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Posts from the ‘Oneida Financial (ONFC)’ Category

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.

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Week 28: Outperformance of the Regional Banks, Buying Xenith Bankshares, Gramercy CDO-2005 and I admit I was wrong (and originally right) about Argonaut Gold

Portfolio Performance:

Portfolio Composition:

If the regional banks are outperforming…

Donald Coxe had a very good conference call last week.  To be honest, I think his calls have been pretty boring for the last 6 months.  He doesn’t have any better grasp on the Euro-crisis then anyone else, yet the situation in Europe is of such a systemic nature that any insight he provided on anything else, always became prempted with the caveat: Assuming all goes well in Europe.

Well last Friday he broke from this mold and made his first endeavour into the terrain of bullish sentiment in some time.

His reason?

The banks.

The main reason for his bullish outlook is the outperformance of the regional bank index, the KRE. As Coxe said:

When you get 3 months of outperformance while the S&P is itself recovering that is a powerful sign that the market has digested the bad news and that things will get better.

The KRE has indeed been outperforming.

I must admit, I’m tentative to proclaim my outright bullishness just yet.  Tto be fair to Coxe, he qualified his own bullihs stance by pointing out that there was still a lot else that had to go right for the bullish call to play out.

I do admit, however, that the signs are beginning to accumulate.  Jobless claims are trending down, the ISM is looking more stable, news out of China (particularly that inflation has fallen) is starting to sound more positive, and heck, even the Italian and Spanish 10-year yields are trending down at the moment.

So what do you buy if you are bullish?

Well, on the conference call Coxe proclaimed (once again) the supremecy of the commodity stocks.  A bit of a broken record is he, but why stop with what works.  Well I am long oil, long gold, thinking about how I might get long copper or coal (but more on that below).  I have those bases covered.  Perhaps the more specific question you might ask, is what does one buy when the KRE is outperforming?

And the logical answer to that?

…buy the regional banks

I’ve been accumulating the shares of a number of regional banks over the past few months.  What is my thesis?

  • The lows of August felt like a bottom
  • There is volume in some bank stocks that typically have had no volume whatsoever (is somebody starting to care?)
  • The housing market in some regions is bottoming
  • The write-downs at many of these banks has peaked
  • How much further below book value these businesses can go?

I’ve been listening to this mortgage broker and originator podcast called Lykken on Lending on my bike ride into work for the last 3 months.  Its interesting stuff.  The first thing that’s interesting is just how intertwined real estate is with regulation.  They actually have a regular segment on this show that is dedicated to new legislation being considered by congress or the senate. Its crazy!  Second thing that is interesting; there is starting to be some signs of life in the mortgage market.  For the first time we are seeing private lenders getting back into the game.  They had a company on a couple weeks ago that was funded by Lew Raneiri (the godfather of securitization) and that is looking for loans that are just below the level of what passes for the GSE’s.

It’s starting again!

In this short clip below, Jim the Realtor, prominently featured on CalculatedRisk, makes out the bull case for a barn-burner spring.  Says Jim: “I think we get into spring time – if rates are still this low – it’s going to be a real frenzy.”

Kyle Bass and MGIC

Another favorite of mine, Kyle Bass, recently bought a large stake (just under 5%) in MGIC.  I stepped through MGIC over Christmas and will review the work I did another time,  but to make a few brief conclusions I determined the value certainly might be there but I just don’t understand the business (the mortgage insurers are hugely levered companies with massive amounts of housing liabilities against them) well enough to pull the trigger.  Specifically, the solvency of MGIC and the rest of the insurers seems to depend as much on the ability of the insurers to mark their liability per payout (in other words how much they owe for the foreclosure they insured) as anything else, and that appears to be a bit of black magic to me.

Nevertheless, MGIC has moved substantially higher since that time, something that seems unlikely if the housing market were about to (triple?) dip again.  Here is what Bass had to say about MGIC and the housing market a couple of months ago.  From the WSJ:

Mr. Bass said that while the housing market was still around two to three years from firmly “bottoming out,” he said any future price declines would be quite modest. “I don’t anticipate a huge decline,” he said.

I think he’s right.  Residential housing is closer to a bottom then a top.  And its bottomed in some markets.

The Housing Market Turns?

