Posts from the ‘Regional Banks’ Category

May 2

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.

Apr 21

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.

Feb 5

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:

The lack of Indian demand brought on by the strong rupee
An improving US economy will mean higher interest rates eventually
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.

Weekly Trades

Jan 29

4 Comments

Week 30: Cognitive Dissonance, Canaco updates, Canadian house prices and the story of Community Bankers Trust

Portfolio Performance

Portfolio Composition

Trying to not be dogmatic

A few years ago I read a book called Mistakes were Made. The book described our ability as human beings to remain convinced that we are right to the point where we ignore all evidence to the contrary.

Our predisposition to fabricate reasons why we are right and ignore reasons why we are wrong is based on a concept called cognitive dissonance. As the book defines it:

Cognitive dissonance is a state of tension that occurs whenever a person holds two cognitions (ideas, attitudes, beliefs, opinions) that are psychologically inconsistent… Dissonance produces mental discomfort ranging from minor pangs to deep anguish; people don’t rest easy until they find ways to reduce it.

All symptoms I am all too well acquainted with.

Along the same lines, I came across an interesting piece on FT this week. The following quote can be attributed to SocGen’s Dylan Grice:

But all is not lost. The bias towards thinking we’re more correct than we are isn’t driven by an inability to fully assimilate undesirable information but an unwillingness to do so. Therefore, the first step in removing the bias is to adopt procedures that foster a more honest acceptance of logical conclusions. Logic has no emotional content per se. There is no such thing as good or bad information; information is only true or false.

But because of our hardwiring, we only want certain information to be true. In particular, we want the information that confirms our prior beliefs and validates our belief systems to be true — about ourselves, about others, about the world. Thus, debiasing ourselves must involve an honest assessment of what we want: do we want to be right about everything, or do we want to know what’s true?

Let’s bring this back to what this blog is about: investing. In my piece last week I stepped through the basic premises on which I am currently invested. The tenants I stated were the conclusion of a somewhat anguished and certainly restless mental reevaluation that I had been running through over the prior few weeks.

As the market moved against me I started to look at why I might be wrong. In my spare time I tried to “assimilate the undesirable information” and paint the most contrary picture I could.

I especially went through the exercise with gold and with my rather significant precious metal stock positions (Aurizon Mines, Atna Resources, OceanaGold, Canaco Resources, Geologix, Esperenza Resources, Lydian International and Golden Minerals). Gold is always easy to question (what does gold really do anyways?). I attempted to soberly evaluate both the prospects of the metal and the companys. I looked for reasons to basically cut them loose.

I hemmed and hawed a lot, and at times began to convince myself that I was indeed wrong. But in the end I was led back to the basic points of valuation and underlying conditions, which seemed to me to remain firmly in gold’s favor.

This is how I make decisions. At times it undoubtably appears that I am flip-flopping. I am sure that my weekly writings must have an aire of contradiction when read one after another. A reader might wonder how it is that my point of view can go from one extreme to another in the matter of weeks (see Argonaut Gold). Or at times even flip 180 degrees only to flip back a few weeks later (see Argonaut Gold).

In truth, this is the only process I know of that allows me to really question whether I am right. If I can push myself to the edge, almost convince myself of the diametrically opposed point of view, and still in the end come back to my original conclusions, then well, that’s really getting somewhere. At times I push myself so far that I actually begin to believe it myself (ah yes, see Argonaut Gold), but that is just a occasionally necessary casualty. Far more often I leave the exercise with more clarity, and with that clarity comes the likelihood that I will act properly when the situation arises.

In the end I came away from my “anguished” analysis of gold more confident in my positions than I was when I started. And this week, on Wednesday, when the Fed news hit the wire that interest rates would be low for time eternity, that gave me the clarity to act.

The moment I read the news I bought a position in Barrick Gold, and I added to my positions in Esperanza Resources and Golden Minerals (though I neglected to make the AUM trade in my practice account). The next day I added to OceanaGold, and thta was followed by additions to Atna and Canaco the day after that.

