Earlier this week I released my video presentation on the State of Banking: Trade of the Decade update. It is on my YouTube channel if you want to check it out but I also want to rehash it in print today. When we hear people talk about bank stocks 99% of the time it has little or nothing to do with our community banks. Most of the problems and issues facing the big banks do not affect community banks at all. Community banks don’t need to worry about lower trading revenues and most of them have little to no exposure to energy loans and troubled emerging market governments. The little banks are less liquid and garner for a less attention from Wall Street and the media. The fact of the matter is that the State of the Community Banks is pretty damn good.

Balance sheets have been rebuilt since the credit crisis and equity levels are well above pre crisis levels .In fact they are at a 70 year high as of year-end 2015. They are so high some worry that carrying excess capital is actually hurting operating performance. Loan to deposit ratios are fairly low so there is room for banks to grow their loan portfolio if we start to see stronger economic conditions. The smaller banks are hiking dividends and buying back stock at bargain valuations, all of which is good for shareholders.

Credit conditions are outstanding. We have now had more than 20 quarter of improved credit conditions and I think that for community banks that streak will continue with the first quarter 2016 reports we are starting to see. Banks have gotten a lot better at underwriting and the regulatory environment has discouraged some of the riskier lending practice we have seen in the past. Some think credit conditions may be near a peak and they may be right. However I do not see credit quality falling off a cliff so conditions will remain above historical averages for an extended period of time. It is probably prudent for a lot of banks to begin setting aside some reserves for future rainy days abut loan losses won’t be a drag on earnings for a long time.

The one troubling area is energy loans. We have run across some medium size bansk where the energy portfolio is larger than the total of equity capital. That is a particularly dangerous situation of oil does remain lover for longer. Moodys just downgraded several banks with high energy exposure. The release said “Moody's said the rating reviews for downgrade considered three broad factors. First, these banks hold comparatively large energy-related loan exposures when compared to their tangible common equity (TCE). Second, the prolonged period of low oil prices and Moody's expectation that prices will remain low for an extended period undermine the quality of the banks' energy-related loans. Third, to various degrees, these banks operate in regional economies where the energy sector contributes more to the local economy than the national average, exposing the banks to deterioration in their non-energy loan portfolios.”

We have developed a fool proof and elegant solution to avoid losing money in energy heavy banks. We don’t buy them.

The biggest issues facing the small banks remain regulatory costs and technology, especially cyber security, costs. These rising costs, together with a sluggish economy and low net interest margins, are making independence an increasingly difficult choice of many community banks. We have seen increased merger activity as many bankers decide to sell. Fortunately we have an even larger pool of banks that need to buy as the only path to growth right now is via M&A. An investment banker I talked to earlier this year told me that for every community bank that wants to sell he usually has two or three potential buyers.

As a result of M&A demand multiples have been firming and are now north of 135% of book value. There is a discrepancy in multiples based on size and returns on equity. The bigger you are the higher the multiple with ht larger community banks receiving bids averaging about 160% of book value while smaller ones are around 115-125% of book Those banks with high ROEs are fetching a multiple of about 165 while the underperformers are getting around 120%. Most of the deal we are seeing are in the smaller underperformers so you have to be careful about the price you pay. There is a reason I try to buy around 85% of book value. That still leaves me a potential return of more than 40% assuming book value doesn’t grow.

Activist investors remain a very large part of the community bank investing landscape. A recent Reuters article noted that “Activist investors are putting the U.S. banking sector in their crosshairs, betting that headwinds whipping through the industry will accelerate consolidation among lenders. Hedge funds such as Ancora Advisors, Clover Partners and Seidman & Associates are buying up stakes in lenders across the U.S., from community banks to large regional lenders.” The April edition of Banking on Profits Monthly reported 6 activist filings in the last 30 days alone.

I have been doing a lot of work on bank stock activist returns. I have gone back though the last decade of SEC filings and tracked the annualized returns from the time the initial 13D is filed until the bank is acquired or the activist reduces the stake below 5%. So far I have researched 7 different bank activist hedge funds and the average annualized return for an activist position is 18.06%. For comparative purposes the S&P 500 has average 7.09% over this time period and the SPDR S&P Bank ETF has average about -3.

I also went back and tracked the activist filings we cover each month in Banking on Profits. I looked at those from one year ago and longer to give a good read of the returns you could have earned buying an equal amount of the activist stocks each month. I computed the returns form the day the issue was released through yesterday, or until the sale of the bank closed as we have seen several takeovers form activist positions in the past year. Here are the returns we found by issue:

Issue#1, July 2014 +29.67

Issue#2 August 2014 +35.37

Issue#3 September 2014 +31.35

Issue#4 October 2014 +59.95

Issue#5 November 2014 +45.42

Issue #6 December 2015 no positions

Issue#7 January 2015 +21.20

Issue #8 February 2015 +22.90

Issue $9 March 2015 +8.91

Issue#10 April 2015 +14.88

Community bank stocks remain one of the most attractive opportunities in an otherwise extended market. If you don’t have a percentage of your long term portfolio devoted to the trade of the decade in community banks you are making a mistake. I will go out on a limb and say that I think it should be a large percentage. If you buy the right banks at the right price it is hard for patient investors to get hurt.

That’s about all for this week. The Orioles are in first place and second only to the altitude assisted Colorado Rockies in home runs, the next two weeks will see some of my favorite authors release new titles, Tobias Carisles new book on concentrated value investing is being released next week and spring is springing across most of the country. Make it a great week!

Tim

Ps Get involved in the Trade of the Decade in Small Bank stocks and

https://www.youtube.com/watch?v=wYrmwUy6kz8