Little Banks, Big Profits

Earlier this week I was lounging around Chez Melvin, contemplating the Orioles playoff chances, reading some brain candy novel and generally minding my own business. This was of course the moment that the Voo-Doo professor chose to share his latest project and sent me a spreadsheet of small bank with less than a billion in assets.  Dr. McNabb  is apparently looking at the same set of facts I used to establish my trade of the decade thesis. Increased compliance costs are going to make it difficult for these banks going forward so they are going to have to seek a merger partner in the very near future. When I spoke with him this morning he said, “With the writers of Dodd Frank favoring the same industry leaders that required a bailout, the small banks will become targets as they will find it easier to sell out than comply with the weight of regulatory excess and loss of business discretion and judgment to pursue opportunities in the marketplace.”

I also spoke to the good folks at FJ Capital the other day on this very subject. The firm runs a community bank stock focused hedge fund and views the market the same way. Managing Director Scoot Cottrell told me, “For many shareholders of community banks with a billion in assets and under, they will likely get better returns on their money from a sale of the bank.  In many cases, the returns that these banks post on equity will be single digits or worse – for a lot of investors, this is insufficient for the risk they take as equity investors.  Returns are going to be lower because many banks are being squeezed from all angles:  higher regulatory costs and higher capital requirements, compressed net interest margins, slow loan growth, still elevated credit costs and regulatory opposition to higher fee income.  While there is definitely a group of smaller banks that will be able to re-invent themselves or survive due to lack of competition or a unique business niche, many smaller banks will be faced with the choice of delivering high returns to shareholders through a sale or paltry-to-dismal returns to shareholders by remaining independent.”

There is another solid reason to focus on the smaller banks. Earlier this week many of the same concerns led the board of Hudson City Bancorp (HCBK) to approve a takeover by M&T Bank (MTB) at a price below tangible book value. The deal should work out in the long run as it is a good fit for both banks. However as a shareholder I made pennies where I should have made dollars. The directors and officers, as well as members of the local community, of the smaller banks tend to have a significant portion of their net worth invested in their bank and are less liley to accept a take under offer. The small deals should be done at a multiple of tangible book value and not a fraction.

In comparing the Professors list of little banks and mine of safe and cheap banks I find a lot of shared names. One of the more intriguing is Berkshire Bancorp (BERK). The 11 branch bank has 11 branches in the New York Metropolitan area and about &880 million of assets. Insiders own 80% of the outstanding shares so no deal that doesn’t fit their objectives will ever get done. The bank is incredibly healthy with equity to assets ratio north of 14 and a nonperforming assets ratio of just .06%, one of the lowest I have seen since the banking crisis began. There will be interesting acquiring the bank but insiders will want a premium price. They are very well run so they may be one of those smaller institutions able to simply grow their way into dealing with higher costs and increased regulations. Either way with the stock trading at just 88% of tangible book value the shareholder should be rewarded with a much higher price over time.

Most of the banks that meet my selection criteria and also have less than $1 billion in assets are way too small to mention on Real Money. As part of constructing portfolios for the Trade of the decade I have been buying community banks with market caps of as little as $10 million. The average capitalization of the merged lists of Dr. McNabb and me looks to be less than $50 million. Your best research on these will be at the local Chamber of Commerce Happy Hour not on Wall Street. You can also use the information available at WWW.FDIC.Gov to check the latest financials and ratios for small banks. Community banks may not be the most exciting investment you ever make but over time they may well be the most profitable.