In my practice account:

And in my actual account:

You do the work so that you have the confidence to act. You put in the time learning and working through why so that when an opportunity makes its brief appearance, when Bernanke comes out and says “yeah we aren’t going to raise rates for a long time” you can recognize it for what it is and say “all right, I’m in” and you know what you have to do.

Had I not been stepping through the thesis of why gold and gold stocks remain a solid investment, I likely would not have had the conviction to buy into the rally. At worst, I would have sold into the rally, because if you really don’t know why you are investing in something you tend to take the first blip after a long period of blah as a “finally I can get out” moment. As it is, with the Fed putting interest rates on hold for another couple years, and with their actions maybe even foreshadowing a true QE event in Europe, I feel quite confident that I am positioned well for that fall out.

Speaking of Canaco Resources…

I bought Canaco Resources at the end of the year at about $1.10 as part of my “tax loss buying binge”. A couple of things happened with Canaco this week.

First, the stock went up.

Second, the company updated us on its activities in Tanzania:

Expect a resource estimate by the end of March
Expect a preliminary economic assessment by the end of the third quarter
Expect further metallurgical testing results at some point

Third, Canaccord Capital came up with an updated price target, and more importantly helped give us a glimpse at what to expect from the upcoming resource estimate (hat tip to howestreetbull who posted this on Investors Hub).

Canaco has approved a US$35-40 million 2012 exploration budget, and is currently drilling 10,000 metres per month at Handeni with nine diamond drill rigs and one RC rig.
Six of the drill rigs are focused on delineating the Magambazi resource in preparation for the initial resources estimate. Two diamond drill rigs are focused on the Kuta and the Magambazi North Extension targets. The remaining diamond drill rig is operating on the Majiri target, where previous surface sampling and RC drilling indicate a gold anomaly. The RC drill rig iscurrently operating on the Bahati target to test preliminary regional targets.
We are expecting an initial resource and metallurgical test results in Q1/12, and a PEA in Q3/12. We are expecting an initial resource of 2.3 million ounces of gold at a grade of 3+ g/t gold. Previous metallurgical testing indicates recoveries of 90+% using a conventional CIL process.

Valuation: with US$110 million in cash, we believe the company is in a strong position to continue to derisk and advance the Handeni project. Our peak gold price estimate of NAVPS (10%, US$1,750/oz) remains unchanged at $7.50. We continue to value Canaco based on a 0.65x multiple to our peakgold price estimate of NAVPS.

At the current price of $1.50 Canaco trades at a market capitalization of $300M. Subtracting the current cash balance of $115M, the enterprise value of the company is a little less than $200M. If the deposit does indeed contain 2.3M oz of gold, the valuation being given for those ounces is about $80 per.

This is a 3 g/t open pittable deposit that looks to be 90% recoverable with a straightforward metallurgical process sheet. In my opinion (and apparently Canaccord’s as well) those ounces should be worth more than $60/oz.

To throw out a comparison point from a recent PEA, Prodigy Gold had a PEA done for its Magino gold property last March. The PEA assumed a CIL recovery process, a 9 year mine life, producing gold from an open pit at a grade of 1.2g/t for 9 years to give a total mine of life production of 1,585,000 oz of gold. The after tax NPV5 of the project was estimated at $259M at $1000/oz gold. That works out to a value of $160/oz.

Albeit there may be better comparisons out there, but this one surely suggests that Canaco is undervalued. Canaco’s Magambazi project is much higher grade than Prodigy’s (3g/t versus 1g/t). The location is Africa, versus Canada for Prodigy, which probably suggests a bit of a discount against Canaco but not enough to make me change my opinion. And while the Magambazi strip is as yest unknown, the Magambazi deposit appears to be around a hill top, which should lead to a reasonable number (the strip for Prodigy’s Magino is 3.3).

