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Posts from the ‘Regional Banks’ Category

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.

  1. With the cash they’ve raised they are going to be able to take advantage of lending opportunities.
  2. 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. 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.


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.


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)

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 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.

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 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.





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:

  1. Concentrated Commercial real estate loans are being affected by the economic downturn
  2. Interest Rates falling
  3. The market value of their investment portfolio declining
  4. Competition
  5. Funding Sources
  6. 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.

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.

Regional bank earnings round-up

Over the course of last week four of the five regional banks in my portfolio reported first quarter earnings.  Since that time I have been busy reviewing those earnings and drawing conclusions on whether the stocks should remain owned, or be punted out for other opportunities.  Below I will go through my analysis and thoughts on each of these banks.

Rurban Financial (Ticker: RBNF)

Rurban Financial reported earnings last Tuesday.  Rurban does not have a particularly troubling loan book, and while they do have some non-banking related problems (such a legacy data processing business that does not appear to be doing very well) they are mostly set to generate strong earnings going forward.  So when I look at Rurban’s results, I focus on what they were able to earn.

Earnings per share came in at 20 cents.  Because Rurban has a  large mortgage servicing portfolio they are subject to big swings in earnings due to the GAAP valuation adjustments that they have to take on their portfolio of mortgage servicing rights.  While these adjustments are GAAP requirements, they tell us nothing about the business and tend to obscure the true earnings of the business.  Thus, I like to look at a “core” earnings number that eliminates the valuation adjustments as well as any other one time charges and the loan loss provisions.  Core earnings came in at 19 cents.  Core earnings for the past 5 quarters are shown below:

I’m not too worried about the decline in earnings quarter over quarter because a lot of it is seasonal.  Rurban sold a lot less mortgages in Q1 2012 than it did in Q4 2011 and that is just the seasonal nature of that business.  For some reason a lot of markets in the US experience high mortgage demand in Q4, and low demand in Q1.  In most Canadian markets it is the opposite of that, with Q4 being the slowest of the four quarters.

Another contributor to lower earnings was reduced revenues from the RDSI data processing subsidiary.  RDSI provides data processing services for banks across the Midwest. RDSI lost $1.4M in 2011 and doesn’t appear to be doing any better in 2012.  Its a strange situation because the big cause of the loss in Q1 were writedowns related to Rurban’s own bank deciding not to use RDSI for their banking related data processing needs.  Clearly they are cutting ties (winding down?) and maybe that will be for the best in the long run.  Below are revenues from RDSI less intercompany over the last 5 quarters.  Its become small enough that going forward it should cease to be the drag on earnings that it has been.  And that’s a good thing.

Mortgage revenue at Rurban continued to be strong; Rurban generated $1.2M in origination volumes in Q1 versus $420K in the same quarter last year.   As I already mentioned originations are always down in Q1 versus Q4, so that number was a decline from $1.5M in the previous quarter.   The year over year growth in origination led to further growth in their servicing business, which was up by another $20MM in terms of unpaid balance sequentially.  Nonaccrual assets continue to fall, down to $6.5M from $8M in the fourth quarter of last year.  And the company continues to rein in cost, witness by another drop in non-interest expense.   Negatives for the quarter were pretty much the same as those I saw elsewhere in the banking sector.  They are getting squeezed on interest margins (down from 4.07% to 3.64%), and loan growth was pretty flat quarter on quarter.

Overall Rurban announced pretty solid results and they are continuing to move towards their potential $1 per share of earnings.  There is still work to be been, ROA remained poor at 0.60%, but that is why the stock trades at only 2/3 of book value, and why the opportunity for further price appreciation remains.  I have been very happy to see the shares move up as they have over the last week.

Shore Bancshares (Ticker: SHBI)

Shore had a tough quarter.  While I had been hoping  that the company’s loan book was on the mend, the first quarter results showed that there is still some work to be done.

The loan book deteriorated over the quarter.  The company had to put aside provisions for credit losses of $8.4M, which was way up from $4M in Q4 and $6.4M in Q1 2011. Nonperforming assets rose to 8.1%.  I had been hoping that nonperforming assets had peaked in Q3 and would continue to roll over in Q1.  Unfortunately not.

The company said that the rise in nonperforming loans resulted mainly from one relationship. 50% of the $9.1M in charge-offs were related to a single large real estate borrower.

If you can get past the loan book (and I wish they could get past their loan book), there were some positives for the quarter.  While deposits increased 4.2% on a year-over-year basis and, notably, core noninterest-bearing deposits were up 17.4% year-over-year, so the company’s borrowing base continues to move towards lower cost loans.

