When my son was in middle school he would mark the calendar for Shark Week on Discovery Channel. All activities of that week were then scheduled around shark shows on that network. While I cannot give you quite that level of excitement this week I do think it will be useful to declare the holiday shortened week to be Bank Week. Bank stocks, especially smaller regional and community banks offer extraordinary upside from these levels as real estate and the economy begin the long healing process in the aftermath of the credit crisis.
I have referred to these stocks as The Trade of the Decade and I think that is still the case.
Bank stocks were the hardest hit when the market melted down in 2008 and first quarter 2009. Plagued by bad loans, tightened credit standards and non-existent loan demand they have been among the slowest to recover. Many institutions were shut down and many more were sold to competitors under special loss sharing arrangements between the acquiring institution and the FDIC. Although credit problems have begun to ebb as the python of stupid loans has worked its way through the system it is still difficult for many banks to generate real profit growth. Since most investors overly focus on the income statement this has weighed on the price of the shares. For those of us who prefer the balance sheet this is creating a real opportunity.
Many banks, especially smaller ones, trade at a significant discount to the tangible value of the underlying assets. This is significant as historically banks have corrected back above book value and mergers in the industry take place at a premium to the tangible book value. It is an almost certain guaranteed lock that we will see an enormous wave of Merger and Acquisition in the industry over the next few years and most of these transactions will occur over book value. As economic and industry conditions improve that multiple of book will increase and if this time rhymes with the last few times this has occurred the takeover premium will reach a multiple of more than 2 times tangible book value.
The simple truth is that it is simply going to be in the banking business, particularly if you are a smaller institution. As we have heard in our talks with bank stock investors like PL Capital, FJ Capital and others running smaller banks is going to be extremely difficult for the next few years. Regulatory costs are going to go up and capital requirements are likely to head higher as well. Net interest margins will remain low as long as the fed keeps rates down in an attempt to stimulate the economy. Loan demand is going to stay well below pre-crisis levels as well until we see more robust economic growth. Growth is going to be hard to come by for many institutions and organic growth will be close to impossible in many areas of the country. The only way to grow will to be buy a competitor.
Another factor leading to a merger wave is the simple fact that it just not a lot of fun to be a banker these days. Most of the last four years has been spent dealing with problem loans and cleaning up related messes. Now the regulators are an increased presence and regulations are being added and changed almost daily. Costs of compliance are going up and staff is being hired specifically to deal with compliance issues. At the same time net interest margins are shrinking and it is harder to make money.
At the smaller banks this is further complicated by the fact that the share price is down and much of your shareholder base if friends and neighbors. Being grilled about the stock price of your bank every time you go to a little league game with your kids or a social function is wearing to say the least. For many banks, especially its with older officers and directors, it is a lot easier to just sell the bank and move on rather than continue to navigate the troubled waters that are the banking industry today.
There are tremendous opportunities for long term investors in banks right now. There are the perfect TOD banks, smaller banks with strong balance sheets and clean loan portfolios that will either be sold or gain market share at competitors expense. There are troubled banks that have attracted private equity or activist investors’ attention. There are banks that will be aggressive acquirers and experience strong earnings and asset growth over the next five to 10 years. TARP Warrants from larger banks also offer the opportunity for profits in multiples and not percentages over the next few years. Investors who ignore banks do so at peril to their net worth as this truly is the trade of the decade.
Over the past two years the Trade of the Decade in bank stocks has taken shape nicely. I have suggested and purchased dozens of little banks, and even a few larger ones and they have done pretty well so far. We have had a few takeovers along the way already but nothing like we will see over the next three to five years. Credit conditions have slowly but surely improved and banks have reorganized or disposed of many problem assets during this period. This morning Moodys upgraded the industry from a negative outlook to stable as a result of improving conditions. In spite of the improvement there are still plenty of bank stocks to buy as Wall Street continues to focus on the earnings outlook for small banks and not the asset value and potential for M&A activity.
The first group of banks that make up a TOD portfolio are those smaller banks that are just sleepy little banks that no one really notices. They have solid loan portfolios, an adequate or even excess amount of capital and the shares still trade below tangible book value. They are not making headlines and they won’t be the subject to cocktail party chatter unless you happen to live in their hometown and have an account with them. Until they day they get taken over they probably won’t be the short term performance leader but my experience has been that if bought right these stocks will almost always be among your top long term performers.
