Posts from the ‘Regional Banks’ Category

Sep 9

The Aptly Named Sound Financial

Over the last couple of weeks I have built a position in a recent mutual holding company conversion called Sound Financial. It took some time. The stock trades 10,000 shares on a good day, so you have to pick and be patient and don’t flood the bid.

Sound joins what is now a rather long list of mutual holding conversions I have owned over the past couple of years. It began with Oritani Financial, which I bought at a little less than $10 and sold out of (too soon) at $12. That has been followed by such names as Oneida Financial, Home Federal Bank of Louisiana, First Financial Northwest, Kaiser Federal Financial, and recently Atlantic Coast Financial. With he exception of Atlantic Coast, the rest have shown decent price appreciation and I probably should have held each longer than I did.

I first became interested in mutual holding companies after reading David Einhorn’s book Fooling Some of the People All of the Time, which is about the mostly unrelated topic of Allied Capital, a couple of years ago. In the first chapter, before getting into the gory details of Allied, Einhorn discusses his investment strategies, and makes the case for value in mutual holding company conversions.

What is a mutual holding company and why do they convert?

A mutual holding company (MHC) is a type of corporate structure whereby the company is partially “owned” by its customers. Now, I put the word “owned” in quotations because the ownership is not quite what you think it might be and I will explain that in more detail in a second.

The MHC structure is most commonly used by insurers and banks. In the case of a bank, which is what I am going to focus on here, the customers/owners are the depositors, and they usually have a majority stake that is held through the MHC. The rest of the bank is held by common stockholders

From time to time a mutual holding company will convert to a fully public stock holding company. This is usually done because there is a growth opportunity, a merger, or some sort of use of cash that makes it desirable to the company to raise capital. The conversion to a publicly held stock is called a second step (with the first step being the initial partial sale of the company).

Along with the second step comes opportunity for investors. The nature of it is such that in addition to the company raising capital to fund future growth, it is often done in such a way that it is not dilutive to equity, and sometimes actually results in a lower amount of shares outstanding.

If that sounds weird it’s because it is.

Here is how it works:

Before the conversion, the bank is jointly owned by shareholders and depositors (the depositors own their share through the mutual holding company). As part of the second step, the shares that were held by the mutual holding company are sold off to investors as common stock in a bank holding company that will take ownership of the bank.

This is why I put the term “owned” in quotes earlier when speaking of the customers ownership. Within the mutual holding structure, the depositors have certain rights (like electing directors) that are consistent with ownership, but when it comes to converting that ownership to shares, the depositors don’t get a free ride. They have a right to buy shares at the set price, but they have to pay up just like everyone else.

In addition to the new shares created, the existing shares outstanding are often restructured to a lower amount when they are converted to shares of the bank holding company. For example, you might find that every existing share is only worth 0.75 shares of the new holding company post conversion. This is done to preserve the percentage ownership post conversion. If, for example, before the conversion the mutual holding company held 60% of the bank and common shareholders held 40%, post-conversion the existing common shares outstanding and would be adjusted to insure that shareholders still held 40% of the company.

Why MHC’s make good investments

As Seth Klarman, an extremely successful fund manager and advocate of mutual holding conversions has described it, the result is that investors are “buying their own money and getting the preexisting capital in the thrift for free.”

Its typically a good deal if you can get into these stocks post conversion. What you end up with is a cashed up company, usually at a significant discount to book value. If the business is solid, you have an excellent opportunity for price appreciation.

And its the gift that keeps on giving. Even though the conversion process has been around for years, ever year a few more companies take the plunge and are inevitably mispriced at the get go. The reason this happens, I think, is simply the size of the prize. Most of these banks are tiny; they often have market capitalizations of less than $100 million and in some cases less than $50 million. They are also illiquid. The combination makes it difficult for them to be bought in size. But what is bad news for larger firms, is great news for us lone gunmen, because we can buy a few thousand shares and still have it make an impact in our portfolio when the stock goes up 40% or 50%.

And that’s what I’ve done with Sound.