Residential housing is the lifeblood of most regional and community banks.  A turn in those markets could turn the fortunes of these companies.That’s why I’ve picked up shares in the following stocks over the last couple of months:

  • Oneida Financial (ONFC)
  • Bank of Commerce Holdings (BOCH)
  • Atlantic Coast Financial (ACFC)
  • Community Bankers Trust (BTC)

Apart from Oneida, these stocks are not for the faint of heart.  I know there are plenty of well capitalized but fairly valued banks out there that can return you 10-15% per year in all likelihood.  I want a bit more than that though.  So I am willing to step out on the limb a bit further to get it.

Xenith Bankshares and the problem with RBC practice accounts

I’m going to get into Xenith in a second but first let me say something about this RBC practice account.

Great idea.  The idea to be able to put fake money into an account, to have it count commissions and to be able to make buys and sells in real time is super.

The problem lies in the execution.  First there was the problem placing orders.  This started back in September.  I wrote them about it. They said they would fix it.  They wrote:

Here we are in January, I still have to do this clugey workaround where before I can place an order I have to start it through my margin account and then at the last step switch the practice account.

Now, just yesterday, another problem.  Apparently I can’t place an order for select NASDAQ stocks.  In particular those that are NASDAQ:CM (capital markets).  This just started.  I phoned RBC.  Luckily I’m on their gold plus customer plan or whatever its called so I get some service.  They look into it, see what’s wrong, but now they have to send it to their “back office people” to fix it.

We shall see.

Thus it is that while I own XBKS, I do not own XBKS in my practice account.  I don’t know when that will happen.  If any of my readers knows of another better service for tracking a mock portfolio, please email me.

Anyways, that’s the story, onto the stock.

My latest bank pick: Xenith Bankshares

Xenith Bankshares is a community bank centered out of Richmond Virginia.

The bank specalizes in making commercial loans, which make up some 88% of their loan book.

Xenith was involved in two transactions during the summer, buying banks from two other distressed Virginia lenders (Paragon Community Bank and Virginia Business Bank or VBB).  In the case of VBB, the bank was bankrupt and the transaction took place through the FDIC.  In the case of Paragon, Xenith just took over the Richmond based operations of the banks.  In both cases, the company is only responsible for the performing loans on these banks books.

The history of Xenith and these two transactions have already been written up in two excellent posts on a website called Frog’s Kiss, here and here.  I will not dwell on the details of the bank to much further, because all the information is there.

Why Xenith?

Xenith is aggressively growing their loan book in Virginia, both through transactions like the above, and organically through new loans.  They have done a good job of making loans, and so far nonperforming assets are not a significant threat.

And yet you aren’t paying much for this growth.  The company has a tangible book value of a little over $65M, whereas at the current share price of $3.70, the market capitalization is a little under $40M.

Why so cheap?

Well for one, the bank isn’t profitable yet.   Xenith has been losing about $1.5M per quarter all in for the last couple of years.  For two, it is a bank and after all no one wants to own a bank, right?

Of course that might be about to change.

Part of the bet here is that the management at Xenith can integrate these recent transactions and bring their profitability up to the company’s standard.    The company was created originally with a takeover of First Bankshares.  This was a sleepy little commercial lender that had a fairly weak interest margin.  The management at Xenith have been successful in increasing the NIM significantly since that time (see below).  The expectation is that they will do something similar with the newly acquired loan and deposit base.

The second part of the bet is that Xenith has a lot more room to grow.  The company’s tangible equity (as noted above), is about $64M.  Loans and securities and other risk assets are about $360M.  So the company is only employing about 6x leverage.  They should be able to raise this to around 10x over the course of the next year.

If they do, and are successful in their lending endeavors, you might expect the company to deliver a return of somewhere around 1% to 1.5% return on assets.  Taken another way, you might expect the company to deliver somewhere between 8% and 12% return on current equity when its all said and done.  Projecting either of these metrics leads to a fairly cheap earnings multiple (somewhere between 4x and 7.5x earnings depending on their success.   This suggests that as this plays out over the next couple of years, you could expect the stock price to at least double (and optimistically quadruple if the banks become loved again) from current levels as they move ahead.

Gramercy Capital: CDO-2005 passes the over-collateralization test?

With Gramercy, as much sleuthing that I am doing of the company, I feel like I do almost as much sleuthing of other investors.  With Gramercy, one of the best to follow is PlanMaestro.  He posts a blog called Variant Perceptions, also posts on yahoo, investorshub, and corner of berkshire and hathaway.  In this case the relevant piece comes from the latter.  Says Plan:

Jameson Inn was already written off 100% for OC purposes and CDO 2005 passed again its most recent test .

