The United States has over 7,000 FDIC-insured banking institutions. Of these, most are community banks that serve a small geographic area. The Independent Community Bankers of America counts nearly 5,000 member banks, ranging from $3 million to $17 billion in assets.
A surprising number of these banks are traded over-the-counter. I have spent many laborious hours compiling a database of over 300 banks that report to shareholders, either through SEC filings or via statements posted on their own websites. I have another list of over 250 institutions that do not report publicly. I imagine that many of them are willing to provide statements to shareholders, or may at least mail an annual report. Whether reporting or not, investors can check out the financials of any FDIC-insured bank by looking up public call reports.
Many value investors categorically avoid all banks and financial institutions for several reasons. Bank balance sheets are opaque and asset valuations can be both subjective and pro-cyclical. By their very nature, banks are leveraged operations and are strongly affected by uncontrollable factors like the yield curve. Banks operate a carry trade, borrowing short and lending long. A bank’s capital structure is fundamentally unstable, depending on short-term deposits.
Community banks are less affected by some of these issues. Community banks generally do not use complex derivatives or engage in proprietary trading, practices many large banks have come to regret. Community banks can also benefit from local goodwill and brand value, many having served their local economies for decades. On the other hand, community banks have unique risks. Profit maximization may not be a chief concern for some of these banks; many are content to earn an ROE of 6-7% year after year. The fortunes of a community bank are tightly intertwined with the state of the local economy, as community banks lack the broad geographic diversification of their national competitors.
All that said, I believe there are attractive opportunities in the community bank sector. To begin my search, I set up a simple screen focused on modest valuation, conservative capital ratios, good profitability and high asset quality. I chose to include only dividend-paying banks, though there are many attractive institutions that do not pay dividends.
I used the Texas ratio to measure asset quality. The Texas ratio is a measurement of the total amount of a bank’s non-performing assets and loans and bank-owned real estate compared to a bank’s equity capital and loan loss reserves. Historically, banks have tended to fail around the time when these values become equal and the Texas ratio equals 100%. All of the banks I have chosen to profile have Texas ratios of less than 20%.
From the list that remained, I have chosen five banks to profile.
Malaga Financial Corp.
Malaga Financial Corp. operates Malaga Bank with five branches in the South Bay area of California. The bank was founded in 1985 and is 48%-owned by its board members. Malaga has seen impressive growth in earnings, book value and deposits since 2007, yet still trades at a P/E of 8.4 and a premium to book value of just 18%. Credit losses have been minimal and the Texas ratio is 0%. Core capital is a strong 9.77%. Malaga has a market cap of $96 million and yields 3.06%.
Home Loan Financial Corp.
Home Loan Financial Corp. owns the Home Loan Savings Bank. The bank has three branches in rural Conshocton County, Ohio, east of Columbus. The bank focuses on residential mortgages. Home Loan Financial has a generous dividend policy and yields 6.18%. The company is tiny, but a market capitalization of just $18.31 million against $19.60 million in equity capital. Trailing P/E is 9.0. The Texas ratio is a low 16.16% and the core capital ratio is a conservative 12.15%. Deposit growth has been slow, but the company has grown earnings rapidly via an expanding net interest margin and controlled loan losses.
Comunibanc Corp. owns the Henry County Bank. The Henry County Bank is another Ohio institution, operating six branches in northwest Ohio, southwest of Toledo. Comunibanc has grown its earnings at a healthy clip on the strength of high net interest margins and moderating loan losses. The company does not release quarterly reports, only an annual letter to shareholders on its website. Despite a healthy core capital ratio of 10.82% and a Texas ratio of 9.12%, Comunibanc trades at just 70% of book value and a P/E of 8.4. Comunibanc Corp. has a market capitalization of $18.18 million and yields 3.37%.