One such bank Is ESSA Bank and Trust (ESSA) a 26 branch bank located in Stroudsburg, Pennsylvania. I have owned this stock for some time and it really has not done a whole lot over that time. They bought First Star Bank last year to increase their presence in the Lehigh Valley and the purchase is working out well for them already. The stock trades at 83% of tangible book value and the equity to assets ratio is a little over 11. The balance sheet is in good shape with nonperforming assets at just about 2% of total assets.
The Berkshire Bank (BERK) is another bank that has been on my list of bank stock buys for what seems like forever. This is a 14 branch banking institution with 793 million in assets located in New York City. The stock trades for less than 90% of tangible book value and they have plenty of capital with equity to asset ratio of more than 16. The loan book is rock solid with nonperforming loans at just .39% of total loans. It is not a particularly exciting stock but is a well-run, profitable financial institution that is both safe and cheap at the current price.
Taylor Capital Group (TAYC), the parent of Chicago based commercial bank Cole Taylor bank could easily be the poster child for the improvements we have seen in the banking industry. The bank serves closely held business and the people who own them and also engages in asset based lending, commercial equipment leasing and residential mortgages. The bank has steadily worked down the problem loans and real estate and the economy improved and total non-performing loans has fallen from more than 5% to less than 2% at the end of March. In spite of improving conditions the stock still trades for just 80% of tangible book value at the current price.
The San Joaquin Valley of California was ground zero for the real estate collapse but at least one bank in the region has managed to stay in good shape throughout a difficult time in the region. The Fresno based bank. Central Valley Community Bank (CVCY) is a 33 year old bank with 17 branches and $885 million in assets. They just received approval to buy Visalia Bank which will give them 21 branches and more than $1 billion in assets when the transaction closes. The bank has non-performing loans of just 1.24% of total loans and the equity to asset ratio is a very healthy 13. The stock currently trades at just 90% of tangible book value. As California and the Central Valley recover this stock should do extremely well for long term investors. Patriot Financial Partners, a bank focused private equity group owns 11% of the shares and one suspects they are looking for a long term payoff of many times the current stock price.
The core of a Trade of the Decade portfolio is made up of what are pretty boring little stocks. They will move like bunny rabbits over time trading in a tight range before leaping ahead on good news or possible takeover offers. Patience pays with these stocks but the small bank stocks have the potential to be the best investment of your lifetime.
I want look at some banks that might fall outside the definition of perfect bank. They may have loan losses that are a little , or even a lot, higher than the perfect little bank standard, but conditions are improving. They may need to raise some capital to get the equity to asset ratio up towards my preferred levels. They have more scars and bruises than perfect little banks but there is still tremendous upside. Most importantly they have attracted the attention of an outside investor or private equity firm with a record of successful bank stock investing. Often these investors are activists who intend to take an aggressive stance towards unlocking shareholder value.
A perfect example of this type of stock is HopFed Bancorp (HFBC) of Hopkinsville Kentucky. The bank does business in Kentucky and Tennessee with 18 branches and $978 million in assets. The bank has come under fire from noted activist Joseph Stillwell as he pointed out that that management had no business going forward with an acquisition of another bank when they have delivered so little returns with the assets already under their control. Stillwell has advocated for a sale of HopFed to another institution to unlock the value of the shares. He has a point. The stock trades at just 80% of tangible book value and has adequate capital. Nonperforming loans are just 1.30% but returns on assets and equity are well below their peers. Mr. Stilwell won the first round of the fight by having his nominee elected to the board a few weeks ago. I would not be surprised to see the pending purchase of a neighboring institution cancelled and HopFed put up for sale in the near future. PL Capital and Arbiter Partners are also shareholders in the bank so there are a lot of smart eyes on the bank which could help force a sale.
United Community Financial Corp (UCFC) is another bank starting to attract attention form noted bank stock investors. The Youngstown Ohio based bank has 33 offices and $1.8 billion of assets. The bank has struggle with asset quality as nonperforming loans are still a little north of 4%, well above the national average in a recovering market. They have been making substantial improvements. In the first quarter of 2010 total nonperforming assets were above 8% of total assets. Today they are down to 3.32% of total assets. The stock trades at 80 % of tangible book value so there problems would appear to be discounted in the current quote. The equity to assets ratio is 10 so they appear to have enough capital on hand to navigate through the troubled waters. At least two noted bank investors think so as EJF Capital has been a buyer of the stock and our old friends at FJ Capital just filed a 13G disclosing ownership of more than 5% of the bank. The bank raised additional equity earlier this year in a private placement and conditions are slowing improving. As the economy recovers and the Youngstown market begins a long slow recovery this bank should see their problems disappear and profits to begin growing once again.
