I have had a restless feeling lately. Something was just off in my world and I could not put my finger on it. I realized this morning that it had been more than two weeks since I had written a column on community bank stocks and all the reasons for buying into the trade of the decade.
That's highly unusual for me, so I shall correct matters as we head into the weekend. I talk to a lot of bankers and investors who buy community bank stocks. I track industry trends, read all the reports from various government agencies and stay on top of industry news.
There are two obvious conditions in the community bank sector that can help us make an enormous amount of money in the years ahead. First is the one I have been banging on the table about for several years. Rising regulatory and technology costs are going to make it very difficult for banks with less than $1 billion in assets to survive as independent banks.
Except for a few niche banks that dominate a small-town market, they have to grow or consider selling to a larger bank. Either works out pretty well for us as investors, so there has been a huge focus the past few years.
The second condition is that the banks with $3 billion to $5 billion in assets are in the sweet spot. They have enough scale to survive. They also are well short of the $10 billion mark where the extra regulation from the Consumer Financial Protection Bureau and fee restrictions of the Durbin Amendment kick in and increase the costs of doing business.
If they are so inclined, they can make several acquisitions before they start bumping on the $10 billion mark. They have achieved cost savings that can be used to grow the bank or reward shareholders with buybacks and dividends.
Once a bank crosses the $1 billon survival level, the next goal is to get to the sweet spot. I first wrote about these bubble banks back in October after talking to a bunch of bankers at the FIG Conference in Atlanta, and I think this is another segment of the trade of the decade with enormous potential. Once they cross that $1 billion mark and have achieved scale there, I see two likely outcomes for the bubble banks over the next few years. Some will make acquisitions to get to the sweet spot.
That's a good thing for us as investors. In last week's Barron's, David Ellison, the manager of the Hennessy Small Cap Financial Investor (HSFNX) said, "I've made most of my money over the years buying the good buyers (of other banks) and holding on, banks that make eight to 10 acquisitions over a decade, don't overpay and create a real company that's worth something."
Bubble banks that are smart buyers on their way to the sweet spot can make us a ton of money.
The other option for the bubble banks is that someone buys them on their way to the sweet spot, or one of the sweet-spot banks,buys them to expand their franchise. Of course. that will be wildly profitable for investors as well. I think that if we buy bubble banks for less than book with an emphasis on those that have activist investors involved, we can do very well over the next several years.
Xenith Bankshares (XBKS) is a great example of a bubble bank worth considering. The bank actually comes under the bank holding company of a private equity firm. BankCap Partners is a private equity firm that owns 27% of the bank after purchasing stocks during 2008 at the height of the credit crisis when ownership rules for banks were loosened.
Since then, the bank has done several acquisitions and now has about $970 million in assets, so it is right on the edge of the bubble. The bank serves the Washington, D.C., Northern Virginia and Richmond markets with eight branches. The bank is in great financial shape with an equity-to-assets ratio of 12.1 and nonperforming assets of just 0.82% of total assets.
The bank caters to middle-market and small businesses, local real estate developers and investors, private banking clients and select retail banking clients. This preference is reflected in the loan portfolio, as about 70% of the loan portfolio is in commercial and industrial, commercial real estate, construction and development and multifamily housing loans.
Concerns about loan concentration are abated somewhat by the fact that the Northern Virginia and Washington markets tend to fare much better than the rest of the country during recession because of the large government presence in the market.
BankCap Partners is not the only investor who likes Xenith. Wellington owns 7.4% of the bank and Basswood Partners, Maltese Capital and Banc Funds LLC all have a stake in the bank. The bank is on the bubble and looking to reach the sweet spot, and that will lead to large gains for both the private equity firm bank specialists and investors who jump on board now.
We will spend more time on the bubble in later columns.