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

The Small Banks That No One Noticed

Regional and community banks are great opportunities.
By TIM MELVIN Nov 03, 2014 | 01:00 PM EST
Stocks quotes in this article: BABA, HMST, SHBI, ESSA

As we continue to move into earnings season, all the chatter is about growth. Who is growing? Are the big tech companies going to hit their numbers? Who is posting big earnings surprises and beating the analysts' estimates? This week, we have big reports form a lot of REIT, healthcare. and energy companies. Traders will be guessing and second guessing the numbers all week.

Alibaba (BABA) will have its first report tomorrow, and that one has folks breathless with anticipation. I was going off some results last night and what I found was that one of the best growing sectors this quarter is the little banks that make up the trade of the decade.

A big part of the earnings growth in the little banks is a result of improved credit conditions. Non-performing asserts have declined for 11 quarters, across the banking industry. The bad loans that had caused the credit crisis have been reworked, paid off, or simply written off. Many little banks sold off their non-performing loans to distressed hedge funds and other institutional investors. Underwriting standards are a lot tighter than they had been before the blow up, and a lot less money is being set aside to cover potential bad loans. In some cases, reserves are being released, which adds to earnings.

There is some is moderate loan growth in some sectors of the country. According to the Fed, total loans and leases were up 6.7% through mid-September. Commercial and industrial (C&I) lending and commercial real estate (CRE) are driving the loan growth. C&I loans were up 12.1%, and CRE loans were up 7.3%. We are still a long way from the peak lending pace of 2007, but things are getting better for the banks, especially smaller regional and community institutions.

Take a look at Seattle-based HomeStreet (HMST). Seattle based bank has 30 branches and 44 lending offices in the Puget Sound, Eastern and Southwest regions of Washington state, and also in Portland, Oregon and Hawaii. The bank reported earning s last week, and the numbers would make a growth stock manager blush. HomeStreet earned $0.33 per share in the quarter, compared to just $0.11 in the year-ago period. Not only was it a huge increase, it also was the fourth consecutive positive earning surprise. The good times should continue, as HomeStreet is acquiring California-based Simplicity Bancorp (SMPL). The deal will increase operations to more than 100 branches and offices, and $4.1 billion in assets. In spite of the strong report, HomeStreet shares are actually down over 12% year-to-date.

Shore Bancshares (SHBI) was one of the very first banks I bought as part of "the trade of the decade," and it has been one of the most frustrating banks as well. Plagued by credit problems for far longer than most small banks, it now appears to have turned the quarter. The bank is back in the black, reporting $0.10 per diluted common share for the third quarter of 2014, and a net loss of $1.35 a year ago. Nonperforming assets decreased by $13 million, or 42.7%, and accruing troubled debt restructurings decreased by $19 million, or 43%, as a result of the sale of a package of bad loans. The company sold stock this year, and the ratio of total tangible equity to total tangible assets was 11.58%, up from 8.41% at the end of 2014. Shore is well-positioned to be a growth bank, but it still trades at about 85% of book value.

ESSA Bancorp (ESSA) is another of my long-time bank holdings, and it just keeps chugging along. The bank saw a more-than-15% year-over-year improvement in earnings. During the quarter, the bank closed on the acquisition that allowed them to expand into the Wilkes-Barre and Scranton areas of Pennsylvania, and that should add to earnings going forward. ESSA showed solid gains in total assets, loans, deposits and shareholders' equity during the quarter. Non-performing assets dropped to 1.59% of total assets from 1.89% a year ago. It was just a solid quarter for this bank, and they appear be on a growth trajectory. Management continues to reward shareholder, as ESSA repurchased 48,100 shares at an average cost of $11.40 per share. The stock is trading at just 85% of book value, and the bank is a bargain growth issue, as much as a value stock, at this price.

The small bank sector is improving. Credit problems are fading, earnings are improving, capital levels are at near-record levels, and dividends and buybacks are rewarding shareholders throughout the sector. On top of that, M&A activity has been picking up all year, and acquisition multiples have increased to over 1.3x book value. The small regional and community banks are the best opportunity for investors right now, as no one appears to be noticing the improvements, and the stocks are still very cheap.

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

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

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