If you look at Shore’s eventual earnings poential, if they could stop taking massive writedowns every quarter, it remains strong.  Earnings ignoring the provisions were $0.39 per share.  Over the previous twleve months Shore has put together earnings of $1.50 per share if you ex out the loan losses.  So the potential is certainly there.  Unfortunately loan book stabilization appears to be a bit further off then I had anticipated.

I’m not sure what to do with Shore.  I am tempted to cut it and run.  I originally got the idea from Tim Melvin of Real Money.   He described the investment as a 5 year hold and a 3 to 5 bagger.  Given that the bank trades at about 1/2 of tangible book value and that it used to be a $25 stock before the collapse of 2008, and you can see where he is coming from.  However I am not quite as patient as Mr Melvin.  I like stories that are in the process of turning it around, not just with the potential to turn things around at some point.  I haven’t sold out of the stock yet, but I have an itchy trigger finger.

Community Bankers Trust (Ticker: BTC)

BTC’s earnings are always obscured by the effect of the indemnification asset that the company carries as a result of an agreement to take over a failing bank, SFSB, back in 2009.  The indemnification asset is an accounting tool that accounts for the FDIC guarantee that BTC received when they took over the SFSB loan portfolio.  Unfortunately, the accounting of the asset it such that when there is better than expected performance in the SFSB portfolio, the company has to amortize the indemnification asset on their income statement.  The size of these amortizations is extremely large relative to earnings.  In Q1 the amortization was $1.9M versus net income of $0.9M.

I always ex-out the effect of the indemnification asset when I look at BTC’s earnings.  The asset says nothing about their cash generation and earnings ability.  In fact it actually works in reverse to that underlying ability.

Ignoring the indemnification asset and a few other small one time gains and losses, BTC earned 13 cents in the quarter.  On this core earnings metric BTC has earned 52 cents over the prior twleve month, which means it remains an incredibly cheap stock trading at a little over 4x earnings.  Looking at the same sort of “core” earnings number that I did for Rurban, you can see that the bank is consistently been pulling in 10-15 cents of earnings a quarter for the last 4 quarters.

BTC has done an excellent job of pulling itself back from the brink of bad loan losses, and this continued in Q1.  Nonperforming loans on its non-covered portfolio (non-covered refers to loans not covered by the FDIC loss sharing agreement) decreased 13% or $4M quarter over quarter.  Nonperforming assets have fallen from a high of 9.7% of total assets in the second quarter of last year to 6.9% of assets in the most recent quarter.

Meanwhile the company grew its loan book marginally in Q1, which is traditionally a slow time of the year for loan growth for the company and a quarter where their loan book shrank last year.   It is also interesting to note that unlike most of their competitors, BTC managed to maintain a flat net interest margin in the quarter, at 4%.

I really like the turnaround that is taking place at BTC.  Having bought the stock at a little over a $1, I am sitting on a double already.  Yet I have no plans to sell.  BTC was a $3.50 stock as recently as the beginning of 2010 and was a $7 stock before the financial crisis hit in 2008.  I don’t see any reason why they can’t return to a level somewhere between those two numbers.

Bank of Commerce Holdings (Ticker: BOCH)

I learned about Bank of Commerce Holdings from a BNN Market Call with Benj Gallander, the Contrarian Investor guy.  He had BOCH as a top pick and I was looking for regional banks at the time so I took a look at the stock and bought some at $3.25.  Watching Market Call is a hit and miss time investment, you can sit there and watch episode after episode and get nothing out of it, but every once in a while there will be a gem.  BOCH was one of those gems.

Bank of Commerce Holdings is steady as she goes.  I’m not quite sure how they have done it, but BOCH has managed to keep nonperforming assets at reasonable levels (2.45% in Q1 which was down from 2.68% in Q4 2011) while operating in one of the hardest hit real estate markets (Sacramento).  To be fair they also operate in a second market, Redding California, which didn’t have quite as bad of a housing decline.

The company has been consistently reporting return on assets (ROA) of 1% and return on equity (ROE) of 8-9% for the last 3 quarters.

Much like Rurban, the first quarter seasonally has lower mortgage banking revenues than does the fourth quarter so I am not concerned about the decline in ROE and ROA sequentially.  Mortgage banking is a big part of Bank of Commerce Holdings banking business so they are subject to these seasonal effects.  What is more relevant is the trend in mortgage banking revenues.  They have climbed substantially from $2.5M in Q1 2011 to $5M in Q1 2012.