Farmers & Merchants Bank of Long Beach
FMLB is giant in the community bank arena, with $4.77 billion in assets and a market capitalization of $568.88 million. It has a giant stock price to match, currently around $4,345 per share. FMLB was founded over 100 years ago and operates 21 branches in the Long Beach/South Bay area of California. FMLB experienced elevated loan losses in 2008 and 2009, but these have since trailed off and the bank’s profits reached all time highs in the most recent four quarters. The company has been extraordinarily successful in attracting deposits, which grew at an annual rate of 14.17% since 2007. The bank is among the least leveraged around with a core capital ratio of 14.38%. Despite its low leverage, success in attracting deposits and low Texas ratio of 9.12%, FMLB trades at a P/E of 9.1 and at just 83% of book value. The stock yields 2.51%.
Independent Alliance Banks, Inc.
Independent Alliance Banks owns two separate banks in the Fort Wayne, Indiana area, Markle Bank and Grabill Bank. Markle Bank has a Texas ratio of 6.32%, while Grabill’s ratio is 16.27%. IAB’s net income has stayed relatively steady in recent years, but the company has repurchased 9.6% of shares outstanding since 2007 and seems poised to continue that trend. Due in part to the repurchase program, the company managed to compound book value per share at 9.42% per year since 2007, even after paying generous dividends. While deposits have been growing at 5.21% annually, the company’s net loans outstanding have not grown at all, suggesting the bank has become more conservative or lacks opportunities for investment. IAB trades at a trailing P/E of 9.4 and a dividend yield of 4.31%.
All of these banks have one thing in common: they do business in areas with challenging local economies. The manufacturing bases of Ohio and Indiana have been in decline for many years, resulting in population loss and declining home values. Meanwhile, California is still feeling the after-effects of the housing bubble. Still, these banks have managed to grow and profit through the worst of the financial crisis and I wouldn’t bet against them.
Other broad economic trends make community banks look attractive. The number of US financial institutions has been in decline for many years, as larger institutions purchase smaller ones and gain access to new markets. Bank mergers typically offer attractive synergies, as business methods tend to be similar and integration expenses low. Furthermore, a tide of new regulations threatens to make business more difficult for smaller operators, which may cause them to seek acquirers.
Because it is difficult to fully understand the risks of any particular bank, I think a basket approach is called for. I think anyone who invests in a basket of these five banks (or any other reasonably-value, financially stable community banks) has a good chance of earning attractive returns over the next few years.
Disclosure: no position in any security mentioned.
awesome post. thanks!
Very good post. I also think that the community bank stocks were/are a tremendous opportunity. A lot of the stocks have gone up close to 50% or more in the last 8-10 months. A lot of them are still cheap though.
Even with the massive increase in price, there are community banks trading at discounts to tangible book AND with low to mid single digit P/E’s. A lot of community banks have “taken their lumps” and are now showing improving earnings.
I would suggest that Birmingham Bloomfield Bancshares (BBBI) is tremendously cheap. They are based just outside of Detroit, but they have really turned things around. They also have taken a tremendous ALLL reserve in relation to their bad loans and market cap. I think they are most likely OVER RESERVED for losses. They have a tangible book of over $5/share and are probably trading for a P/E of about 6.
Another interesting community bank in Ohio is Rurban Financial (RBNF). This bank collapsed and appears to be on the mend. They have a book value of about $10.50/share and have reported earnings $.60/share. There are two interesting things about RBNF.
A). Their earnings are on the mend, and will almost certainly be increasing in the upcoming 12 months.
B). Their earnings are masked by amortization of intangibles when they took over some small banks a few years ago. TRUE EARNINGS are about $.15/share higher than what is reported, and they are poised to go higher…
Another Midwest community bank is Community Bancshares of Indiana (CBIN). They are trading at a big discount to book. They have a P/E of about 7 and pay a nice dividend.
I’m a sell-side banks analyst. Those banks don’t seem particularly cheap to me… The easiest way to value a bank is the gordon growth formula (google it for details)… Basically, if the return on tangible is equal or below your cost of capital, then you shouldn’t pay more than tangible equity for it.
In terms of PE’s, its not often you see developed world banks trading at more than 10x E…
Nice post. i own FMBL and have recently added to my position. I believe it is a well managed bank that could grow earnings significantly, if they could increase their loan portfolio again and use the low yielding bonds they own as a source of funds. (their loans yield twice as much as bonds right now).
This is an interesting article. Any retrospectives with successes or failures? My concern with OTC-pinks is how would one sell them as there is no market?
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