These Small Banks Have Big Potential

by Tim Melvin | July 24, 2013 1:24 pm

Editor’s note: This is Tim Melvin’s inaugural piece for He’ll be covering deep-value investing in small- and mid-cap stocks.

All small banks are takeover targets for the next several years.

Although that may strike you as a bold statement, the recent financial crisis has created a unique situation in small bank stocks. These stocks are very cheap as a result of the losses that piled up due to bad loans and toxic mortgage securities, and earnings are just beginning to stabilize for the industry.

Investors would be wise to pay attention.

There’s even a precedent, though it was a long time ago. The savings and loan crisis back in the late 1980s and early ‘90s caused the same conditions, and alert investors made a fortune as small banks entered a consolidation phase that lasted the better part of a decade.

There are two major factors driving the coming consolidation and takeover wave among small banks. The banks are very cheap on a price-to-tangible-book-value basis, and larger banks will find it easier to grow by takeover than by opening new branches or internal expansion. With the economy still relatively weak, organic growth is almost impossible, so big banks must buy smaller competitors if they want growth — and they very much do. With the credit crisis fading into memory, banks will once again be focusing on growing shareholder earnings and increasing shareholder value.

The other reason behind the coming deluge of hookups is the simple fact that it’s not a lot of fun to be a small bank these days. The increasing cost of regulatory and compliance issues are going to compress margins and make it difficult to earn a decent profit. The smaller banks did not create the problems that crashed the industry, but they’ll be subject to the same regulations and higher capital requirements as the bigger institutions. And frankly, after five years of dealing with bad loans and unhappy shareholders, many of these smaller bank officers and directors just want to get a decent price for their shares and be done with banking.

Put simply, we’re about to begin one of the most profitable market trends of the past 20 years.

A good example of the stocks I’m targeting is Northeast Bancorp (NECB[1]). Northeast is small bank headquartered in White Plains, N.Y., with eight branches in New York and Massachusetts. The bank was founded in 1934 and offers basic banking services and boasts a loan production office in Danvers, Mass. The bulk of the loan portfolio is in multifamily and commercial real estate; credit quality is decent, with nonperforming assets at just 2.6% of the total asset base. With an equity-to-asset ratio just over 20, the bank is awash in excess capital — and yet the shares trade at less than 80% of tangible book value right now.

The financial strength and excess capital has attracted the attention of some outside investors. Two large bank activists both own significant stakes in the bank. Joseph Stillwell, a longstanding prominent bank stock and activist investor, owns 9.9% of the bank stock. PL Capital runs a hedge fund dedicated to bank stock activism and owns a little over 1% of the bank right now. These activist investors are lighting a fire — if Northeast management stumbles in earning a satisfactory return for shareholders, pressure will mount to perform better … or sell the bank at a premium to book value.

Small bank stocks are poised to deliver outsized returns for several years. The credit picture is improving, and the consolidation cycle is just getting started.

At the time of publication, Melvin was long NECB.

  1. NECB:

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