The Sound Financial Second Step

Let’s take a look at the conversion just completed by Sound. In Sound’s case, the mutual holding company, called Sound Community MHC, owned 55% of the shares outstanding before the conversion took place, with common shareholders owning the other 45%.

Here is what Sound looked like before the second step conversion.

The second step conversion took the 55% ownership of the mutual holding company and sold it to shareholders for $10.00 per share.

To keep the ownership percentage of existing shareholders at 45%, existing shares were converted at a rate of 1 existing share to 0.87423 new shares.

The result: there are less shares outstanding than initially were and the book value is much higher because of the additional cash.

Why buy Sound?

The value proposition with Sound is pretty straightforward. The book value after the second step conversion is $17.13 per share. You can pick up shares right now at around $10, which is a 70% discount to book.

But I don’t like going after a strict value play. You can sit around for years waiting for a scenario to develop that might allow that value to be realized. I want to be able to see the catalyst on the horizon.

With Sound, that catalyst is going to be earnings growth. I see a couple different ways Sound could increase earnings over the next few quarters.

With the cash they’ve raised they are going to be able to take advantage of lending opportunities.
The company’s existing book has been taking swrite-downs against earnings every quarter, and when those write-downs dry up we’re going to see a jump in net income.

Of course both of these catalysts are contingent, or at least will be easier to achieve, if the Puget Sound area economy recovers. Let’s start by taking a look at that.

The Puget Sound Region

Sound Financial operates in the Puget Sound region. Puget Sound encompasses Seattle and Tacoma and consists of the Clallam, Jefferson, Kitsap, King, Pierce and Snohomish counties. The map below shows where those counties are:

Sound has three branches in the King-Pierce-Snohomish beltline; one in downtown Seattle, one in Tacoma, and one in Everett. They have another two branches in Clallam County; one in Port Angeles and another in Sequim. Locations are shown below.

The bank started with the 3 branches in the Seattle-Tacoma corridor. The expansion to Port Angeles was relatively recent, with the purchase of a branch from 1st Security Bank.

A large majority of Sounds loan book is related to the real estate market. They had $302 million in loans outstanding at the end of the second quarter. Of that amount, $98.6 million were 1-4 family homes, $38.6 million were home equity loans, and another $105 million were commercial real estate and multifamily homes.

Thus, as the Puget Sound real estate market goes, one might expect Sound to go.

The first thing I set out to do was find out how the housing market is doing in Seattle. What I found was that it was turning, and rather hard at that. I have taken the chart below, which shows August housing statistics, from the Seattle Bubble blog.

I was somewhat shocked by just how low single family home inventory is. Months of supply is down below 2? I’ve lived in a city with inventory below 2 before, and I have to say that in my experience it doesn’t portend to flat or gradual price increases. Below is an inventory chart (again via the Seattle Bubble blog) that shows the state of affairs even more vividly. Inventory is at the lowest point in the last 12 years! And by a significant margin.

Something has to give here. I think its going to be prices.

Its not as easy to get data on Port Angeles and Clallum County, which is a smaller and more remote center. From the data I have been able to gather, I don’t see the definitive bottom that I do in and around Seattle. But I also know that it is the major metropolitan areas that will turn first, followed by the periphery, so I wouldn’t rule it out.

Port Angeles, WA Inventory

See more Port Angeles, WA statistics and real estate market trends on Movoto.

Looking at the broader economy in Washington state, I think the generalization that could be made is that things are picking up. Economy.com has all Washington regions except for Spokane in “Recovery” mode according to their Regional Recession watch.

Also bullish was this presentation on the state of the Washington economy.

The speaker points out that the major employers in the Washington area are Microsoft, Boeing and Amazon, and that these companies are all doing well. I found it interesting that he described Boeing as undertaking “a huge hiring frenzy” to staff themselves for the 7 year backlog they currently have. The speaker also notes the unusually tight conditions in the Puget Sound area real estate market. If you look at some of the inventory charts he shows for the various counties, they reinforce just how tightly wound the housing market there has become.

How an improving economy is going to funnel down into earnings

Here is a back of the napkin estimate to provide an idea of what Sound might earn if they can put the capital they raised to good use.

