Douglas Hughes, money manager at Hughes Management and editor of BankNewsletter.com, specializes in smaller commercial and investment banks in the U.S. The MoneyShow.com contributor focuses on bank stocks that have the potential to be takeover targets. Plus, 21 ideas for investing in smaller banks.

 

Today community banks and regional banks are more like utility stocks, with steady earnings growth and fairly low valuations that have been rising all year from very low levels. Many of these small and mid-sized regionals should be increasing their cash dividends and buybacks this year and next as earnings grow, with higher interest rates coming. Many also pay special year-end dividends, sometimes making the yield almost double from the current rate.

Although 2017 had been the best year for many banks stocks in a long time, many smaller names have not moved at all; this should cause a wave of mergers in 2018. The banking industry totals over 6,000 banks, down from over 10,000. In my view, deals are going to happen over and over until we get to say, 2,000 banks 10 years from now. 

Usually only one or two analysts follow some of the smaller banks we cover. Many of the stocks we follow have no analyst coverage. That’s why the small-cap space usually has the best values. In fact most deals lately have been banks under a billion dollars in size and a price tag of around $150 million on average. That’s how you find value in a fully- priced-over market where not many are looking.

You must be willing to hold small bank stocks for 3 to 5 years or more, as many have large spreads between the bid and the ask that will take a bunch of your profits away if you sell to soon; always use limits and never market orders as well. Try to buy larger liquid names on big down days and sell on big up days.

Today’s banks have solid balance sheets and great expense control due to the technology that’s now helping them. Also, most banks now have a diversified income structure limiting exposure in any one area. Technology has really helped limit losses by spotting bad credit risks early, especially for credit card losses. 

So, firms like Capital One Financial (COF) should really benefit going forward with their huge market share. Capital One offers 20 different credit cards now, with very low losses, due to the technology today that is now saving them from costly loans, and from bad credit risks. I really think Capital One is setting themselves up for a sale in the coming years. Some big bank will want their growth, their model and loan book someday soon at around $125 a share.  

Non-performing loans are currently about the lowest in a long time; this may change soon with rates moving up now finally. That’s why we always stay with the best asset quality banks and they usually have the best and smartest people running them. And that is why you buy a bank for the people running them. If management is not honest and trustworthy, then stay away.

Iberia Bank Corp. (IBKC) took over many Florida franchises on the cheap. It proved to be very smart to move into that area as Florida has boomed during the past five years after the crash. Now Iberia is a $4 billion powerhouse with almost half of their branches now in Florida. One day, they will be a target themselves at $110 a share; we got in at $45 and may double down if they get back to $65 to $70 a share range this year. Florida is a place you want to be in the next decade.

Some big regionals that we feel are in play as potential acquisition targets are TCF Financial Corp. (TCF), SunTrust Banks (STI) and Fulton Financial (FULT). Many of these large regionals are entering the investment banking business like Iberia is doing now, trying to capture the large depositors in retail banking. For many, this diversification is in response to a deterioration in their core lending business. As they expand, it becomes harder and harder to grow loans at a pace that exceeds the growth of the economy in which they operate.

At the same time banks like Avidbank (AVBH) in Palo Alto, CA have been able to grow loans at a super fast pace as they fill a niche in the market that was left open from mergers. Their market is just plain red-hot, with the tech area booming. It is these customers who value good local service and are willing to pay a higher interest rate. If you find a small bank with a true monopoly in their niche market like Avidbank, stay with your position until they sell out. These situations are very hard to find at cheap prices in today’s world. 

There are several small banks and investment banks like Oppenheimer (OPY) that are benefiting from the removal of regulations. Oppenheimer has paid $100 million in fines over the past 10 years; now, that will all go to the bottom line. And with higher interest rates, they can get a double-bonus. Trading at a forward P/E of 7 for 2018 makes no sense. In my view, this investment bank will get bought or the price will go up a lot. It is the largest holding in our portfolio

We usually look for takeout deals, but there are also many banks nowadays paying 4%-6% cash dividends as well as stock dividends, so sometimes we get paid to wait. A great example is Arrow Financial (AROW), which seems to always pay us well. It’s an upstate New York bank at the top of its game year after year. Do some research on this bank and you will see why we love it. In addition, banks such NBT Bank (NBTB) do this from time to time. Make sure you always roll the cash dividends into their dividend reinvestment plan so you are always buying more stock. Over time both of these dividends really add up.

Many of the smaller bank stocks also do not usually have the high volatility of the overall stock market. Many investors do not like seeing their accounts up 25% then down 25% in hard sell-offs. The smaller banks sometimes don’t go down at all.  Again a few names that seem to always hold are Arrow Financial, Avidbank and Greene County Bancorp (GCBC).

Make sure the management again has a huge stake in the bank. This is the only way you know you should be safe and that they are always adding to their stake, never selling any shares. Management at Oppenheimer and River City Bank(RCBC) do this. When you find gems like these two banks, you load up the truck. Then you sit and wait for the payday.    

Oppenheimer is a steal at current prices, with just two firms covering them. The stock offers low downside risk and if they don’t sell out, the dividend should double this year. Fair value is $40 a share, at a minimum, on a P/E and book value basic.

Some of our other current holdings include Midlands Capital Holdings (MCPH), River City, Avidbank, Fulton, TCF Financial, Iberia and First Financial Corp. (THFF). Research these banks, buy them at the right prices and one day you will be rich.

Some final rules for investing in smaller banks:

1. Never pay over 1.25 times book. Try to pay under book.

2. Never pay over a P/E of 14 unless they are growing very fast and no one knows this but you.

3. Banks with low share count usually under 4 million shares often get higher deal prices.

4. Strong earnings growth must be there, otherwise don’t pay over book ever. 

5. Look for recent mergers in the local market area that will help your bank.

6. Look for banks with over $50 million in deposits per branch.

7. Make sure management owns 10% or more of the stock.

8. Never buy a full position at once. Average in over time, always use limits.

9. Banks showing above-average earnings growth and returns on equity are the ones we like with great asset quality, of course.

10. A recession, depression, a bear market or stagflation which may come up in 2019 or sooner could hurt the banks.

11. Make sure you have 3 to 15 years to invest, as banks can have long bear markets, but if you buy at the right prices you should be ok.

12. During the next 10 years the number of banks left will get cut 30% to 50%. Hopefully, we own a lot of them.

13. Own only 5 to 12 stocks in this market. There are not many great deals out there today. This may change. We own just 11 banks today.

14. Do not diversify until you are rich, or you will never get there.  Load up on the ones you love. Our top holding makes up 35% of all funds today.

15. Be conservative on future valuations, and once they get fully priced, sell them even if no deal happens.

16. Stay in cash if there is a bear market or at least 50% in cash. Today we are 25% in cash, but soon it may be 50% cash or zero cash. Mr. Market will tell us. A lot of banks are fully priced today. That is a fact.

17. Downside risk must be very limited. Don’t be afraid to sell for a loss, and move into a better value if things change.

18. Buy the bank at a large discount to present value and your downside is limited.

19. Banknewsletter.com has had over 80 of its stock picks taken-over in the past 20 years.

20. Watch and trade the last day of each quarter. This is our secret. With hedge funds playing with their books all the time, and indexes changing the stocks they have several times a year, usually the last day of each quarter you can find a few banks either being sold off hard or being bought hard. 

21. If you are ready in the last 15 minutes of trading, there is usually some free money to be made here. This happens a lot. Just trading around this principle can be quite profitable if you have the financial resources, time and education to take advantage of it. This can occur several times a year.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.