(By Chris Mayer) The end of small banks in America seems near. Instead, America will be a land of giants. But the small banks will go out with a bang — one that investors can capitalize on.
First, let's look at why small banks are on their way out.
One little-appreciated side effect of the financial crisis is the hostile conditions it created for small banks — and not for the reason you think. It wasn't that these smallest of America's banks got in any financial trouble. Many did not. In fact, many remain among the best capitalized of America's banks. These banks just stuck to simple business of banking — taking deposits and making old-fashioned loans.
But in the wake of the financial crisis, U.S. regulations began to impose costly rules on all banks — not just the big behemoths that got in trouble. This month, the beating continued as the Federal Reserve determined that even the smallest lenders must comply with the new Basel III accords.
These compliance costs can easily top a million dollars. For a small bank, that may be more than they make in profits all year.
The Federal Reserve policy of keeping interest rates low hurts too. It crimps small bank profit margins. These banks rely on the lending spreads. They don't have big fancy trading desks or big fee businesses. And the lousy economy doesn't make life any easier. It's tough to grow.
So what many small banks are doing is selling out. There have been more than 90 transactions announced so far this year, according to The Wall Street Journal. We're on pace for the busiest year for bank mergers since 2007 in terms of transactions.
What's interesting here from an investment point of view are the prices paid. Buyers are paying premiums to book value for healthy banks with lots of capital. Yet many such small banks trade for well under book value.
My favorite small banks to own are the recently converted thrifts (or savings & loans). A thrift conversion is when a thrift converts to a publicly traded bank. To do this, it offers shares to the public. But unlike a traditional IPO — like Facebook — there are no selling insiders. All of the money raised, less underwriting fees, goes back to the bank. So the new shareholders own the cash they put in, less fees, plus the bank.
As a result, these thrifts have tons of cash and often trade below book value. They have plenty of room to buy back stock or pay dividends. Often, they get bought out. By law, they can't until after they pass their three-year anniversary. But once that happens, investors can see immediate big gains from a takeover.
According to SNL Financial, which tracks such things, of the 56 completed conversions from 2003-08, there have been 16 buyouts, with two more pending. The median price-to-tangible book ratio at announcement of the takeover was 164.2%. That means that if you paid no more than book value, you got a 64% gain over a three-year span.
If you paid 80% of book value, then a 164% premium means you doubled your money — and that assumes that book value hasn't grown at all since you bought it, which is unlikely. Most healthy thrifts increase book value per share over time.
Hold longer than three years and your odds are better. SNL recently published a table on the class of 2000. Nearly two-thirds were bought out. And the ones that weren't still did well by their investors, see the table below:
Many of them doubled. A few were even monster winners. Connecticut Bancshares went from $10 to $52 per share. Port Financial went from $10 to $53.98 per share. There was one failure, but otherwise, the rest made good returns.
In summary, the nature of thrift conversions — all that cash to start, often with an attractive valuation plus the added kicker of a likely takeout (made more likely in today's environment) — means that converted thrifts often prove good investments. As Barron's recently reported:
"Converted thrifts have outperformed the broad market significantly in the past 20 years, and that could remain the case. In the 10 years ended Dec. 1 (2011), the SNL Thrift MHC Index, based on 30 partially converted thrifts, returned 188%, versus a return of just 63% for the small-cap Russell 2000."
This kind of outperformance has been going on for a long time. Peter Lynch, the great investor who ran the Fidelity Magellan fund to glory, included two enthusiastic chapters on them in his book Beating the Street. And superinvestor Seth Klarman also writes about them favorably in his book Margin of Safety. I included a discussion of thrifts in my new book World Right Side Up: Investing Across Six Continents in the chapter on the U.S.
Again, nothing works all the time. But here again the odds heavily favor you.
The end of small banking in America means this window will surely close one day. But for now, there are still lots of small banks in America. My bet is that a good number of them will make their investors happy.
Sincerely,
Chris Mayer
for The Penny Sleuth