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Think Small Banks for Big Profits

April 30, 2014 | About:

The banking industry avoided the attention of activists, for the most part, as the industry was still recovering from the financial crisis and the regulatory outlook was very uncertain.

Buyers were unwilling to step up to the plate, absent some clarity of what the future would like from a regulatory point of view. But according to a recent Harvard Law School forum, that is all about to change.

A post from William Sweet, partner and head of the Financial Institutions Regulation and Enforcement Group at Skadden, Arps, Slate, Meagher & Flom LLP stated, “With resolution of some of these uncertainties, and some improvement in the bank M&A environment (which is becoming more active among smaller community banking institutions), banking organizations can expect greater attention from activist investors.”

Related: The Global Search For Cheap Investments

This could be a real boon for investors in the smaller community banks and thrifts. In a presentation at the recent Balue Investing Congress in Las Vegas, Richard Lashley of activist investing firm PL Capital pointed out that industry fundamentals have almost returned to pre-crisis levels, but the stock prices of the smaller banks are still very cheap when compared to tangible book value.

He also noted that we've had a cyclical consolidation wave in the industry for some time, with the number of U.S. banks dropping from 18,000 in 1984 to less than 7,000 today. And according to Mr. Lashley, we are going to see a cyclical surge in bank M&A deals that should last another three to five years, at least.

PL Capital and other investors, such as Joseph Stilwell and Lawrence Seidman, are experienced activist investors who have specialized in community banks with a great deal of success over the years. They have forced the management of these sleepy little banks to focus on shareholder value by adding buyback plans with the stock trading below book value.

In many cases they have forced the outright sale of the bank to a larger competitor, at a large premium to the prevailing stock price. They have been focusing on those banks that are too small and, as Mr. Lashley pointed out in his presentation, cannot justify remaining independent.

Investors would be wise to piggyback with these investors, as there is an enormous amount of money to be made in the sector over the next few years — as the small banks sell out to larger regionals banks that need to buy growth in a slow economy.

Chevoit Financial Corporation (CHEV) is a great example of the type of bank these activists are focusing on right now. The branch bank in Hamilton County, Ohio has 13 branches with about $589 million in assets. The bank has plenty of capital, and has equity to asset ratio of 13.78, well above the industry average of 10.54. The loan portfolio has shown steady improvement, and nonperforming assets are just 1.87 percent of total assets,

In spite of the improving conditions the bank is trading at just 77 percent of book value, and all three of the activists have a stake in the bank. The stock pays a 3.41 percent dividend, so you get paid to wait for the activists to push the stock higher over the next few years — or force an outright sale of the bank to a larger competitor.

Tracking the activists in the smaller banks around the country requires a lot more work than just turning on the television to see what Carl Icahn or the other big activists have been buying. You will to dig through 13D and 13F filings on a regular basis, but you should be very well rewarded for your efforts. The industry continues to present opportunities similar to these for value-investors who can weed through the daily noise of the market. A perfect example is the 3 Low Risk, High Yield Stocks that Tim Melvin identifies as the trades of the decade.

© 2014 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

Read more: http://www.benzinga.com/general/education/14/04/4499812/think-small-banks-for-big-profits#ixzz30KASstpu

About the author:

Tim Melvin
Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, adviser and portfolio manager. He has also written and lectured extensively on the markets with his work appearing on RealMoney.com, DailySpecualtion.com, Benzinga.com as well as several print publication including Active Trader and the Wall Street Digest.

Visit Tim Melvin's Website


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Comments

Enjoylife
Enjoylife premium member - 2 months ago

Hi Tim,

Thank you for the article. I too have been interested in bank stocks since the financial meltdown. Obviously there has been some good value there.

But I can't see the value in these small banks. I once saw Buffett talk about banks and he gave me some good insight into how he thinks about them. Obviously with WFC and BAC being two of his five largest holdings, he is extremely well versed in the banking game. Anyway he said "If you can buy a bank that gives you 1% ROA (over time) at 1x its book then you will make roughly 10% a year on your investment."

That makes great sense to me and I use it as a yard stick to value banks. With WFC they are the low cost provider so when I bought them a couple years ago at $34/share they had historically made 1.5% ROA and were available at 1x book. So to me that seemed like an opportunity to make 15% per year on the investment. BAC historically has made 1% ROA so when it was available at 0.5x book there was an opportunity to make 20% per year for a while.

But your example CHEV has made only 0.24 ROA. So paying .8x Book (current level) it leads me to believe there will be a 3% return on my investment for the next 5 years or so. Not an acceptable return.

The catalyst of selling the bank is a good point. IF that happens good value could be created. But if a growing bank doesn't overpay for it, then we are stuck with an underperforming bank.

I fear it doesn't sell. If I'm a big bank and want to compete in a region, why not just open a branch there? Why do I have to buy the competition? I would only buy the assets if I get a great price. They are worth more to the big bank than the small but that doesn't mean the big bank has to pay for the difference when they can open down the street, charge lower fees, offer more services and still make more money.

So if it doesn't sell, there are some tailwinds to big banks that are going to make the situation even worse for the small banks.

When ATM's came out all banks got more profitable because it reduced labor costs. Now costs go down again with online banking options and I-phone check cashing like Chase is doing.

Now these are expensive things to start doing. If you can spread the cost over thousands of branches that is a big edge.

I think your theroy is like saying that a local mom and pop store is a good investment because Walmart could buy them out. But Walmart could move next door and just crush them because they are the low cost provider.

I would never buy an inefficient high cost provider at .8x book and 50x eps hoping to get bough out at an even higher price than I paid. Especially when I can buy the big banks at an even cheaper valuation!

Maybe I'm wrong and their is good value there but I don't see it. I'd rather just buy BAC at 0.7x book and when their ROA returns to a more normal leve of 1, (which it should as they reduce loss reserves back to a normal historical level) and then make a 14% return on my investment by being one of the 3 or 4 large low cost providers in the industry.

Do you disagree?

Thank you.

Warmest Regards,

Jeff

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