Bank of Commerce Holdings earned 35 cents per share in 2011 and 31 cents per share in 2010.  I would expect them to earn over 40 cents per share in 2012.  BOCH is not going to be a shooting star type of a performer.  Its not going to double in a year.  But the company is consistently profitable and consistently adding to shareholder value.  There is also the chance for them to raise ROE above 10% and ROA above 1% by increasing their operational efficiencies.  I hope to see this occur over the next year as the economy improves and opportunities present themselves.   I think it is reasonable to expect the stock to trade to the $5.50 range by the end of 2012.  That is good enough for me.

A look at the Rurban Financial Annual Report

Rurban Financial is quickly becoming my favorite regional banking investment.

Under the retail name of State Bank and Trust Company, Rurban operates 20 branches in Northwest Ohio, servicing the mostly rural communities of Allen, Defiance, Fulton, Lucas, Paulding, Wood and Williams.

I’ve already discussed Rurban in a small amount of detail here.

The company is generating an improving return on equity, improving earnings, and has a reasonably low amount of non-performing assets.

I just finished reading through the Rurban Financial Annual Report that arrived in my mail box a few days ago.  There were a few highlights that I thought were worth noting.

The Ohio Economy

In the CEO Letter to Shareholders, Mark Klein pointed to improvement in the Northwest Ohio economy.  He noted that the downturn in the Midwest economy occured later than in other parts of the country and so the recovery has been likewise delayed, but that signs of recovery are appearing.

Klein also pointed out that Ohio has risen to number one in job creation in the Midwest, and is up to ninth nationwide from 48th a year ago.

As part of a section of the Annual Report titled “Commitments to our Communities” Rurban profiled two farm lending relationships that they have cultivated, as well a tractor parts dealer.  Rurban’s primary clientele is rural Ohio residents and business.  I feel quite confident that grain prices will remain at profitable levels and that opportunities to service these folks will only continue to grow.

The loan book

In 2011 loans outstanding grew by a small amount, from $428M to $443M.  Unfortunately agricultural loans decreased from $40.8M to $38.4M but I would expectt this to pick up in the next year as another year of strong grain prices is under the belts of farmers.

I was pleased to see that the company has no land loans and no contruction loans.

Non-performing assets make up a fairly small 1.77% of total assets.  This is down from 2.87% at the end of 2010.

Increasing exposure to mortgage banking and mortgage servicing

Mortgage banking activity is seen as “exceptionally strong”. One of the attributes of Rurban that I like is that they hold onto the servicing rights of the mortgages they originate.  While these mortgage servicing rights (MSR’s) are not being valued very highly by the market, I expect that to change.

I was surprised to learn that Rurban will not revalue the MSR’s upward if (when) rates begin to rise or defaults begin to fall and, as a result, the valuation model used to put a value to the MSR begins to show increasing value.  As part of Note 1 to the financial statements the company wrote that “the valuation allowance is adjusted to reflect changes in the measurement of impairment after the initial measurement of impairment… Fair value in excess of the carrying amount of servicing assets for that stratum is not recognized.”

Rurban took a beat down because of the valuation adjustment that they had to make to the MSRs that they hold.  The valuation adjustment for the full year 2011 was $1,119,000.  That works out to 0.22 per share of before tax earnings.  Rurban reports the MSR adjumstent within its “core earnings” calculation, so it does not get ignored as is the case for some of the other mortgage servicers like PHH.  I’m not sure why they don’t “ex” it out of core earnings.  Its a somewhat bogus accounting requirement in my opinion.  If an asset can be adjusted up or down 25% in a single year is than you have to question the valuation period.

There has certainly been a move by the company to increase its MSR portfolio.  Below is a graph of the unpaid balance held by Rurban over the past 5 quarters.

Core earnings are increasing and not reflected in the stock price

If you ignore the effect of the valuation adjustment that Rurban has had to take on its MSR portfolio, and you look strictly at the company’s recurring core earnings, you quickly realize that the company’s stock price is not pricing in the full extent of its earnings generation or its earnings growth.

To come up with core earnings I have taken GAAP earnings and made the following adjustments:

  • OREO impairments
  • Goodwill impairments
  • Provisions for loan losses
  • Gains on securities
  • MSR valuation adjustments

Earnings have been improving both because of loan and mortgage business growth as well as because of prudent management of costs.  Looking at the income statement I was struck by the degree of cost cutting that the company has done in the past 3 years.  Looking at salaries and employee benefits, they were reduced from $21M in 2009 to $18M in 2010 and to $14M in 2011.   Similarly, professional fees fell from almost $3M to less than $2M.  Even postage and delivery expenses fell, from $2.1M to $1.1M.