As those of you that read last weeks letter would know, I pointed out that CDO 2005 was unlikely to pass any time soon if it was only curing its undercollateralization with interest payments.  To have passed again, one of two things must have happened.

  1. About $100M of the assets held were paid back, with the proceeds being used to pay out the senior CDO holders
  2. One of the written down loans began to reperform

To discuss the possibility of the latter, there was news this week that the Vegas Hilton, which is in receivership and which has been 60% written down by Gramercy in CDO 2005.  For some time now Goldman Sachs, which holds the mortgage on the LVH along with Gramercy and another party, have been trying to convince the courts to let them run the hotel and gaming operations while it goes through the foreclosure process.  The problem is that the gaming license is owned by the previous owners Colony Resorts.  Colony Resorts had been fighting back saying that if their gaming license was used by the receiver, they could be liable without having any oversight control.

The issue was very recently brought to the court, which ruled that the receiver would only have non-gaming authority.  But then the Nevada Gaming Commission passed its own contrary verdict, allowing for the casino to operate under the existing license.  The matter went back to the courts and just last week news came out that the ruling was in favor of Goldman.

Given the information I have, I can only speculate that this contributed to the change in the collateral test.  The loan sat on the books of CDO 2005 at about $29M as of March.  It was apparently written down 60%, though I have no confirmation of that figure.    CDO 2005 was about $18M short as of last October.  Putting that all together, it seems very unlikely the loan could have had that big of an impact on the collateral test.  Still its an interesting exercise to go through, and a positive development both that the CDO 2005 is now passing, and that the LVH loan is likely accruing some interest again.

Argonaut Gold Pulls together a Strong PEA

This whole short Argonaut Gold trade didn’t exactly work out..  In fact, I don’t know what I was thinking.  I need to start reading my own press clippings.

To recap, two weeks ago I shorted some Argonaut against part of my long of Aurizon Gold. My reasoning was that if gold continued to fall Argonaut, being much more highly valued then Aurizon and at the same time having less cash, would have further to tumble.

I’m a little embarrassed that I made this suggestion. It was only two months ago that I had been arguing that Argonaut was one of the better gold stock investments out there.  I had it right originally. That thesis, which is available here, was that Argonaut had very strong growth opportunities and those growth opportunities could be accomplished with minimal CAPEX. If there is one thing the Street loves, its growth. If there is another thing the Street loves, its not having to put up a bunch of cash up front to get that growth.

Today the company released the PEA it had completed on the La Colorada project.

The PEA showed the following highlights:

  • Initial Capital Expenditure for the project is estimated at $14.5 million with a Sustaining Capital of $11.7 million.
  • Operating costs of $620/oz over the LOM, including $1.50/t mining costs, $2.36/t processing costs, and a 3.4:1 strip ratio
  • Gold equivalent production of 53,000oz per year over 9 years
  • Pre-tax Net Present Value (“NPV”) of $278 million using a 5% discount rate at $1500/oz gold

Overall the numbers would be mediocre if it were not for the capital costs, which at $14.5M is chump change for a project this size.  This is even less than the my estimate of $25M to which I commented: There are not many companies that can boast near term production potential with so little up front costs.

When I had shorted Argonaut against a portion of my Aurizon long it was with the idea that the quarterly results might show disappointment and the idea that the gold price might be susceptible to an even bigger pullback. El Castillo has underperformed the last couple of quarters, and with a mine that is of as low a grade as El Castillo the operators run a very fine line between success and failure.

That could still be the case, but having witnessed the stocks continuing rise I am reluctant to wait and find out. I got out Monday when the PEA came out.  At this level ($8) the stock is too expensive to buy.  I have to just admit I made a mistake by selling it in the first place (I owned both Aurizon and Argonaut back in October, but sold Argonaut after poor 3rd quarter results), and move on.

Is Aurizon a Value Trap?

How bad was that decision I made back in October to sell Argonaut and hold Aurizon?  Well, I owned both stocks until the middle of October, when I sold Argonaut after less than impressive 3rd quarter results.

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This is a painful chart for me to look at.

Nevertheless, pain is a necessary condition of learning, and it helps some time to agonize over your own stupidity for a while, just so that its really grilled into you not to do the same thing again.

With that in mind, what did I do wrong?

