With the interest rate environment expected to change significantly over the next 12 months, I believe some exciting opportunities are starting to emerge in the banking sector. Smaller banking institutions are particularly attractive.
Recently, I have noticed that the market is overlooking many small and micro-cap stocks as well. There could be several reasons behind this trend. Smaller companies are more challenging to analyze. Therefore, as asset managers and retail investors have flocked away from active funds and individual equities to passive strategies, the number of buyers which may be interested in these securities has declined significantly.
But this may have created an interesting environment for value investors who are willing to take a long-term view of a company's prospects and put in the time and effort required to analyze a small business.
An undervalued option
One such enterprise that has recently appeared on my radar is Timberland Bancorp Inc. (TSBK, Financial). With a market capitalization of $240 million, this bank stock is a micro-cap. It also appears deeply undervalued compared to the rest of the banking sector and its own financial metrics.
According to the lender's fiscal first-quarter results, which cover the three months to the end of December, the business earned an average return on equity of 10.6%. This is relatively impressive and even compares to the sector leader, Bank of America (BAC, Financial). For the fourth quarter of 2021, Bank of America reported an average return on common shareholders' equity of 10.9%.
Meanwhile, Bank of America's net interest margin averaged 1.7% in the quarter. Timberland's net interest margin in the quarter was 2.92%, down from more than 3% in the previous quarter.
In addition, total assets increased 15% year-over-year and 2% from the prior quarter, and total deposits increased 17% year-over-year and 2% from the preceding quarter. Due to a $657,000 decrease in interest and accreted loan origination fees associated with the Paycheck Protection Plan (PPP) loan portfolio, the lender's overall net income fell 3%.
Bank of America and Timberland are not directly comparable. Still, putting the two institutions side-by-side gives an idea of how profitable the latter is compared to its larger peer. It also shows that the business is already earning a double-digit return on equity with a robust net interest margin nearly double that of its large peers before interest rates start increasing.
Value creation
Using book value growth as a proxy for value creation, Timberland has increased book value per share at a compound annual growth rate of 12.2% since 2016.
So far, management has proven to be quite skilled and conservative when it comes to growing the balance sheet. Net profit has increased at a compound annual growth rate of 22% since 2016.
Loan impairment charges have not incurred significant losses on the balance sheet or consumed considerable cash resources, allowing the company to reinvest its profits back into the balance sheet for further growth.
Over the same time frame, the dividend has also grown. It has nearly tripled since 2016. At the time of writing, the stock supports a dividend yield of around 3%.
Moving on to valuation, the stock is currently selling at a trailing 12-month price-earnings ratio of 8.8. Considering the outlook for interest rates, this multiple seems to undervalue the company's growth potential, especially as earnings more than doubled over the past six years.
The stock is also selling at a price-book ratio of just 1.2. Once again, this seems conservative considering the book value growth reported over the past six years.
If the company continues to increase book value at the rate it has done since 2016, and the valuation remains the same, the stock could return more than 12% per annum over the next six years, excluding dividend income. Adding the 3% current income from dividends produces a potential annual return of 15%, although this is just a rough projection based on historical results and estimates for the macro environment.