Cape Bancorp of New Jersey (CBNJ) is another bank that has been showing up in the portfolio of seasoned bank stock investors. Michael Price, PL Capital and EFJ Capital are all owners of the 15 branch, $1 billion in assets institution. The bank serves the Cape May and Atlantic County areas of New Jersey including the beach towns of Wildwood and Atlantic City. Non-Performing loans are declining from almost 6% a few years ago to just 2.57% right now. The bank is still chipping away at its other real estate owned portfolio with the total decreasing by $1 million last quarter. As the economy improves the banks should see strong profit growth and is also a takeover target given its attractive service area. The shares are trading right at tangible book value and they have plenty of excess capital which they are using to buy back stock.
I also want to take some time and suggest some more little bank stocks that do not necessarily fit firmly into the perfect bank category. These banks aren’t in perfect condition and are fighting through the cleanup of the loan portfolio and super slim net interest margins. Bankers are one of the few groups of people who would like to see higher interest rates right now. Richard Lashley of PL Capital told me earlier this week that most bankers would like to see higher rates across the curve to widen interest margins and make it easier to produce lending profits. He thinks a perfect world would be a 2% cost of funds and loan rates around 5.5-6%. Until that happens profits will be compressed and in the income statement focused world of Wall Street that may keep the profits lower than normal into next year. That gives us asset types time to accumulate these stocks at favorable prices.
One bank that catches my eye at the current price is Newbridge Bancorp (NBBC) of Greensboro North Carolina. The bank has 30 branches in the Piedmont and Coastal regions of the state and has total assets of $1.7 billion. The ban recently repurchased the TARP warrants it had issued to the treasury and its TARP preferred was auction off in the first week of May. The bank disposed of over $160 million of troubled assets in 2012 and raised $56 million in new capital to shore up the balance sheet. The lack of losses related to problem loans caused the bank to see a huge jump in earnings of the first quarter and the are positioned to continue that trend. They are seeing organic loan growth and have added experienced commercial banking team to help grow that business in the Charlotte and Raleigh regions of the state. The shares are cheap at 70% of tangible book value and the equity to assets ratio currently stands at 10. After disposing to troubled asset nonperforming assets are now just 1.21% of total assets. This is a very cheap bank in one of the strongest economic regions in the state and is an excellent addition to a Trade of the Decade portfolio.
I touched on Simplicity Bancorp (SMPL) a few months back when I reviewed California banks. This bank used to the credit union for employees of Kaiser Foundation Hospital and concerted to a mutual saving bank in 199. In 2010 they converted once again to a stockholder owned institution. They function as a community bank with 9 offices and $882 million of assets. The still have plenty of capital with equity to assets ratio of more than 15. With the stock at 80% of tangible book value management has been buying back stock and pay shareholder dividends of 2.2%. Non-performing loans are 2.72% of total loans and have been improving over the past few quarters. Given its presence in the LA market I would not fall out of my chair if I saw a takeover offer for this bank early in the M&A cycle.
Mutual First Financial (MFSF) is another bank I have discussed in the past. PL Capital has a large position in the bank and owns more than 5% of the stock right now. Former hedge fund superstar Jeffrey Gendell has more than 4% of the shares as well. The bank is moving to add commercial and consumer lending to their loan portfolio as they are overly exposed to residential real estate. The Muncie Indiana based bank has 32 branches and $1.4 billion in total assets. If we see a proxy fight between outside investors such as PL Capital and current management it could get interesting. The board and officers are fairly young and own a good deal of stock so they may choose to fight back. With shares trading at 80% of tangible book value it is a decent buy for a long term bank stock portfolio.
The trade of the decade is developing and is reaching the sweet spot. By the end of the year we should see merger and acquisition activity begin to pick up. I think this sector is going to soar by multiple five to ten times the current quotations over the next decade. The train is building up steam and the time to board is now. I was asked yesterday if I worried about the market direction when I was buying bank stocks. Other than my insistence on not buying up days I really do not. I am buying these for what is going to happen over 5 to 10 years not next quarter or even 2014 for the most part. Any weakness that is market related just gives me a chance to buy more at better prices. I firmly believe that buying community banks today will be helping me pay for my books and wine collections well into the 2020s.