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.
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.
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.