The company raised $14 million. Return on equity (ROE) has been around ~7.5% over the last year (it was 7.9% in the second quarter). So assuming the company can put that capital to work at approximately the current ROE, one might expect incremental earnings in the neighborhood of $1 million.

This is not an insignificant sum. Annualized earnings in the second quarter were a little less than $2.4 million. So the potential here is for 40% earnings growth just from the company putting to work the excess capital on its balance sheet.

Provisions for loan losses and their impact on earnings

One of the reasons that Sound has a less than stellar 7.5% ROE is because the company has been taking losses on its legacy loan book.

The losses have been cutting into net income every quarter. But even so, Sound has had decent earnings over the past number of quarters. Earnings in Q2 were $0.20 per share, while earnings in the first half of this year were $0.39 per share. Judging the company on current earnings alone, the stock trades at 12.5x ttm.

Nevertheless, earnings have been significantly reduced from what they could have been by the provisions that have been made to loan losses. Provisions for loan losses were $1.5 million in the second quarter and $2.6 million in the first half of the year. Provisions were more than double what earnings were. Going back a couple years, Sound has been consistently taking provisions in the range of $1 – $2 million per quarter.

This need to take provisions for loan losses will not continue indefinitely. First of all, the troubled loan book is centered on the residential real estate market, which is recovering.

Second, the company does not have a large delinquent loan book to begin with, so the back log is small.

As with incremental earnings, while the numbers involved in the provisions do not seem large, they are significant on a per share basis. $1 million of earnings lost to provisions is over 40 cents per share for the company. If and when those earnings come back onto the income statement, the company should be valued higher to reflect that.

Management

The one area where I still feel like I’m in the dark is with respect to management. Unfortunately this is the case with a lot of these tiny thrifts; there just isn’t a lot of information out there about the people involved. This isn’t like a mid or large cap where you can dig up articles or even books on the personalities at the helm of the company.

What I have found though has been reassuring. This link here gives a few good reviews from customers.

Another article I stumbled on reported that Joseph Stilwell purchased 153,000 shares of the company pre-conversion. He paid somewhat less than I am paying today (I calculated that taking into account the conversion his price was around $8.25). The article also implies that Stilwell was instrumental on getting the second step done.

Finally, there was a significant amount of buying taken up by insiders from the second step. Over 200,000 shares were bought, including $50,000 worth from the CEO and Chief Credit Officer.

Summing it up

This isn’t like some of my holdings where the stock could be worth $30 or $3 next year depending on whether it plays out the way I think it will or not. At best Sound Financial gets to book value by this time next year. More likely, the stock trades up to $13 or $14 as loans get made and loan losses begin to taper off. Still, that would be a return of 30-40%, which is nothing to scoff at, and I won’t. I’ll just sit on my hands and watch to make sure it plays out that way.

Sep 1

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The Community Banks of Arbitar Partners

You just keep on trying to find things that you think are cheap and that you think will wind up being worth a fair amount more then they are worth now.

– Paul Isaac is the founder of Arbiter Partners

Paul Isaac is the principal and portfolio manager of the hedge fund Arbitar Partner. Arbitar has had 20% plus returns per year over the past 25 years. They are one of a small group of funds actively proving that the efficient market hypothesis is hooey.

Every quarter hedge funds have to report their holdings to the SEC. When I caught wind that Arbiter had invested in a number of community banks over the past two quarters (thanks to an article by Tim Melvin), I felt that I better take a look at their 13-F filing.

What I found was that Arbiter had, as of June 30th, positions in the following community bank stocks (name and symbol followed by share amounts held by Arbitar Partners in brackets).

ASB BANCORP, ASBB (30,433)
AMERIANA BANCORP, ASBI (14,469)
HOPFED BANCORP, HFBC (29,334)
INTERVEST BANCSHARES, IBCA (16,317)
LAKE SHORE BANCORP, LSBK (53,171)
LAPORTE BANCORP, LPSB (10,877)
OCONEE FED FINANCIAL CORP, OFED (19,335)
PREMIER FINANCIAL BANCORP, PFBI (11,748)
PEOPLES BANCORP OF NORTH CAROLINA, PEBK (22,355)

I’ve looked at each of these stocks, with the exception of Intervest Bancorp, in some detail. I didn’t look at Intervest because I missed them on my first scan of the 13-F and didn’t realize they should be on the list until I had already finished writing this up.