Aurizon Mines: Visions of Joanna someday

In contrast to Argonaut, Aurizon does not seem to be in much of a rush at all to bring Joanna into production.  This timeline says it all:

May 12th 2008

Aurizon first commissioned a pre-feasibility study on Joanna.

November 11, 2009

Aurizon finally received that pre-feasibility study and proceed to a full feasibility study.

September 14th 2010

Aurizon notifies shareholders that the original recovery process assumed (called the Albion process) would show lower recoveries and higher costs than first anticipated. Additional metallurgical test work would be done and the study delayed until mid 2011. http://www.aurizon.com/English/News/News-Releases/News-Releases-Details/2010/Aurizon-Reports-On-Progress-Of-Joanna-Feasibility-Study/default.aspx

August 11, 2011

Aurizon delays the feasibility study for Joanna again, saying: “the projected capital and operating costs appear to be significantly higher than previously anticipated. The increased scope of the project, as a result of the expanded mineral resource base, has increased capital costs, including those associated with an autoclave process. The costs of ore and waste stockpiles, tailings and of materials and equipment have also all been trending higher, along with the gold price.”

January 11, 2012

Another update giving an ETA: Feasibility study work on the Hosco deposit will continue in 2012 with completion of the study anticipated by mid-year. The feasibility study will incorporate a reserve update based on the increased mineral resource estimate announced on June 13, 2011, together with results of metallurgical pilot tests, a geotechnical study, updated capital and operating cost estimates, and other relevant studies.

Its been almost 4 years since the original pre-feasibility study on Joanna was complete! At this rate they should be mining by 2100.

As is obvious from above, there have been some metallurgical difficulties with Joanna. Was I too optimistic with my analysis?

To compare, the original pre-feasibility study assumed $187M in CAPEX. The operating costs were estimated at $434/oz. My analysis assumed $215M CAPEX, and operating costs of $717/oz. I think I have been safely conservative on the operating costs. I may turn out to be less so with the CAPEX.

The more fundamental point is that when I invested in Aurizon I strayed from my usual criteria for choosing mining companies in a couple key respects. Both of these have come back to haunt me:

A. Look for miners with a strong pipeline of growth. The market likes growth. It does not always appreciate value. The reason there is supposed “value stocks” is because the market does not appreciate value in itself.

B. Capital costs must be low and mining methods must be simple. The best mine to invest in is a simple heap leach deposit. High capital costs tend to get higher. Complicated mining and recovery processes tend to underperform to plan.

So what am I going to do about it?

Unfortunately there is not much I can do. Argonaut is $8 and Aurizon is $5. Most of the move in AR has been done. I’m not going to chase it at this point. Aurizon is probably much akin to OceanaGold, which I have played much more intelligently by buying the stock at $2.20 and selling it at $2.70 again and again. With Aurizon those numbers are probably around $5 and $6. Indeed I did sell some Aurizon around the $6 range the last time it was there but I think that its time to recognize that without a strong feasibility study for Joanna, that $6-$7 is about all you can expect here.

Portfolio

I’m getting too many stocks in my portfolio.  I am also seeing my cash position dwindle because I keep picking up new stocks without selling old ones.  I am still extremely cautious about Europe, and being so, I am getting uncomfortable with both of these trends in my portfolio.  In the next couple weeks I am going to reevaluate what I own and start paring where I need to.  The problem, as it always is, is that I like the prospects of all the stocks I own.  Unfortunately, as I think I showed rather clearly in my last post describing my 2011 performance, I am just as often wrong about that as I am right.  The likelihood of my own fallibility must never be underestimated.

Letter 23: Thinking it Through

Let’s Start with Europe (again)

The unfortunate reality of investing at the moment is that you cannot make a decision without first appraising the situation in Europe.  Correlations of most stocks, most asset classes, have gone to one.  The ability of the ECB to buy Italian debt, or the liquidity position of Societe Generale weighs as much on the price of Coastal Energy or Arcan Resources as does the success of their next well.

Its a bizarre new world.

This week Europe had their latest summit installment.  The response of the market to what transpired was confusing.  The market crashed mightily on Thursday, only to rally just as mightily on Friday.  Italian and Spanish bond yields spiked on Thursday but then dropped modestly on Friday.

Given the confusing signal sent by the market, I want to take a few minutes to step through what was agreed to at the ECB and among the EU members.  Hopefully we will be able to draw some useful conclusions as to what it means to the stocks we invest in.

