When we think of opportunities in the stock market, we tend to think of the really exciting areas like technology and social media. These are the stocks that dominate financial media reporting. It seems that everyone owns a few shares of these super exciting stocks and expects to see huge returns. However, as Warren Buffett once pointed out, you pay a high price on Wall Street for this kind of consensus. When everyone loves a stock or sector, they tend to trade at very high valuation multiples, and there is a very good chance that future returns will be far more constrained than expected. Often, the very best opportunities come from the most boring sectors and companies, like regional and community banks. 

An Unsexy but Profitable Opportunity

Right now, the very best opportunity in the stock market is probably in small regional and community banks. Very few investors spend much time thinking about how to make money from these sleepy little off-the-radar stocks. But they should. Under normal conditions, buying these stocks below book value and holding for a long period of time can be a very profitable enterprise. However, right now when it comes to smaller bank stocks, we are in extraordinary times. There is an opportunity for price-conscious and patient investors to earn enormous returns investing in these stocks.

Community banks suffered right along with their larger cousins during the credit crisis. Although they didn’t make many of the toxic loans or dream up the deadly real estate loan-backed securities, they did see collateral values of the loans disintegrate. Many of them experienced very high loan default rates, and hundreds of them were closed or forced to merge with healthier competitors by the Federal Deposit insurance Corporation. 

The small regional and community banks that survived the meltdown have solid financial conditions. Their loan loss rates have declined while capital levels have risen pretty much across the board. Now, however, they face a new challenge. In the aftermath of the credit crisis and the global economic recession, the government has introduced new regulations to protect the nation from another economic crisis or taxpayer-funded bailout of the banking industry. 

Cost of New Regulations

A recent Harvard study, “The State and Fate of Community Banking,” by Marshall Lux and Robert Green found that the cost of complying with these new regulations is forcing many small banks to find a merger partner as the cost of remaining independent is too high. In a recent Reuters article, RBC Capital Bank Analyst Gerard Cassidy said that these costs pressures are going to cause the pace of merger activity in the industry to accelerate over the next year or two.

This creates a tremendous opportunity for individual investors. Many of the smaller banks still trade at prices well below book value. They do not attract the attention of larger investors and are not included in the indexes and exchange traded funds (ETFs) that are the favored vehicle of many traders and investors today. They tend to be far less liquid than most stocks and trade well below market multiples of earnings and assets. 

According to a recent white paper by a banks stock specialist hedge fund FJ Capital, the average value of a bank takeover is 1.38 times book value right now. Even better book values are growing across the industry as FIG Partners, a community bank research and trading firm in Atlanta, reported that 70% of all public bank stocks grew their book value in the second quarter of 2015. As long as book values are growing, the potential return for bank stocks investor are going higher every quarter.

As much as there is a willing pool of potential sellers due to regulatory costs, there is a potential pool of active buyers as well. The U.S. economy is not growing very quickly, and the competition for residential mortgages, personal loans and commercial loans is intensifying. Low interest rates compress net interest margins and make earning profit more difficult for many banks. Mid-size banks that want to grow their assets and earnings are looking to make acquisitions that allow them to achieve their targets. First National Bank of Northern California CEO Tom McGraw recently told the San Francisco Business Times, “It does seem in this prolonged low rate environment that acquisitions are the new organic growth. When rates begin to move up organic growth will be more organic."

How To Find the Right Bank

The best community banks to buy are going to be those with a total market capitalization of $500 million or less. These are the ones most vulnerable to the rising regulatory costs and most likely to seek a buyer. To maximize the profit potential limit your purchases to those banks trading at book value or less.You want to favor those with strong balance sheets and solid loan portfolios. Limiting your purchases to those with equity-to-asset ratios of 10 or higher and non-performing assets that are less than 3% of total assets will enable you to maintain a high margin of safety in your community bank investments. While an decent stock screener can produce a list of banks stocks with market caps under $500 million, you will have to either subscribe to a bank stock specialty database or spend a little time with earnings reports and quarterly SEC filings to uncover the other two ratios. Many banks provide the ratios in the earnings release, but even if they don't, it only takes a few minutes to calculate equity-to-assets and non-performing asset ratios.

A Small Bank in Montana

Eagle Bancorp Montana Inc (EBMT) is a great example of the type of bank you want to search for. The bank is located in Helena, Mont. and has 13 branches with $577 million of assets. Non-performing assets are just .20% of total assets and Eagle Bancorp has an equity-to-assets ratio of 10.82. They are financially strong, and the loan portfolio is safe. The market cap is just $43.8 million, but the shares trade enough each day for patient investors to accumulate a position. The loan portfolio is a diversified mix of single family and commercial real estate loans with no unhealthy concentration in just one area. The stock trades at just 82% of book value and pays a divided yield of 2.7%  of the current price. Officers and directors own more than 8% of the bank, so they have a vested interest in working to move the stock price higher over time. 

ESSA Bancorp Inc (ESSA) of Stroudsburg, Penn. is another bank that would be a great buy for investors looking to take advantage of the powerful trends in the community bank sector. ESSA has 26 branches with almost $1.6 billion in assets. The bank has been expanding in the past few years by making smaller acquisitions that have allowed it to expand towards both the Scranton and Philadelphia areas. They have now reached a size that will put them squarely on the radar screen for regional banks looking to expand into the state. Non-performing assets are just 1.46% of total assets and the equity-to-assets ratio is 10.54%, so the bank is financially strong. The shares trade at just 93% of book value and yield 2.79% at the current price.   

The Bottom Line

Small regional and community banks are not as sexy as hot new biotechs or cybersecurity companies. However, you have a group of banks that need to sell and another group that needs to buy. Many of the potential target banks trade at a significant discount to the average takeover multiple of book value, and this creates a tremendous opportunity for individual investors.

Disclosure: The author held shares of ESSA and EBMT at the time of writing.