(By James Brumley) On Thursday, June 21, credit-ratings agency Moody's downgraded the debt of 15 major U.S. banks, including Bank of America (NYSE: BAC)
, Morgan Stanley (NYSE: MS)
and JP Morgan Chase (NYSE: JPM)
. Though the move didn't come as a complete surprise, the credit downgrades could still ultimately crimp profit
margins for those banks.
For investors in large-cap banks, it's another headache in what has become a frustrating environment. In fact, this collection of headaches has lingered long enough to create a shift in consumers' perceptions about the banking industry. The new mental mantra is simple enough: Big banks are bad, small banks are good.
That's why we've seen a slow migration of banking business away from the major names and toward credit unions, along with small and regional banks. Problem: Though fruitful for their bottom lines, the new interest in smaller banks hasn't actually done much to boost the value of small-bank stocks yet.
But this started to change last week. Let me explain...
Method to the madness
Most folks either strictly use charts to "trade" or strictly use fundamentals to "invest." Not me. I'm a half technical-trader, half fundamental-analyst, so I use the best of both worlds. Through weekly software-based scans, I come up with my short list of "right company, right time" choices.
Last week's scanning process was no different. The funny thing is that for the first time in months, my weekly scan of technical/fundamental "buy" signals was overloaded with small-bank stocks. And I mean a lot. Of the 88 bullish small cap stocks my scan found, 12 of them were banks. That's more than I've seen any one industry dominate the list in months.
When I see this happening within one specific group, it usually means there's a well-supported trend developing. This time doesn't look any different: Earnings are decidedly on the rise for 11 of the 12 banks on the list, and with another 11 of the 12 stocks recently forming clearly-bullish technical signs.
This chart of the S&P 600 Small Cap Bank Index makes the point. The group has rocked its way into a modest string of higher highs and higher lows, and recently pushed up and off of the key 200-day moving average line. Yet, there's still an enormous amount of room the group to rally before revisiting 2007's peak levels.
Throw in a pinch of new momentum, and it's an ideal investing situation.
Proof in the pudding
While the chart for this segment of the banking industry speaks for itself, it's not a hollow rally. These small-cap outfits are backing it up with solid results and measurable growth trends.
Take Lakeland Financial Corp. (Nasdaq: LKFN) for instance. The modest 2009 earnings lull took the Midwest bank's bottom line to $28 million, but the number has grown back nicely since then, to last year's $45 million. In fact, last year's per-share earnings of $1.89 were a record for the small bank.
For perspective, Bank of America, Citigroup (NYSE: C) and several of the other banks Moody's recently downgraded are still nowhere near their pre-crisis income levels.
It all begs one question: How can Lakeland Financial do what most of its large-cap counterparts can't? The answer is, the old-fashioned way.
Lakeland Financial is simply cleaning up what was never an overly-toxic loan portfolio to begin with. For example, the loan-loss provision (the amount of money banks sit aside as a precaution to cover bad loans) for the first quarter of 2012 was only $799,000, in comparison with $2.9 million in the fourth quarter of 2011 and $5.6 million for the first quarter of 2011.
At the same time, the bank continues to grow its loan portfolio by, you know, lending. The loan portfolio as of the end of the first quarter was 6% bigger than the $2.1 billion portfolio from the same period last year. Meanwhile, charge-offs -- the amount of debt that is unlikely to be collected by the bank -- continue to sink.
Another bank rebuilding momentum: Williamsport, Pennsylvania-based Penns Woods Bancorp (Nasdaq: PWOD), which has more than doubled its bottom line since the 2008-2009 recession. Between the growth trend that's carried the company to record profit levels, on top of its almost 5% dividend yield, this little-known name may be one of the industry's best-kept secrets.
Union First Market Bankshares (Nasdaq: UBSH) is a promising small-cap bank stock as well. The $375 million bank has pumped up its 2009 bottom line of $5.8 million to $41.7 million last year, giving the stock a trailing price-to-earnings (P/E) ratio of only 12.5. Analysts are saying per-share profits are on pace to rise from last year's $1.07 per share to $1.16 this year, but even this 8% growth forecast may not do justice for Union First. The bank topped estimates -- by quite a bit -- every quarter in 2011.
When only one of these banks is doing well, I can chalk it up to coincidence. When almost all of them are on a roll, that's not luck. That's an investment worth looking into.
Risks to Consider: Though none of these banks took hits as hard as the major banks did in 2008 and 2009, most of them saw earnings fall during that rough patch. Another harsh recession could chip away at the bottom line again.
Action to Take --> While it may feel far more comfortable to buy a well-established uptrend from a familiar large-cap bank stock, the smaller, unfamiliar names simply look better poised to dole out bigger gains from here.
Of the three small banks in question, I love the high yield from Penns Wood, though the company's market cap of $150 million is pushing the lower edge of my envelope. Therefore, Union First Market Bankshares would be my all around top pick. It's the only one of the three stocks I've mentioned that isn't already generating record profits, meaning it still has a lot of room to grow before closing that gap. It's also the one closest to the beginning of its technical long-term breakout.
-- James Brumley
James Brumley does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.
This article originally appeared on StreetAuthority
Author: James Brumley