The Fiddling of the ECB

A tweak here, a tweak there and pretty soon you have… well not a whole lot to be honest.  Let’s take a look at what the ECB did:

  • They lowered the rate for banks to borrow money from the ECB
  • They increased the types of collateral that banks can use to get liquidity from the ECB
  • They extended the period for banks to do long term borrowing from the ECB to 3 years and suggested they would facilitate such loans in unlimited amounts.

While these actions are somewhat helpful, what the ECB failed to do (at least directly) was to agree to buy significant quantities of government bonds.    This failure was likely responsible for the collapse in the market on Thursday.

Some have argued that the change in long term borrowing requirements will effectively let banks buy sovereign bonds on behalf of the ECB, effectively skirting the rules.  From the horse’s mouth:

There is no need to be a great specialist to understand that tomorrow, thanks to the central bank’s decision, the Italian state can ask Italian banks to finance part of its debt at rates which are undeniably lower than today’s market rates,” Sarkozy told reporters at a European Union summit on Dec. 9. “I take Italy but I could take the example of Spain. This means that each state can turn to its banks, which will have liquidity at their disposal.”

What Sarkozy is talking about is theoretically possible, however I am skeptical that it is going to be very meaningful in practice.  For one, the EU banks are already in the process of deleveraging.  By all accounts they are already too leveraged.  The process described by Sarkozy just adds more leverage.  For two, you have to think that the last kind of assets that the EU banks want more of are questionable sovereign bonds. Finally for three, if the banks decided to leverage up with even more sovereign debt all you’ve really done is doubled down on eventualy bailout that will be required when that sovereign debt goes bust.  You haven’t actually solved anything.

One of the last gasps of a Ponzi scheme is to use one investment vehicle to start purchasing the assets of another at an inflated price.  In other words, once you run out of outside suckers, you try your best to shuffle around the funds to appear solvent.  Needless to say this typically doesn’t last very long.

In all I don’t think that what the ECB did amounts to much more than a temporary blip of increased demand.  The problem of too much debt remains, liquidity to banks only helps solve the banks liquidity crisis, and the ECB still refuses to get its hands dirty by buying that debt in bulk.  However, if you want another opinion on this, on the bullish side, I think there was an excellent summary written by Savannahboy on Investors Village.

What did the EU do?

Describing what the EU did is trickier.  It is easy to get caught up in the market move upwards on Friday and assume that something significant must have happened at the meetings.  Well, I did a lot of reading and if something significant did happen, nobody told the journalists.  I suppose that the existing “plan of a plan” got tweaked and even pushed forward a couple of steps. Yet it  still remains a long way off from being a clear path to solvency.

A good Globe and Mail article by Eric Reguly reported the following summary of what was accomplished:

At least 23 of the 27 countries in the European Union – soon to be 28 with Croatia’s apparently suicidal desire to climb aboard the listing ship – agreed to a new, long-term fiscal pact designed to ensure that the euro never again gets hit with an existential crisis. (Britain isolated itself by refusing to join the deal, for fear that it would have to sacrifice the safeguards on its banking industry.)… On top of that agreement, the EU is strengthening its roster of financial stabilization tools. The EU will lend about €200-billion ($272-billion) to the International Monetary Fund, co-sponsor of the bailouts of Greece, Portugal and Ireland, to boost its firefighting capabilities. The European Stability Mechanism, the permanent bailout fund, is to launch next summer, a year earlier than originally planned, and its lending capacity is to be increased.

Reguly goes on to make what I think is the very valid point that all of these moves will do nothing to deal with the fact that the peripheral countries are not growing.

Look at Greece. Two years of austerity demanded by the EU and the ECB – read: Germany – with the IMF at their side have pushed the country to the verge of failed state status as economic activity vaporizes. The rest of the EU is slipping into recession.

With no growth, budget deficits everywhere refuse to disappear. Debt is going up. Perversely, the German-inspired response to the persistent deficits is demand for even deeper austerity. This is self-defeating, vicious-circle economics. At its worst, the lack of growth will erode the ability of the weakest countries to service their debts. Once investors figure that out, their sovereign bond yields will soar again, to the point their funding costs become unsustainable. Italy is getting close to that point.

This is key.  Markets are almost exclusively focused on what bandaid can be created to keep the banks from going belly-up next week. Perhaps the summit made some strides in this regard.  We should be able to make it through Christmas without anything catastrophic occuring.  But nothing that is being done about growth.

