category over the next few years. The bank has made several acquisitions in the past few years to expand in the Southeast. HomeTrust has just converted from mutual thrift status in 2012. It has made three acquisitions since, and it has a pending purchase of branches in Virginia from Bank of America (BAC). Unlike most banks that have seen assets decline or could barely stay even, HomeTrust has doubled its assets since the start of the meltdown in 2008. Management is committed to growing the bank by smart acquisition and expansion across the Carolinas, Tennessee and Virginia.

HomeTrust has what it takes to be one of the Darwinian "survival of the fittest" small regional banks, but I would not be shocked to wake up one day and find that someone had made an offer to buy the bank. They have a very attractive branch network, and the stock is cheap enough at 85% of book value. Of course, management is not interested in selling, so the offer must be well above the current takeover multiple of 1.3x book value to have any chance of being accepted.

ESSA Bancorp (ESSA) is another former mutual thrift that is committed to growth. It has recently completed an acquisition that allows expansion in the Wilkes Barre and Scranton region of Pennsylvania. The bank is open to more acquisitions in this region in the future. ESSA is also using its capital to reward shareholders, as it has recently announced a new buyback plan, and the shares yield 2.45%. ESSA has what it takes to be a survivor, but again they have an attractive presence in their market, and the stock is cheap at 80% of book value.  Officers, foundation directors and ESOP insiders own almost 40% of the shares, so it would have to be a very attractive offer to generate serious interest. With the stock trading at 80% of book value, ESSA Bancorp appears to be a definite win-win community bank stock.

Most of the credit problems are in the past, but growth is still difficult. This is creating a win-win situation in small banks stock that will last for many years. If you are not investing your long-term funds in small banks, you should be.

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At the time of publication, Melvin is long HTBI and ESSA.

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

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