Finally, the last bit of news was that Brent Cook came out with the following plug about Canaco:

“The funds were just jumping in on this thing – and they all bailed out as well – the stock got down to $1.20. During this time period they’ve been drilling and drilling and drilling, and the results continue to show me that they’ve got what I think is going to be a legitimate, decent size, decent grade, open-pittable deposit in Tanzania,” Cook says. “So we’re buying this stock at $1.30 with $115 million in the bank, and a $41-million exploration program. That, to me, seems like a good buy.”

Yup.

When the gold price broke out on Wednesday, Canaco was the first stock I added to.

and speaking of gold…

I came across this interesting piece of information regarding the appetite of the Chinese for gold. This may be old news to some but I think it is still worth reporting.

The People’s Bank of China research director Zhang Jianhua was cited as saying Monday in the central bank publication Financial News that gold purchases should be ramped up when prices drop, although he gave no indication of what proportion of the nation’s $3.2 trillion forex reserve should be allocated to investments in gold.

Apparently, Jianhua called gold the only safe haven left and said that:

“the Chinese government needs to further optimize China’s foreign exchange asset portfolio and seek relatively low entry points to buy gold assets…no asset is safe now. The only choice to hedge risks is to hold hard currency – gold”.

High House Prices

I’ve been doing some research on house prices in Canada and in particular in my city, Calgary. I plan to do a separate post on my findings shortly, but for the moment I just want to throw up a couple teaser graphs that gave me pause for thought.

The chart is taken from a speech given by Mark Carney to a Vancouver audience last June. The methodology used is the ratio of the nationwide median home price to the median household disposable income. A ratio of greater than 3 has traditionally been seen as unaffordable.

It makes you think.

One other chart from the same report. Below is the average house price in Vancouver:

Its either a heck of a bull market or a bubble. To say it another way, I don’t know about house prices, but when a stock goes parabolic you typically know how it is going to end.

Anyways, more on this later.

Community Bankers Trust

It was a good week for Community Bankers Trust (BTC).

Earnings will come out for the company on Tuesday. Hopefully the company will put together another profitable quarter.

The BTC story

I bought BTC as a turnaround story. Community Bankers Trust is a bank that has been trying to reincarnate itself after the first incarnation came close to an early death. My observation is that they have been successfully navigating this resurrection, and with the recent turn in profitability (and a helpful turn in the economy) the bank is on its way to realizing its earnings potential.

The bank was hit hard by the recession in 2009. The company saw nonperforming loans skyrocket from 2% of total loans in the first quarter of 2009 to 10% of total loans in the second quarter of 2011. Yet there have been signs that the efforts the company has been making to turn itself around are working, culminating with a profitable quarter in Q3.

Let’s hope they can keep that momentum.

How did they get to here?

The original strategy of the bank was, as far as I can tell at least, to simply buy other banks and get bigger. Witness, the name of the original company was called Community Bankers Acquisition Corporation (CBAC), so they weren’t exactly being subtle. Along with the acquisition strategy, the bank seemed to have a “worry about the profitability later” strategy, which may have worked ok when the economy was growing but that fell flat when the economy didn’t in 2008.

As best as I can discern the acquisition effort was spearheaded by Gary Simanson. He headed up the original company CBAC, and then moved into a position of Strategic Vice President, a position I don’t think I’ve ever heard of with any other company. According to this article, Simanson was responsible for subsequent acquisitions.

In truth, the timing was what killed the acquisition strategy. To quickly step through the timeline, in May 2008 the company began its journey by acquiring two local Virginia banks, TransCommunity Financial Corporation, , and BOE Financial Services of Virginia, Inc. In November the bank moved ahead and acquired The Community Bank, which was a little bank in Georgia. Finally in January 2009 they acquired Suburban Federal Savings Bank, Crofton, Maryland.

So you had 4 bank acquisitions in less than a year happening at the time of a 100 year financial tsunami. How do you think things turned out?