Jane Jacobs and the Feedback Nature of Currencies

The reality is that the fundamental problem in Europe is what brings it together in the first place: the existence of a single currency.  Italy, Greece, Spain, etc, cannot compete with Germany on a level playing field.  These countries need to have a way of leveling that reality out.  The primary (perhaps the only market based) mechanism for doing so is the relative value of the currency of each region.  If there is only one currency, there is no way to rebalance between the Eurozone countries.

This was the salient point made by Jane Jacobs years ago in her great book “Cities and the Wealth of Nations”.  In that book Jacobs begins with the basic premise that a currency is a feedback mechanism.  She goes on to argue that the problem with a country based currency is that it doesn’t allow for proper feedback of the individual cities that make up that country.   Cities within a country have a wide range of productive capacities.  What needs to occur in order to correct imbalances between cities is a readjustment of each city’s currency.

Jacobs provides a number of examples of how national or imperial currency regions usually results in one or two economically powerful cities, and a number of other dependent cities, usually requiring transfer payments of some sort to survive.

Speaking particularly of Europe she says (remember this was written in the early 1980’s):

In Italy, as time has passed since the unification of the country a century ago, the economics dominance of Milan has grown only more marked, not less so.  Even Rome itself has only a meager cioty region, vanishing a few miles south and east of the city where, immediately, the poor south of Italy begins.  In Germany before its postwar partition, Berlin had become ascendent…In France, only Paris has a significant city region now, unlike the country’s so-called eight great peripheral cities: Marseilles, Lyons, Strasbourg, Lilli, Rouen, Brest, Nantes, Bordeaux.

Outside of Europe she points to the example of Canada (Toronto and central Canada has typically grown briskly and propped up the weaker maritimes provinces), the  US (cities of the northeastern corridor typically being much stronger then those of the south), and Britian (where “the passage of time simply widened the economic gulf between [the rest of Britian] and London”) to name a few.

What Europe has embarked on with the Euro is the exact opposite of what is needed.  Currency regimes need to evolve to produce better feedback, not worse.  The Euro currency feedback mechanism is skewed by the strength of the German economy (actually more exactly the economy of its one or two prime export replacing cities, Berlin and Frankfurt).  Peripheral countries like Italy, Greece, Spain and Portugal are doomed to receive faulty feedback rather than the natural “export subsidy” that would occur if those countries had (lower value) currencies of their own.

US Housing Market

Getting away from Europe, I spent some time this weekend listening to an interesting debate at the AmeriCatalyst Housing conference.  I was introduced to this conference when I discovered some of the videos of Kyle Bass being interviewed at it.  As it turns out there is a lot of interesting stuff at the conference, not the least of which is the discussion below about the state of US housing.  This is a debate / information session put on by experts in the mortgage and housing industry.

Probably the most interesting aspect of the debate was with regard to shadow inventory.  I’ve never been totally clear on just what shadow inventory was, and it seemed to be a number that varied significantly depending on the conclusion the purveyor was trying to draw, so it was interesting to hear the comments of these experts on the concept.

The truth is that the magnitude of shadow inventory depends as much on the definition as anything.  A couple of different estimates of shadow inventory are made by different analysts.  Laurie Goodman (who I first learned of from ftAlphaville fame) pegged shadow inventory at 11M (which is an amazing 20% of housing mortgages outstanding).  Mark Fleming pegs it at 2M.  Both analyts are using the same data.

How is this possible?  Its all in the assumptions.  Shadow inventory is really just houses that are expected to go into default at some point.  There is nothing particularly nefarious about the concept, even though the name suggests it is some sort of inevitable flood of housing supply.  It may be, but it may not.  It depends on what happens.  Laurie, to come up with her 11M number, assumes a fairly large number of prime mortgage defaults, including some that are currently with LTV (loan to value) of less than 100%.   Laurie also looks at 60 day past due as her “bucket” from which to extrapolate current nonperforming loans.  Mark on the other hand, uses 90 day past due, and does not include currently performing prime mortgage defaults.

As Mark Fleming puts it, the true shadow inventory is “behaviorly perception driven”.  In other words, if the housing market begins to be viewed as bottoming, if the economy is perceived as improving, the impetus to default will be less and the shadow inventory will be on the lower end.  If the view is another lengthy recession, then expect a lot more inventory to come out of the shadows.