The Objectives of the Exercise

I’m trying to get two things out of this.

First, I’m looking for potential investments. I’ve been adding to my community bank investments over the past two weeks. I added PremierWest Bancorp and Sound Financial, and I would like to add others if they present a clear story of a combination value, growth and turnaround.

Second, I hope to gain some insight into the criteria that Arbiter is using when they choose bank stock investments. So I’m looking for patterns.

I’ve left the list in point form because I don’t really want to spend the time to format it into some sort of spreadsheet. And anyways, some of the observations are qualitative and so are best left in point form. Finally, I think better when I read through a list than I do when I see a bunch of numbers in columns and rows.

View this document on Scribd

What is Isaac Thinking?

The first thing that I noticed was that the size of each bank is between $50 million to $100 million. Isaac is clearly going after the overlooked, illiquid, unfollowed community banks. I wonder whether his positions have been taken from some sort of stock screen that weeded out banks outside of this range? It seems coincidental that all of the bank stocks Isaac likes just happen to have this narrow range of market capitalizations.

To help get some additional insight into the strategies that Isaac might employ, I scoured the web for interviews and quotes. Among other things I found this short clip from a CNBC interview.

In the interview Isaac describes how if you have a good manager of the business, the balance sheet should lead the income statement. He goes on to explain that Wall Street focuses on the income statement, and doesn’t always understand its relationship to the balance sheet. What he tries to do is to buy cheap balance sheets with good managers, and then wait for the balance sheet to begin to impact net income.

This is a common theme on the list. With the exception of Oconee Federal Financial, every one of the banks on the list trades at a discount to book value. Some trade at a significant discount. For example, HopFed Bancorp ended Friday at $7.73 while its tangible book value is $13. Ameriana Bancorp closed at $6.54 with a book value of $10.80.

While earnings at many of the banks aren’t stellar, what Isaac appears to be betting on is improved earnings over time as the balance sheets get deployed to more profitable assets. In fact, it seems that Isaac has gone out of his way to pick banks that have had, up until now, poor return on assets and equity. The only bank with return on assets higher than 1.0% was Oconee Federal Financial. Next on the list was Lake Shore Bancorp and they were still a less than stellar 0.77%. The others all had ROA of 0.5% or less.

One of the reasons that bank earnings have been lackluster is because many of the banks have been making significant provisions to their loan books. Ameriana took provisions for loan losses of $624,000 in the first half, versus net income of only $798,000. ASB Bancorp had negligible net income in the first half of the year but took loan loss provisions of $0.34 per share in the first half and $0.23 in the second quarter. Premier Financial had a little over 50 cents in earnings but took loan loss provisions of $0.21 per share.

Once these loan loss provisions taper off, you can expect that earnings at these banks will look a great deal stronger.

The strategy makes sense and mimics my own. I tend to focus on more distressed banks than Isaac (though he does have one what I would call distressed issue in the list; Premier Financial, and another semi-distressed one, ASB Bancorp), but we both appear to be looking for banks that don’t have very good earnings right now, and so are being penalized by the market, but have very good earnings potential if they could get past the issues that have been dragging their earnings down. its a strategy that seems to work.

Another commonality among many (not all) of the banks is that they have unrealized gains on their securities portfolios. In some cases, these are substantial. HopFed Bancorp has over $2 per share in unrealized gains. Peoples Bancorp of North Carolina has over $1.50 in gains.

Finally, there seems to be a pattern with respect to location. Three of the banks operate out of North Carolina with another in South Carolina,while two banks operate in each of Kentucky, New York and Indiana. In addition to Kentucky, Premier Financial has branches in Ohio and Virgina.

There is a cluster here around the middle eastern states. I would note that if you look at the Economy.com recession risk indicator, the majority of counties in these states are in “Recovery” mode. It could also be that Arbiter Partners operates in New York and so they looked for banks that allowed for due diligence within a reasonable traveling distance.

