Why Small Banks With $1 Billion in Assets Have an Advantage

A value investor's weekly look at the world and markets

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Feb 04, 2016
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I just came back from the Bank Director Acquire or Be Acquired Conference in Phoenix with three things. The first is a nasty cold, obtained no doubt on those germ-soaked, bacteria clouds we call modern day passenger aircraft (many apologies to the poor woman who sat next to me on the flight back to Florida. Doubtless she is in a very nice hotel somewhere in Orlando racked with chills, congestion and feeling like she is coughing razor blades), a new reminder of how much I detest cold weather (Phoenix had a nasty cold snow while I was there and it was in the mid-30s in the mornings of my last two days there. No, thank you), and a deeper than ever appreciation for the trade of the decades in small banks.

When you talk to the bankers themselves, you get the feeling that they know they need to get to $1 billion and they are opening to making deals. The problem for these sub-billion dollar franchises is that there are lots of banks with more than $1 billion in assets that have more attractive currency in the form of higher multiple stock that are targeting the same institutions they are. They are scrambling to get to the billion mark, but it is becoming more likely every day that they get purchased by a bigger bank on the way to the magic $5 billion mark.

Stephen Hovde, who is one of the best speakers in the banking industry in my opinion, gave a presentation at the conference that clearly spelled out that bigger is better. Banks with over $1 billion in assets have lower efficiency ratios, better interest margins and higher returns than those under $41 billion. Higher regulatory and technology costs simply take too much out of the bottom line for the small banks to perform. Hovde also pointed out that peer-to-peer lenders and credit unions are proving to be fierce competitors to community banks, and that is also taking a bit of profit for the smaller institutions.

Making it to a billion may be worth a sigh, but Hovde also clearly showed that the sweet spot in banking is in the $5 billion to $10 billion range. These banks have the scale for regulatory and technology demands, but have not reached the $10 billion mark, where the Durbin Amendment and increased attention from our friends at the Consumer Financial Protection Bureau. These banks have a return on average assets over the past four years that is 18 basis points higher than those under a billion, and a stunning 31 basis points higher than the baby banks under $500 million in assets.

The $5 billion to $10 billion in assets banks also have a huge premium in valuation, as they trade at more than two times book value until the smaller ones are at just 1.19 on average. Size comes into play when selling as well. Since 2000, sellers with over $1 billion in assets have commanded a 40% premium over those sellers with less than $1 billion. The ideal scenario is for one of our smaller banks to reach the billion dollar mark and then get acquired. We have seen several portfolio banks make it to the billion dollar mark. Their value as takeout candidates is even higher now than when we originally bought them. Dr. Ruth be damned, when it comes to banking, size matters.

Not much of the big picture changed while I was gone. The stock market continues to struggle along. We have improved a little bit in the past week, but are still down for the year. The economic numbers are bad enough that they are good news for the psychotic soul of stock traders, as they now doubt that the Fed will be able to raise rate again in 2016. Recall our conversation with Louis Navellier last year when he said that he doubted that interest rates would rise meaningfully again in his lifetime. The monetary and fiscal stimulus policies are not working, and in the short run, stock traders are a big fan of lower rates. Earnings are not great and I remain hopeful that we see a big event in 2016 that slows us to snap up a lot of cheap assets.

During my last night in Phoenix, I started coming down with this rotten cold, so instead of further damaging the economy by sharing with 600 or so bankers, I stayed in my hotel room and watched the Iowa coverage. I usually avoid politics, but I find that I am writing about it more right now as it has spill over for the economy and the markets in an election year.

I hate to say it, but none of these folks are qualified to be a local postmaster, much less president of the United States. The liberal candidates seem to have no idea that money is earned or even begin to grasp the concept that the very same government that caused the problems is highly unlikely to have the solutions. They are naïve and economically unaware at best, and criminally ambitious and vote panderers of the highest order at worst. The conservatives are genuinely scary people. I am fiscally conservative to the nth degree, but these folks' social policies make Attila the Hun look like a scholar and a gentleman of the highest order. The need to stakeout these aggressive wing nut policies to win a party's nomination is helping to polarize the nation, and is not doing anything to help deal with the very real social and economic problems we have as a nation today. We have reached that state that John Adams feared when he warned us that “There is nothing which I dread so much as a division of the republic into two great parties, each arranged under its leader, and concerting measures in opposition to each other. This, in my humble apprehension, is to be dreaded as the greatest political evil under our Constitution."

It is going to be an interesting year. It is one of the strangest presidential election years of my lifetime. The Fed is going to find out just how far into the corner they have painted themselves and the answer to that has some interesting implications for all of us. The pace of community bank mergers will accelerate. The Cubs are legitimate World Series contenders. The Orioles have an outside shot. There is a slim chance that George RR Martin will finish the next Game of Thrones novel. New seasons of the American and The Vikings will both start soon. The markets will do what they do, and we have lots of community bankers and cash, so we are positioned to take advantage of whatever happens .

Have a great week,

Tim

Sometimes I feel like our economy, markets and political system are like this.