What it Means to the Portfolio: Lightening up on Gold

I sold out of Newmont Mining earlier this week, and I lightened up on my position in Aurizon Mining. I remain bullish of gold stocks, just not as bullish as I was.

I have been expecting that the European problems would precipitate ECB money printing.  I still believe this is going to happen, At some point that is; as I pointed out the structural flaw in the Euro currency union means that there simply is no way that Italy, Greece, Spain and Portugal (maybe even France) are going to grow themselves out of  their debt.

Nevertheless Draghi’s comments this week suggested that money printing may be a little further off into the future than I had hoped.  Without that, gold remains vulnerable to the headwind of its own price appreciation, and the damage that has done to jewelry sales.

The WSJ  had a good article on this:

India’s wedding-season gold demand has nearly disappeared as the yellow metal’s local prices have climbed to near-record levels because of a fall in the rupee’s value, sparking a rush to sell scrap during the usually peak buying period.

“There is virtually no demand for gold,” said Prithviraj Kothari, president of the Bombay Bullion Association.

I feel reasonably comfortable holding story stocks like Atna Resources and Lydian International (I also started a position in Esperenza Resources this week, though not in my online portfolio).  I feel less comfortable with Newmont, which is basically a play on the price of gold.  The same case can be made to a lessor extent with Aurizon Mines (though the reason to hold onto Aurizon is an eventual consolidation of the gold sector).

Buying the Banks

While I am reducing gold, I am buying back some of the regional bank holdings I sold off after beginning to be concerned about Europe.  The truth is, the regional banks have faired better than I would have expected during the past 6 months.  The recent bottoming of the ECRI weekly leading index, along with decent jobless claims data, suggests to me that the US economy does not have its bottom falling out.  I suspect that a muddle through for the US should be good enough to see decent price appreciation in some of these beaten up regionals.

Bank of Commerce Holdings

A bit of a punt here.

I was listening to BNN last week and I caught Contra The Herd’s Benj Gallander’s top picks.  One of them was Bank of Commerce Holding (BOCH on the Nasdaq).  I did some work this week on the company and it looked cheap (less than 10x earnings, trading at about 50% of tangible book), it had a reasonable level of nonperforming loans (3.3%), and it has the potential for better earnings in the future once it works its way through its loan loss write-downs. So I bought some.

The worry about this regional bank is its region.

The Company conducts general commercial banking business in the counties of El Dorado, Placer, Shasta, Tehama and Sacramento, California.

This is not-exactly-but-close-enough-to the inland empire that didn’t fare so well during the housing bust:

Given the circumstances, the company has done an admirable job of keeping their loan book clean thus far:

  • Nonperforming loans to total loans 3.33 %
  • Nonperforming assets to total assets 2.30%

As well ROE has been decent, particularly if you consider that the number includes the provisions to losses the company has taken:

Return on average assets (ROA) and return on average equity (ROE) for the three months ended September 30, 2011, was 0.91% and 7.45%, respectively, compared with 0.67% and 5.95%, respectively, for the three months ended September 30, 2010. ROA and ROE for the nine months ended September 30, 2011, was 0.75% and 6.45%, respectively, compared with 0.70% and 6.61%, respectively, for the nine months ended September 30, 2010.

I estimate that if you looked at ROE ex-provisions, the number would be very close to 10%.

Bids in for Oneida Financial (ONFC) and Community Bankers Trust (BTC)

While I managed to pick up a position in BOCH quite quickly, I have bids in for, but so far haven’t been able to purchase, too many shares of ONFC and BTC.  Rest assured I will wait patiently until I do.  Both of these banks represent good value, and unlike BOCH they are both in areas with stable economies and housing (Virginia for BTC, Central NY for ONFC).

In the case of Community Bankers Trust, the 3rd quarter brought the first profitable quarter in quite a while.  It also showed a continuation of the trend towards less charge-offs.

BTC trades at less than a third of tangible book value ($3.67) at this point.  Meanwhile, insiders continue to buy shares.

Oneida Financial is a NY based bank with stellar loan performance (well under 1% nonperforming assets to total assets), strong earnings performance (should earn in the neighbourhood of $0.80 this year), and is trading slightly under tangible book value of $9.10.

I am particularly impressed with Oneida’s consistency of earnings throughout this tumultuous period.

Oneida also pays a dividend of 5%.

Portfolio Composition

What I’ve Been Doing

On the weekend I posted the reasons why I am very afraid that the situation in Europe is about to get a whole lot worse.  At the end of that post I highlighted a number of things that I planned to do to deal with this risk.  Over the last 3 days I have mostly completed these items.