And what’s different

While there are similarities, almost as interesting is what is not similar about the list. First of all, the banks run the whole gambit of loan quality, from Oconee Financial, which has non-performing assets at less than 1% of assets, to Premier Financial, where over 6% of loans are non-performing. Three of the banks have TARP preferred securities on the books (Premier Financial, HopFed Bancorp an Peoples Bancorp of North Carolina), though admittedly in each case the bank appears to be well on their way to paying off the funding, which would likely be a significant positive event for the company. There are banks trading at fair earnings multiples (Oconee Federal and Lake Shore Bancorp, Ameriana Bancorp) low earnings multiples (HopFed Bancorp,Peoples Bancorp of North Carolina, Premier Financial) and banks with no or negative earnings (ASB Bancorp).

Clearly, if the bank has underutilized assets and is trading cheaply on the basis of those assets, Paul Isaac is less concerned with the reason why this may be the case than that it is the case and that an opportunity presents itself.

Any Prospects?

Honestly, they are all prospects. Each of these banks looks like a solid candidate for future price appreciation. Paul Isaac didn’t get 20% returns for 25 years by picking duds. I could probably stick each of these banks in a portfolio, tuck it away for a year, and I bet that absent a collapse in Europe or a return to recession in the US I would be up 15-20%.

The two banks that I see the most potential for are two of the most distressed issues; Premier Financial and Peoples Bancorp of North Carolina. Both stocks are trading well below tangible book value (the discount is 24% for Premier Financial and 39% for Peoples Bancorp. Both banks are already earning good money (annualized $1.08 per share for Premier Financial and $0.90 for Peoples Bancorp), and both banks have catalysts, in addition to basic balance sheet earnings leverage, that should allow them to increase earnings.

Peoples Bancorp took over $0.45 per share in loan loss provisions in the first half of 2012. As I mentioned earlier, they have over $8 million in unrealized gains on securities in their portfolio. And their loan book has shown consistent improvement; loans past due have dropped from $38 million at year end to $26 million at the end of the second quarter and 30-89 delinquents have dropped from $28 million to $16 million in that same period.

Premier Financial took $0.21 per share in loan loss provisions, have over $1 per share in unrealized gains on securities and are also have improved their delinquent loans over the last 6 months.

Both companies are also in the process of paying down their TARP preferred shares. I suspect that once TARP is paid off, and the banks are free and clear of any government support, the market will be more inclined to revalue the stocks toward book value.

Jul 31

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Three Community Banks worth keeping an eye on Part II: Shore Bancshares

I owned Shore Bancshares earlier this year but don’t own it now. It was one of four banks that I bought back in January when I jumped into the community bank sector whole heartedly. While the other 3 banks I bought worked out to various degrees, Shore did not, and I sold out shortly after the first quarter results came out for a small loss.

At the moment I’m out, but Shore is not forgotten. I continue to review the company’s results and look for an improvement that would justify an entry point. Looking at the second quarter, while the eventual value proposition is still there, the company doesn’t seem to have quite turned the corner just yet.

Shore operates 10 branches in Maryland and 3 branches in Delaware. The majority of its lending activities revolve around the commercial and residential real estate market in these regions. Shore has a particularly high percentage of commercial real estate loans. Of the company’s $819 million in loans at the end of the first quarter, $315 million were commercial real estate, while $309 million were residential real estate and another $114 million were construction loans.

The loan book has been hit by the downturn in the economy in Maryland. Maryland’s economy is not doing badly, but it is also not doing particularly well. The economy has pretty much mirrored the US as a whole. Below is an Economy.com table of the key economic regions in Maryland. The table denotes each area as either being in recession, being at risk, being in recovery, or expanding.

Another informative research piece on Maryland’s economy was put out by JP Morgan. One point made that I found of particular note (and that is illustrated in the chart below) is that Maryland (not surprisingly) derives a larger than average percentage of economic activity from government.