Change in Direction

By 2010 Simanson had left the company and the direction of the company was changed to the more pragmatic “we need to get profitable before we go belly up” strategy.

This was described pretty bluntly in the 2010 second quarter report. CEO Gary Longest said at the time:

Our strategy has shifted from that of an aggressive acquisition platform, to one that meets the banking needs of the communities we serve, while providing sustainable returns to our stockholders. To this end, we are taking the necessary steps to return immediately to profitability. We are actively analyzing our market base to assess the contributions of all branches to our franchise value and will take the appropriate actions in the third quarter of this year. Additionally, we will make aggressive expense reductions, and will look to restructure and strengthen the balance sheet. We are confident that the analysis of these potential critical paths and the resulting execution of these initiatives will lead us back to profitability quickly.” “Our goal is an immediate return to consistent quarterly profits. To accomplish this, we have no alternative as a Company but to make clear and intelligent decisions in the next 60 days, no matter how difficult, to accomplish that goal as soon as possible. That is our full focus.”

In a somewhat odd twist to which I’m sure there is a good story, Longest himself was gone only a couple months later. Nevertheless the interim CEO and soon to be permanent CEO Rex L. Smith took up the reins and has carried out the strategy quite well given the circumstances.

Where are they now?

I already mentioned that the company had its first profitable quarter in a long time last quarter. I don’t believe this was a one time fluke. It looks to me like its the culmination of a number of initiatives put forward by the bank that have been geared towards making the bank more profitable.

The company has made an effort to lower the cost of its deposit base. Time deposits, which are expensive high interest bearing deposits, have decreased from 73% to 67% of total deposits since the end of 2009. As well, the cost of the time deposits has come down from 2.9% in 2009 to 1.6% in the third quarter.

The effect has been a steadily rising net interest margin (NIM) since the strategic direction change in 2010.

(note that this graph is a simplified version of NIM calculated as a percentage of all assets rather than the more common formulation of interest bearing assets)

The company also undertook efforts to reduce expenses. The most common way of illustrating the day to day expenses of a bank is through something called the Efficiency ratio. The Efficiency ratio is simply the ratio of the total non-interest expenses at the bank (so the salaries, building costs, lawyer fees, pretty much everything except the actual cost of borrowing money) to the net interest margin (so the amount of interest made minus the amount of interest paid). The reason that you look at the Efficiency ratio is because it ex’s out growth, since growth should occur for both NIM and expenses in concert with one another.

The Effiency ratio of BTC has been falling consistently.

What’s it worth?

To get an idea of what the bank might be worth if it continues to pull itself together, I put together a proforma earnings estimate. I stripped out all the provision for loan losses, the FDIC intangibles (from their earlier acquisitions) that the bank is required to amortize, as well as losses on real estate and gains of the sale of securities. So basically I looked at the banking skeleton that is BTC. Here is what I found:

What this clearly demonstrates is that if get rid of all the scabs, there is quite a profitable little enterprise here.

Meanwhile, the bank sports a tangible book value that is much greater than the current share price ($1.40 after last weeks run up):

What is left to be done?

The story that still needs to play itself out is the healing process. The really big negative for the bank is that it still has an extremely elevated portfolio of non-performing loans. There are signs that this is abating, and in truth part of the bet here is the same one that you make on any regional bank: the US economy is turning the corner, the Fed is not going to allow it to fall into another recession, and so the worst of the loan defaults are behind us.

But just to get an idea of the risk here, typically you wouldn’t want a bank to have non-performing loans in excess of a couple of percent. Many of the best banks I’ve looked at have nonperforming loans of well less than 1%. BTC, onthe other hand…

There are tentative signs that the peak has passed, but it will take a few quarters before we know for sure that further write-downs are not coming.

Earnings on Tuesday will give us a lot of insight into the direction of the trends. I’ll be looking closely at nonperforming assets and the 30-89 day deliquents (which are an early warning of the soon-to-be not performing. I also will be hoping to see some decent earnings.