Where the money is

April 24, 2017 09:00 AM

When individual states began passing legislation that allowed Bank Holding companies to acquire institutions in neighboring states back in the mid-1980s, there were around 15,000 commercial banks and more than 3,000 savings institutions in the United States. Regional franchises began to be created, and banks took advantage of the opportunity to achieve economies of scale and access new markets. In the aftermath of the savings and loan crisis that came to head in the late 1980s, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 that allowed for real interstate banking. 

At that time, there were still about 10,300 commercial banks and about 1,000 thrift and savings institutions operating in the United States. Today, we have a little under 6,000 commercial banks and fewer than 1,000 thrift and savings and loan institutions.

While a small handful of the thousands of banking and savings institutions that disappeared were bank failures, most were the result of merger and acquisition activity. The consolidation trend in the United States is now about 30 years old, and it shows no signs of stopping. This trend should go on for at least another decade and possibly longer depending on how the economy fares and the form of any new legislation that may be passed in the future. Consider that Canada has six banks, the UK just 366 and France has only 565, and you can see that we simply have too many banks right now. Continued consolidation is pretty much inevitable.

Since the credit crisis, we have seen more reason for small bankers to consider selling their bank. Low-interest rates have caused net interest margins to shrink to historic low levels for an extended period. Legislative changes like the Dodd-Frank Act have dramatically increased the costs of regulatory compliance. While it is not a big deal for major regionals or money center banks to add to their compliance staff, it is a big deal for a three-branch bank with $500 million in total assets to bring on additional staff to deal with the paperwork. Much of the M&A activity we have seen in the past five years has been directly related to the cost of regulatory compliance. 

New threats to the small banks are emerging because of technology. To remain competitive small banks have to add digital and mobile services, and those can be costly to implement. As daunting as that may be, the real challenge for small banks is going to be the cost of keeping customers’ information and funds safe from cyber criminals. The costs of cyber security are high, and they will continue to grow as hackers find new ways to attack financial institutions. Hackers target banks for the same reason Willie Sutton used to rob them: “That’s where the money is,” so the costs of fighting cyber-crime will continue to escalate.

Robert Hendershott, portfolio manager of small back focused fund Context BH, pointed out another reason many small banks are considering a sale. Banking simply is not fun anymore. Community Bankers before the crisis were the folks who provided funding for homes, cars, small businesses and college educations. They were respected members of the community and were often involved in the leadership of many civic organizations across the country. Banking was fun and very profitable with returns on equity running above 12% for most U.S. banks.

Post-crisis that’s not the case. Bankers today are the ones who foreclosed on Uncle Fred’s home a few years ago and turned down Cousin Ernie for a loan to expand his business. Bank executives spend as much time dealing with regulators as they do talking to customers. Profits are much harder to come by with returns on equity falling into single digits in recent years. Hendershott pointed out that the burden of running a bank today is high and that creates an incentive to merge into a large institution that has the economies of scale to deal with rising costs.

There is another factor developing that is going to spur merger and acquisition activity during the next several years. The average age of community bank executives is more than 60 and the average director is over 70. These folks are starting to consider retirement and a sale of the bank provides the liquidity needed to monetize their ownership stake in the bank. It has been hard for many of these banks to develop a succession plan as community banking is not seen as a desirable career choice today as it was back then and the talent just does not exist to take the reins at many small banks.

While all this is depressing, if you run a small bank, it is an exciting opportunity for investors willing to adopt a long-term approach to small bank stock investing. Hundreds of these small banks are publicly traded, and investors acquiring a stake at bargain valuations should do very well as they are acquired by larger institutions in the years ahead. Many trade at tangible book value or less and current deal multiples are around 135% of the book, so there is a significant long-term opportunity for profit. 

A lot of money has been made in small bank stocks since the credit crisis, and there will be a lot more over the next decade as the consolidation trend continues. 

The biggest problem in implementing the small bank investment strategy is that they are illiquid. That is true. They are thinly traded, so patience is required to build a position. You will not be able to sell at will, as it can take some time to find a buyer for your shares. You have to take the mindset that you are an owner and not just trading bank stocks.

For long-term investors, illiquidity is actually a positive. Small bank stocks below book value would fit the definition of small, illiquid high-value stocks. In his study “Liquidity as an Investment Style” Professor Roger Ibbotson found that “Among the high-value stocks, low-liquidity stocks had an 18.43% return whereas high-turnover stocks had a return of 9.98%.” 

Buying small bank stocks below book value is a form of forced buy and hold with the powerful tailwinds of the ongoing consolidation trend driving long-term gains.

Finding the best banks to buy

Smaller banks require a good stock screener and a decent relationship with one of the big market making firms. They can provide you with statistical data on hundreds of small banks that don’t show up on some of the screeners. You want to search for banks that are trading below tangible book value. You have to use tangible book as banks that have engaged in a series of M&A transactions will have a book value that is much higher than tangible book value as a result of goodwill that needs to be amortized. Acquirers will make their bid based on tangible, not stated, book. Make sure the bank is not overly leveraged and has an adequate amount of capital on hand. An equity-to-assets ratio of greater than 10 is usually an indication of a solid bank. Limit your purchases to banks with nonperforming assets of 3% of total assets or less, and track that number carefully every quarter in the earnings releases and call reports. 
All banking problems start with increasing nonperforming loans and assets. 

Finally, check the proxy and make sure the executives running the bank own enough stock to make a difference in their attitude towards managing the company. A lack of skin in the game in a small community bank is a huge red flag and those with low ownership are usually best avoided. Also be aware of any institutional ownership and research any 5% or higher ownership levels revealed in the proxy filing. Having a known bank activist like Joseph Stilwell, Lawrence Seidman or PL Capital as owners gives you an additional edge as they will be agitating for the sale of the bank sooner as opposed to later.

About the Author

Tim Melvin is a 27-year veteran of the financial services and investment industry who has served as a broker, advisor and portfolio manager. He specializes in value investing. @timmelvin