This would have to be considered a headwind to growth going forward. As one Baltimore economist put it:

We know the decline in federal government outlays has just begun,” said Anirban Basu, a Baltimore economist. “The economic outlook, I think, is pretty grim.”

The article goes on to point out that “because Maryland gets a disproportionate share of federal contracting dollars and other spending, it’s likely to feel a harder hit from any reductions [in government spending]”

To drill down a bit further to the counties Shore operates, (Talbot, Dorchester, Kent, Caroline, and Queen Anne’s), you can see from the following unemployment charts that each fairly closely mimics the experience of the US, with some improvement from the worst levels of 2009-2010, but still an elevated unemployment level.

Talbot

Dorchester

Kent

Caroline

Queen Anne’s

The economic malaise shows up in the impaired loan book. Shore has $33 million in impaired construction loans (28.9% of outstanding), $30.9 million in residential real estate loans (9.9% of outstanding) and $30.6 million in impaired commercial real estate loans (9.7% of outstanding).

The problem with Shore remains what it has been for the last few years. How much longer will economy lead to deterioration of the loan book deteriorate?

Company CEO W. Moorhead Vermilye did not paint a terribly encouraging picture in his second quarter comments:

“The operating environment remains tough as we are not yet seeing a meaningful upturn in the real estate related activities that drive the Delmarva economy. We continued to work diligently to resolve and dispose of problem loans, as reflected in a higher level of troubled debt restructurings this quarter,”

So those are the negatives, and why I am not ready to buy Shore just yet. The positives with Shore is its valuation is compelling in the event of a recovery.

The potential when Shore recovers

A great deal of the current problems are priced in the stock. Shore has a tangible book value of over $12 per share. Its trading at less than half of book. The underlying earnings potential of the franchise remains strong; if you ignore the effect of all the onetime charges due to bad loans, the underlying banking business (ex provisions, one time charges, and gains) has been producing earnings at over a $1 per share clip for the last few quarters.

But even this may underestimate the earnings power of a stabilized Shore. Again excluding the onetime charges, ROA and ROE are solidly below where they were before the financial collapse. This suggests to me that once (or I guess if) the bank has its problem loans under control, they can embark on a cost reduction strategy to size the bank to the new level of business.

You can see the same influence if you look at the efficiency ratio, which has been hovering around 100% for the last six quarters.

Not quite there yet

One positive for the second quarter was that Shore did see a significant reduction in charge-offs. Charges were cut to half of what they were in Q1, extending the previous downtrend that had been in place before Q1.

I would be more excited about this reduction in charge-offs if nonperforming assets had shown an improvement. Unfortunately they did not.

Until I begin to see a leveling off and ideally a drop in the non-performing assets, its difficult to make a move into the stock.

Other risks

Apart from the economic risks I already outlined and the presumed impact on the loan book, there really isn’t a lot else to worry about with the business. Reading through the risk factors of the recent 10-K was mostly an exercise in the plagiarisms of the standard banking risk fare:

Concentrated Commercial real estate loans are being affected by the economic downturn
Interest Rates falling
The market value of their investment portfolio declining
Competition
Funding Sources
Key Personnel

The only item of any concern is the one I’ve already highlighted. Their loan portfolio, and in particular their commercial real estate portfolio, needs a strong economy to right itself. Its really just a wait and watch until the bad loan book stabilizes.

Waiting on my hands

The reason I am reluctant to buy Shore is because until they start to see a sustained downward trend on their nonperforming loans, the company remains at risk for panic. We saw that panic back last fall when the stock fell into the mid-$4s. It could happen again with the right confluence of European and US financial worries. Rightly or wrongly, the stock will likely remain range bound until the book turns around, and we won’t begin to see that until at best October, when the next quarterly is released. I, before then, the stock dropped another 15%, which would put it in the $4.50 range, I would be tempted to buy. Absent that, I will wait patiently on my hands.

