I’m a shareholder of this pictured Louisiana community bank.
I periodically run screens of the U.S. banking sector to look for the most discounted banks around. Not surprisingly, after a huge run-up in the banking sector in recent months, there’s not a whole lot of options coming up as compellingly cheap – at least in the large-caps banks. The likes of Wells Fargo and State Street didn’t stay at their knockdown prices for long.
Interestingly, however, the community (think very small) banks have continued to lag the overall market and certainly haven’t caught the same tailwind that the big banks have. I’ll give a theory why in a second. In any case, for this month’s screen, I ran the cheapest banks on a price-tangible book value basis
- which earn at least an 8% return on equity,
- pay a decent dividend,
- and have raised their dividend at least fractionally over the past five years.
Why this set of criteria?
A big theme going forward has been that banks need to merge and get bigger quickly. The increased compliance costs from post-Financial Crisis legislation has greatly hit banking profits in the low-end segment – call it $1 billion of assets or less. Between more regulatory overhead and the need to roll out digital apps and move to mobile banking, there’s simply no need for so many tiny community banks anymore.
Hence, over the next decade, we’ll see a massive wave of mergers in this space, with bigger regional banks buying up the little guys. Generally, banks tend to get acquired at at least 1.35x tangible book value, if not more, so buying banks at a discount to that gives you a fairly wide margin of safety assuming the bank is run responsibly and doesn’t actively erode its book value.
The combination of the ROE screen – which ensures they produce at least industry median (8%) profitability, on top of the requirement for a decent and growing dividend yield tends to rule out most of the low-quality banks. Additionally, if a bank pays a fair and increasing dividend, you get paid alright while waiting for M&A activity to occur.
Anyways, here’s what the screener came up with this week, sorted by cheapest on a price-to-tangible-book-value basis:
If you look at the market cap table, it becomes clear that the vast majority of these banks are $200 million market cap and below. This makes sense for several reasons.
- Compliance costs
- Liquidity
- (Lack of) Index Fund inclusion
One, that’s around the level where compliance costs really start eating into your margins as a tiny bank. Investors are naturally concerned about these sorts of banks because they think the mere increasing regulatory burden on doing business will limit upside.
Two, liquidity there is more limited so your average hedge or mutual fund isn’t going to take a meaningful position in a bank of that size. Katahdin (OTCQX:KTHN) – the second cheapest bank on the list, for example, trades an average of 1,000 shares a day ($18,000). That’s fine for individual investors but doesn’t work if you’re trying to put hundreds of thousands of dollars let alone millions into a specific stock.
Buy Community Banks Stocks That Indexes Miss
And three – and I’d argue most importantly – most of these banks are not included in any significant index funds. The cut-off to get in the Russell 2000 small-cap index is around the $200 million mark, and so anything above that level is getting huge passive money inflows as the market goes up.
Meanwhile banks below that size have to rely on microcap ETFs or specialty ones that include small finance companies; needless to say, the pool of passive assets chasing microcap banks is rather limited. So there’s no relentless bid driving these stocks up, like you’d find with any of the larger banks.
Even so, these sorts of banks have managed to do alright in recent years – here are the five cheapest banks that screen brought up on a price/tangible book value basis over the past six years, compared to the S&P 500 (dark blue line):
While none of these have been rock star performers, a fair chunk of them have beaten the S&P 500 and all of them have put up at least respectable returns. Even with their sizable gains, however, all remain around or below tangible book value; contrary to the popular story, tiny community banks are still able to create economic value despite the increased regulatory hurdles.
As such, they’re not a bad place to park money, collect a dividend yield and enjoy modest capital gains in the interim while waiting for buyout offers that create windfall gains.
You may recall that the IMF’s Fidelity Southern (former ticker LION) – a Georgia bank – was acquired earlier this year, resulting in an 87% capital gain plus dividends over a two year holding period. Buy a basket of cheap banks and you tend to get decent returns as a baseline along with the occasional sudden big gain when that sort of takeover event happens.
There is downside risk if another steep recession hits. Most of these sorts of banks are tiny though, and only make mortgages and commercial loans in their immediate surroundings at very low risk. Given that the U.S. doesn’t have anything resembling a housing bubble this economic cycle around, it’s unlikely that the next correction will cause significant losses for most well-run small banks.
Meanwhile, the wave of takeover M&A should accelerate in the community banking space soon. In fact, analysts had forecast it would have already picked up by now, however, the combination of uncertainty around the change in the corporate tax rate and Trump’s shift on banking regulations seems to have led some banks to delay M&A strategies for the time being. It’s inevitable that we’ll see much more consolidation in coming years, particularly as digital banking makes traditional small community banks less and less relevant in many areas.
Also, as longtime banking executive and Seeking Alpha author Richard Parsons noted in his recent books on the industry, there’s an increasing shortage of young skilled managerial talent in the banking space as the declining number of banks and the dreadful 2008 experience has scared off many young people from the field. As a result, as the current generation of bank executives retire, it will be harder and harder to find skilled replacements, leading many small banking franchises to sell to larger players.
Those sales transactions can be highly profitable for both the buyer and the seller.
An Example: Why Is WFS Financial Still An Independent Company?
Take the cheapest bank on this list by book value, WFS Financial (NASDAQ:WVFC). You can currently buy $1 worth of its assets for 83 cents – quite a decent price.
WFS earns about $7 million per year in Net Interest Income. It spends $2.2 million per year on salaries and another $1.6 million on general corporate overhead and other costs, thus leaving just $3.2 million of profit before tax.