  1. Get out of Gramercy – I sold out of Gramercy today at $2.56.  In retrospect I could have waited and sold out 10 cents higher.  We can’t know which way the market will go on any given day.  I may regret this.  Gramercy is likely coming ever closer to the day they settle their Realty division issues with their lending consortium.  The stock could make quite the pop on that day once the deal is announced.  I will be watching the news very closely for that day and will pounce if it settles positively.
  2. Trim Oils – I did this in my actual account but not in the practice account.  In my actual account Arcan, Coastal and Equal Energy were all trimmed by 10%.  I am dealing with somewhat larger positions in my actual account, so trimming is a more reasonable proposition.  I have found that using my strategy of taking off little bits at a time leads to extraordinarily high commissions with the practice account.  If and when I get to the point where I want to trim these positions to 25%, I will do the same in the practice account in one move.
  3. Cut the Banks in half – Oneida Financial was cut in half.  I held onto all the Community Bankers Trust that I own.  I sold all of Xenith Bancshares.  I don’t think I will regret these moves.  The US economy, at best, will be sluggish for the next few months.  I don’t expect big moves in the banks for a while yet.
  4. Cut Leader Energy Services by as much as I can – In my actual account I cut the position by half.  In the practice account I had a stink sell order at 69 cents and low and beyold it got filled today so I am out of Leader entirely there.  Some might say this is hypocritical.  How can I write up Leader a few short weeks ago and then suddenly turn around and liquidate my position.  All I can say is that when the facts change…  look I underestimated the crisis that is occuring in the Eurozone.  Leader Energy is in a cyclical business and has a lot of debt.  This is a good company to be in during a economics expansion and especially during a time when oil prices are highly profitable.  This is not a good company to be invested in during a time when debt markets tighten.
  5. Watch Gold Stocks Closely – I haven’t done a lot here, though I did lighten up on Jaguar on Monday and add to Argonaut Gold today.   I’m still of the mind that gold stocks are breaking out and have higher (maybe much higher) to go.  But I reserve the right to change my mind here. I am wary of how far this gold correction will go.  However, the stocks never priced in the move anyways.  To take an example, should Newmont be crushed as gold moves from $1900 to $1600 when its price is lower than when gold was $1200?  Its ridiculous.

We’ll have to see how the next few days play out and what Bernanke announcement comes out of Jackson Hole.  But for the moment I feel a lot more secure after having made these moves.

Oneida Financial – Local MHC Continues to Make Good

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.

After spending a few months getting to understand the banking industry, and scouring the net for cheap MHC’s trading below or at book value, I stuck money into a couple of them, with one of those being Oneida Financial.  Now, in the 5 or so months that I’ve owned it the stock has done absolutely nothing.  You might want to take that as neither a good or bad thing in this market.  Oneida has bounced back and forth between 8.40 and $8.80, but does not seem in any hurry to break out in either direction.

I have already written an extensive write-up on Oneida’s regional banking business and why I picked Oneida as one way to play this trade of the decade.  I’m not going to go further into the details of my reasons here.  I’m just going to focus on their second quarter results.

Another strong quarter for earnings.  Oneida earned 24 cents for the quarter.  Stripping out loan loss provisions they earned 25 cents.  Over the past 4 quarters their earnings have been 84 cents basic and 91 cents after stripping out loan losses.  Below is a chart of their earnings over the last 5 years.  There has been a steady upward march over the past two years.

I bought Oneida in part because I thought they were cheap based on earnings power.  They should easily be able to earn a $1 next year, meaning they are trading at less than 9x earnings on a forward basis.  What I have been waiting for is for Oneida to begin to grow their loan book again.  Its been shrinking (albeit at a small rate) since the 2008 debacle.  This looks like it might be starting to change.

Oneida’s loan growth is a bit tricky because they sell of much of the fixed rate loans they generate.  So to get a true picture of their loan generation, you have to add back the fixed rate loans that are being sold off.  Below is a chart of loan growth at Oneida showing both growth before and after accounting for the fixed rate loans sold.  Up until this last quarter loan growth has been negative since Q2 2009.  That changed this quarter with the uptick.

Deposit growth declined somewhat in Q2 from the last few quarters.  Nothing to worry about yet though.


The company continues to sell below book value and tangible book value.  More importantly, book value continues to grow at a smart pace.