I’ve always loved the regional banking industry. I began my financial career working for a regional savings institution and spent almost a decade in the banking business before branching out into securities. And in my first job as a security analyst, my primary focus was the banking industry.
During those years, I learned a lot about banking — some good, some not so good. For instance, I discovered that the large super money center banks are generally not the greatest of investments, as they just dip their toes into too many — and often unrelated –areas that made it very difficult to analyze. And as it turned out, that very quality is what got them into so much trouble during the recent financial collapse.
But along the way, I found a kinship for the smaller regional banks, for a number of reasons:
1. Smaller regional banks don’t quite have the leading market share, leaving them hungry for more.
2. Companies that pay a nice 2% to 4% dividend give shareholders a little something extra while they wait for stock appreciation.
3. Many of these businesses are often run by the founder or his descendants and are anxious to keep their family’s good reputation in the community, so they are extra diligent about keeping their operations lean and fairly risk-averse.
4. Financial institutions of a certain size frequently are prime takeover targets for their larger competitors who find it easier to buy than to build.
5. Regional banks generally don’t take on high-risk, esoteric investments like their larger peers, making their financial statements more visible and their financial conditions more stable.
And during my years of recommending stocks to subscribers, these kinds of banks have served us well. During the technology boom and bust, I stocked my portfolio with smaller regional bank stocks — often to the ridicule of other advisers who were bent on buying “the next Microsoft.”
But when their portfolios bit the dust in the early 2000s, our portfolio was a safe haven, delivering dividends first, and then excellent appreciation later, as investors flocked to safer stocks after being critically burned by the tech stocks.
So it has just been gnawing at me that the condition of the U.S. banking industry for the last few years has prevented me from recommending companies in one of my favorite sectors.
Even through 2010, U.S. lending institutions were under considerable distress. More than 300 banks with more than $600 billion in assets, failed since 2008. And last year, there were more bank failures than in any year since the 1992 savings and loan crisis.
The first to fall were the large institutions which took big real estate risks. But last year, the contagion caught the smaller banks, too, especially those that operated in local economies that were hard-hit by the recession. The federal government created the Troubled Asset Relief Program (TARP), in the fall of 2008, to keep the national banking business from a wholesale collapse. At the time, it was estimated to cost taxpayers about $300 billion. But, thankfully, the banks recovered faster than expected and now the cost is predicted to be about $25 billion, or even lower.
But the crisis had a devastating effect on the industry. Today, there are some 7,700 commercial banks, savings banks, and other savings institutions in the United States — a far cry from the more than 15,000 in 1990.
The FDIC now requires stress tests in banks that have more than $10 billion in assets, as they consider their survival critical to the global economy. But the majority of banks –more than 70% — are actually quite small, with assets less than $300 million, and they have not received a lot of regulatory attention.
Now, that’s a little small for our investing purposes. But my favorite segment — the next tier of banks — those from $300 million to $10 billion in assets (about 2,000 institutions), until recently, also received little oversight, leaving investors with uncertainty and a fear of “what’s coming next?” And that has kept me out of the bank stocks, as it seemed like a “flip of the coin” was about the best analysis you could do for the past couple of years.
Of course, the FDIC does put all banks through its CAMEL analysis, to determine if they make the “troubled” list. That test involves a six-pronged analysis:
C – Capital adequacy
A – Asset quality
M – Management
E – Earnings
L – Liquidity
S – Sensitivity to market risk
But since the FDIC doesn’t share their list of troubled banks with the public, there just wasn’t enough information and too much unknown risk in terms of bad loans that might not have been accounted for to make a rational investment decision.
The Dodd-Frank Act of 2010 helped establish more oversight, requiring additional capital from banks, and that focus on shoring up reserves, along with the recovering economy, has helped the banking business begin to get back to a semblance of normalcy. There are still many banks in distress, but, thankfully, their numbers are declining.
The major money center bank stocks have been faring very well in the recovering markets, but I think their biggest gains are probably reflected in their prices right now. But the good news is the smaller regional banks are now coming into their own. Their financials are improving, their local economies are recovering, and their shares are undervalued.
Below is chart of the SPDR KBW Regional Banking ETF (KRE), which just crossed the 50-day moving average line, and bodes very well for the near-term.