Going forward in 2012, Rurban is going to focus on growth in revenues.  I expect loan totals to increase along with originations.  I expect further increases to mortgage banking activity.  Both of these should drive further improvements in earnings.

Improving return on equity

In the chart below I am looking at core earnings return on equity, which ignores one time charges and MSR valuation adjustments.

Why doesn’t the market care?

It seems kind of crazy to me that a bank with a solid loan book, decent growth and with earnings that look set to top $1/share in 2012 can be trading at less than $4.  But I guess that is why the regional banking sector remains the trade of the decade.

Listening to the financial news for the last couple of weeks, I am starting to hear some positive comments made about the large money centre banks.  I think this is the first step in the healing process of investor sentiment towards the banking industry.  It may take some time yet, but at some point solid regional and community banks like Rurban are going to benefit from that change in sentiment.

Rurban trades at 4x core earnings and at about 60% of a tangible book value that is valuing their MSR portfolio at an extremely low level.  That just doesn’t seem sustainable to me.  As the cycle turns I would expect to see the company trade at a premium to book value and at a double digit earnings multiple. Both would suggest a share price over $10 per share.



Letter 31: Bank earnings and more bank earnings, lightening up on gold stocks (again) and a soon to come Canaco Magambazi resource

Portfolio Performance:

Portfolio Composition:

Waiting on Magambazi…

I have been working most of the week on an evaluation of Canaco’s Magambazi deposit in Tanzania. I was hoping to be finished the work by today but its carrying on and I don’t have a lot of time to finish it today (what with the superbowl and all) so this will be a rather short update, but with a longer, hopefully rigorous analysis of the Magambazi deposit will follow shortly tomorrow or the next day.

Outperformance of the US

Now that is something that I haven’t said in a few years.

While it was another good week for the S&P and a decent week for my portfolio it was not a great week for the TSX.  Again.  This is becoming a pattern.  Its striking how badly the TSX is underperforming so far this year.  The S&P is up almost 6%, the TSX is up hardly at all.

I have tried to increase my positions in the US-sensitive stocks I own to take advantage of this American out-performance with a particular emphasis on leverage to the mortgage industry.  Most recently, in the last week I added to my positions in Community Bankers Trust, PHH Corporation and I introduced a new position in Rurban Financial Corp.

Rurban Financial Corp

Rurban was  recommended in a comment (by Robert) to my post last week.  I did a quick look at the company, which released 4th quarter earnings on Monday, and they do indeed look cheap.  And while I haven’t had a chance to take a close look at their prospects, I’d liked what I saw on the surface, so I bought a small starter position.

The company produced earnings ex a one time merger charge and ex OREO losses of 23 cents per share in the 4th quarter.

Now I admit I have not dug into Rurban to the point that I need to (this Canaco resource estimate has been all consuming of my spare time).  I plan to do that in the next week.  I’d like to put together a comparison of Rurban and Community Bankers Trust and perhaps Bank of Commerce Holdings (both of which I will touch on below) side by side to better evaluate Robert’s legitimate skepticism in BTC.

Community Bankers Trust 4th Quarter Earnings

And speak of the devil, they released 4th quarter earnings on Tuesday.  I thought the numbers looked pretty good. The quarter was summed up by the following statement from CEO Rex L. Smith III:

“Our goals for 2011 were to make major improvements in our problem assets and to rebuild the fundamentals of the core bank, and I am pleased to report that we accomplished our goals. Both nonaccrual loans and net charge-offs saw continual and substantial declines throughout the year. At year-end our ratio of nonperforming assets to loans and other real estate was at its lowest level since the first quarter of 2010. Additionally, the fourth quarter showed a strong increase in new loan production in our targeted growth areas. All of this occurred while we lowered noninterest expense for the year by 21%.

Let’s step through some of the key metrics and update the graphs I showed last week with the 4th quarter numbers.

Pro-forma earnings (that is earnings before the FDIC amortization and before any one time hits to investments and real estate owned) were strong in the fourth quarter, coming in at 14 cents per share.  Again I think the bank has a lot of earnings power going forward once (if) it is able to bury its past misdeeds.

Equally important, nonperforming loans were down again in Q4.

The only negative I saw for the quarter was something I have seen a lot of with the banks reporting fourth quarter results thus far.  Net interest margin is on its way down.