If you could cut one-third of those expenses as redundant – you don’t need to pay a CFO, have your own auditors, or pay your own listing fees for example once you merge – WFS would save roughly $1.3 million per year as part of a larger bank.
After tax, that adds about a million dollars a year to WVFC’s earnings power – thus EPS would jump from $1.60 now to about $2.20 just from simple cost savings.
What could an acquiring bank pay to buy out WVFC? If they paid 11x post-cost cutting earnings, that’d be $25/share versus the current market price of $15.75. A still modest 14x those earnings would $31, or 100% upside from the current price.
Based on a takeover premium at 1.35x tangible book value, WVFC stock would be worth $25.50; an acquirer should be willing to pay at least that much as WVFC’s deposit base is valuable; they have a nice chunk of deposits that are earning nearly no interest and thus add value to a strategic buyer.
So why not make something like WVFC stock a big position if it is so clearly worth $25+ in a buyout?
That would be because there is no obvious timeline on when the bank may decide to sell itself and it could choose to remain independent for quite awhile. If it does, potential returns would drop. Here’s the indicator that drives a small bank’s long-term returns, tangible book value:
As you can see, over the years, WVFC’s tangible book value has risen nicely since they finished dealing with the financial crisis. However, the slope of this isn’t particularly fast; over the past 5 years, tangible book value is up $3/per share. The rate of tangible book value increase, along with dividends received, will roughly determine your annual return.
Thus, fast forward, and if gains continue at the same rate (and they are based in southwestern Pennsylvania so the odds of a major housing bust locally aren’t high) tangible book value would then be $22. Slap the 1.35x buyout premium on it and you get $29.70 per share.
Getting $29.70 in five years for a stock you paid $15.75 for now is still a great investment, don’t get me wrong. And don’t forget the 40 cents of annual dividends it pays out as well. But it’s clearly a higher return on your capital to get paid $25 a share tomorrow – the point is that the longer the bank keeps plodding along delivering fine but not outstanding returns, the less overall alpha you’ll get as compared to the market.
That’s why you want to own a basket of these if you are involved in the space at all, rather than just buying one or two. As the long-term return chart showed, these banks can certainly keep up with the S&P 500 on their own, even despite their small size.
Buyouts Are How You Make Big Bucks In Community Bank Stocks
But the real kicker – the thing that makes these attractive, is the buyout math I presented above. WVFC and other such small bank stocks could produce vastly more EPS than they do now to an acquirer. Thus, a bigger bank can buy WVFC and other such small tickers at a fat premium and still have it be accretive to their earnings immediately. Big regional bank trades at 15x earnings, for example, can issue their higher-priced stock, pay 11x post-synergies earnings for WVFC ($25/share) and immediately add a bunch to their EPS next year. We’ll be sure to see plenty such mergers in future years.
If you buy just one small bank stock, however, if the management team decides not to sell out, for whatever reason, then you get no big merger premium. Buy a basket of quite a few, however, and you’re almost certain to get some buyouts within the mix. As I’ve noted elsewhere, my IMF portfolio already got one buyout with Fidelity Southern and got another 100%+ gainer in Oak Valley (OVLY) which I subsequently sold out of the portfolio as there was no clear justification for that bank’s particularly huge run.
As such, parking money in a basket of sleepy bank stocks with the expectation that a few will trade sideways, a few will trade up decently, and a few will get taken over leads to excellent overall returns, particularly if you pick dividend-paying names that give you decent income in the interim.
I’d reiterate that this opportunity is available because these banks aren’t included in many ETFs. Thus, the $4 trillion or so money that has flowed into the stock market via passive ETFs over the past decade has simply missed these stocks altogether.
They haven’t missed the larger community and regional banks, which is why so many of my mid-size IMF bank holdings such as Washington Trust (WASH), Northrim (NRIM), Old National (ONB) and the like have been big winners. I’m happy to own more of those larger regional banks – and I’ve sought out a few like First of Long Island (FLIC) and PacWest (PACW) where there has been some specific reason in 2019 for why their shares have underperformed. In general, though, the deep bargains are gone on the $250 million+ market cap banks. The cheap spot left are the true small-town community banks.
If you want to buy banks now – with the sector rally already well under way and the obvious names like State Street (STT) already up huge, the small community banks are the place to go looking – or to buy a general basket of the cheapest names and wait for the dividends and buyout offers to start rolling in.
An Alternative
Or, you could just buy Citigroup (C). I’m joking. But in all seriousness, that firm remains a notable embarrassing entry on the otherwise list of largely unknown cheapest bank stocks in the country at just 1.09x price/tangible book value. If you’re bullish on national U.S. banks and don’t mind some hair on the story, C stock remains astoundingly cheap even as the other banking laggards like State Street (STT) and Wells Fargo (WFC) have suddenly surged higher. I’m not buying Citigroup as I already own enough large banks and quality does count for something – but it is cheap, there’s no denying that.
Two of these are not like the others.
Also, stay away from Bank OZK fka Bank of the Ozarks (OZK). It’s the only other larger-cap bank on this list and with good reason; they’ve gone nuts making ambitious real estate development loans far outside of their home market and could get leveled during any sort of economic downturn.
As for me personally, of this group of stocks, I own First Guaranty (FGBI) in the IMF currently – from a $16 basis with a 4% yield on cost – so that’s worked out nicely as a growth and income play. I also owned BCB Bancorp (BCBP) but sold it this year as it became clear that management wants to grow the bank internally rather than selling out to a larger M&A partner in the New York area – and management’s past track record is mixed. Remember, M&A is a big part of the thesis on these.
As a general strategy, grabbing an equal dollar amount of the cheapest ones on a Price/Tangible Book Value should outperform the market nicely over time.