Jul 30

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Three Community Banks worth keeping an eye on: Part I

For those of you new to this blog, I have been investing in community banks since early 2011. I described my foray into the sector in this post, almost a year ago today. To reiterate:

I got introduced to the idea of buying regional banks stocks about 6 months ago. Two separate catalysts piqued my interest in the idea:

Last summer I read the David Einhorn book, “You Can Fool Some of the People All of the Time”. In that book, which is about a fraudulent business development company called Allied Capital, Einhorn spends a chapter outlining his investment philosophies. One of the ideas he puts forth is investing in mutual holding companies. Seth Klaman has been another proponent of investing in MHC’s.
Tim Melvin’s trade of the decade. Melvin, a fairly well known value investor, believes that the small regional bank stocks have been beaten up well beyond what is justified and that their recovery represents the trade of the decade.

I’ve had some good luck investing in community banks over the last year. Some have turned out extremely well (Rurban Financial (RBNF) and Community Bankers Trust (BTC) have been more than doubles). Others have been less prolific (Oneida Financial (ONFC), Home Federal Bancorp of Louisiana (HFBL), Shore Bancshares (SHBI), Atlantic Coast Financial (ACFC)) but generally I have gotten out of with either a small loss or a small gain. One of my biggest mistakes has been a lack of patience; indeed if I had held onto Oneida and Home Federal, I would have seen 20% gains from my purchases last year.

Community banks are simple businesses. It makes them easy to compare and evaluate, and relatively straightforward to project into the future. A community bank income statement generally looks like this:

Banks earn interest on the loans they make and the securities they buy. The extent to which the interest earned exceeds the interest paid on funding (for community banks the vast majority of funding is deposits) is the banks margin, called the net interest margin. With only a few other wrinkles, such as revenues received from originating and servicing mortgages, or in some cases from running insurance or investment wings, the degree to which the net interest margin exceeds the expenses associated with running a bank (called non-interest expense) is the profit of the bank.

How I’ve made money on the banks

There are plenty of solid banking franchises trading at reasonably cheap prices. You can probably make 10-15% per year by buying well run banks with low levels of nonperforming assets and reasonable return on assets and equity, and socking them away.

This was how I started with my own banking investments. The first three banks I bought were Oritani Financial Corp (ORIT) Oneida Financial (ONFC), Home Federal Bancorp of Louisiana (HFBL). Each is a solid franchise, each has a low level of loan losses, and each trades at or near tangible book value with decent returns on assets and equity. I’m sure each will continue to go higher over the long run.

But I am always in the pursuit of the best returns and those are usually found a little further up the risk ladder. One of the basic premises of my investing strategy is that while the price of risk is ultimately assigned by the market, the perceived quantity of risk involved varies, and can be reduced by research, critical thinking and sweat.

Going further up the risk ladder meant looking at banks that most investors would shun. I studied the banks that had been hit the hardest by the financial crisis. While a bank with non-performing loans above 3% is generally considered of questionable quality, I started looking at banks with 8-10% non-performing assets. While banks with return on assets of 1% and return on equity of 10% might be thought to be worth considering, I looked at banks with negative returns, shrinking assets and dwindling equity.

This tact has proven to be fruitful. Three stocks that I have bought have resulted in above average returns. Two of them, Rurban Financial (RBNF) and Community Bankers Trust (BTC) have been in the neighborhood of a double so far. The third, Bank of Commerce Holdings (BOCH) returned a quick 30% before I took the position off, though I am looking at adding it back at the right level.

My one regret has been not to have taken more positions in banks. To give a couple of examples of banks I looked at but just couldn’t get comfortable with, First Financial Northwest (FFNW) has doubled from $4 to $8 in the last year and a half, while Heartland Financial (HTLF) has nearly doubled since last fall.

But even with some of the moves we’ve seen I think there is still more to come. As the economy recovers banks should see improvements to their loan book and strengthening margins on the securities they buy. And I continue to believe that the banks most likely to outperform will be those that were hit hard during the recession but that managed to survive.

3 Banks I’m Looking at

I have my eye on a number of banks that meet these criteria. There are 3 in particular that I have been looking at this weekend. While I am not quite ready to pull the trigger on any of the three, I am getting close, and I think the ultimate upside once they work through their books of problem loans is a multiple of the current share price. I am going to look at each one individually in the upcoming 3 posts.