Banks are struggling with the headwind of low interest rates.  Basically,  purchasing non-risky securities (ie. Treasuries and government backed MBS) means accepting extremely low returns.  As older securities mature and roll off the books they are being replaced by low yielding new securities.  Of course this is exactly what Bernanke is looking for to try to get the banks lending again.  That seems to be working in the case of BTC, as loans originated was up in Q4.

Bank of Commerce Holdings 4th Quarter Earnings

I wrote a short piece ofter my purchase of Bank of Commerce Holdings about two months ago.  Since that time the stock has risen about 15%, so its been an okay purchase but nothing exceptional.

I have yet to really evaluate the stock in the kind of depth I need to.  I hope to get to that in the next week.  In the mean time I have been compiling the basic statistics to do that evaluation.  The company came out with another data point on Tuesday when they released their 4th quarter earnings.  I would call it a mixed bag.  On the bright side the company showed another strong earnings per share number when you ex-out the one time hits, and ROE and ROA also showed strength on a proforma basis.

Note that my estimates of ROE and ROA exclude provisions from loan losses, losses on real estate owned and one time investment gains so they are somewhat higher than the posted numbers in the news release.

On the negative side the company struggled in much the same way as Community Bankers, posting a lower Net Interest Margin quarter over quarter.

Perhaps more worrying is that nonperforming loans are rising.

I’m not sure about Bank of Commerce Holdings.  I don’t have a large position in the stock.  I don’t love where the bank is based (around Sacramento California) and I don’t like how non-performing loans are rising at all. As CalculatedRisk pointed out recently, there aren’t any signs of things improving in Sacramento yet.

The percent of distressed sales in Sacramento was unchanged in November compared to October. In November 2011, 64.1% of all resales (single family homes and condos) were distressed sales. This was down slightly from 66.1% in November 2010.

I’m going to evaluate it closely and turf it if I don’t see a strong story being written that will lead the company back to the $6+ level.

I need to understand gold better

Early in the week the gold stocks and the bullion looked to be breaking out together and there was a hope (at least in my mind) that it was for real.  Then the Friday employment number came out and presumably frightened everyone about the prospects of inflation and the gold price dropped 1.8%.  Some of the gold stocks got hit much harder.  I’m not willing to find out if this is a blip or another true correction; I reduced my trading positions in Aurizon, Canaco, and OceanaGold (though as you will note at the end of the post with respect to my weekly practice account trades, I mistakenly bought rather than sold OGC.  This is something I will have to rectify on Monday).

What I need to do to gain some lasting confidence in my gold stock position is gain a better understanding of the supply/demand dynamic right now.  I’m flailing a bit here and I’m fully aware of it.  But there are a number of headwinds happening here that I don’t want to ignore:

  1. The lack of Indian demand brought on by the strong rupee
  2. An improving US economy will mean higher interest rates eventually
  3. The ETF has become such a big part of demand and I wonder how much of those holders are “weak hands”

The problem is that while I believe in gold in the long term, I also know that a lot can happen in the interim.  Rick Rule was pointing out a few months ago how in the 70’s and early 80’s, when gold rallied from $35 to over $800, it also had a number of corrections, including one of over 50%.

My lack of clarity in understanding just what is driving gold at the moment (and whether in the short term, particularly given that the seasonality effect is about to turn against the metal, it remains sustainable or not) is leading me to these short term in’s and out’s with OceanaGold and to a lessor extent Aurizon.  Gaining back some clarity, and with it hopefully some more certainty in my decisions, is another endeavour I hope to accomplish in the next week.

Speaking more company specifically, Atna remains the strangest bird of the bunch in the gold stock sphere.  It consistently outperforms (even goes up) on days when other gold stocks are going down and then does nothing (or goes down) when all the other gold stocks are up.  I don’t understand the stock for a second, though I am happy that the trend in the stock is, to borrow the phrase from Dennis Gartman, from the lower left to the upper right.

My soon to be complete Canaco Magambazi Estimate

In a next day or so I will be posting my interpretation of the resource estimate at Mogambazi.  I basically have went through the deposit, cross-section by cross-section, and evaluated the resource using a rough block model.  I thought it would be a fun project, and it has been, but its also been a lot of work.  My tools consistent of Visio, Excel and the screen capture tool snip-it, and my main resource to educate myself has been google, so its been a bit of a process.  Still, I’ve learned a lot and have become developed a better understanding of what Magambazi is (both the good and the bad) which I think will allow me to act prudently on it in the future.

So stay tuned for that.

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