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:

1. 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.
2. 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.

1. Shore Bancshares (SHBI)
2. Premierwest Bancorp (PRWT)
3. United Community Bancorp (UCBI)

Next up will be a post on Shore Bancshares shortly.