Community Banks and Thrifts

As promised, I am going to talk about banks, which are very intriguing kinds of companies. Not all banks are created equal, but once you know what to look for, you can seperate the good from the bad and find some great investment opportunties.

The first place to look is not necessarily the big, well-known names, such as Bank of America, Citigroup or Wachovia, although these companies can certainly turn a profit. In my opinion, the opportunity lies in the smaller community banks and thrifts (also known as Savings and Loans) for three main reasons:

1) Even moderately well-run banks generate nice steady Returns on Equity (ROE) of 10-15% and dividends of 2%-4% by performing such cutting-edge activities as taking deposits and lending money to Johnny and Sally homebuyer. No superconducting fiber-optic nanotechnology involved here. They get their returns by generating local brand loyalty in their towns and suburbs through personalized service and convienient locations.

2) Although there are notable exceptions, small banks don't cost as much per dollar of book value as their larger cousins.

3a) They are getting bought left and right by bigger banks...
3b) ...who pay a premium.

The challenge is to find a bank that is not being run into the ground by incompetent (or worse) management, in which case you won't be getting paid (point #1) to wait for it to get bought (#3a) at what ultimately will be a tiny premium (#3b).

So how do you tell good from bad?

1) Start with the balance sheet. Let me say this again - START WITH THE BALANCE SHEET! Despite their down-home folksy appearance, even the most innocent-looking community bank is leveraged far more than Donald Trump. Imagine taking out a 90-95% mortgage on your house, then lending out that money to other people. You would probably keep an eye on those loans! Remember It's a Wonderful Life and the scene where everybody wants their money back, and Jimmy Stewart is telling them he doesn't have it? "Your money's not here...it's in his house and her house and..." A great place to find financial statements for any bank (even private ones) is at the FDIC's fantastic website. All FDIC-insured banks and thrifts must file financials with them.

a) First - look at tangible equity (very close to the more official "Core" or "Tier 1" capital) to assets ratio. It must be above 4%, or the FDIC gets nervous.

-4%-7% the bank is close to their limit. If it wants to increase loan issuance, raise the dividend or acquire another bank, it has to think about raising more equity, either in the capital markets or through retained earnings.
-7%-9% is strong. Low enough to provide leverage, high enough to provide a cushion for unplanned events.
-9% and above is very well capitalized. There is a lot of excess capital to give to the shareholders through dividend increases, expand through selling more loans or simply keep around if they are worried about a recession.

b) Non-performing assets (NPA) represents customers who have fallen behind on their payments. Anything above 1% is cause for alarm, unless the Net Interest Margin (NIM) is very high, like 5-6% at today's rates. Bad loans will destroy an S&L very quickly, and gave the industry a bad name in the early nineties when crooks made speculative loans to their developer buddies to build shopping malls in the desert. A well run bank's ratio will be well under 0.50% of loans, and should have reserves at least 2x this figure.

c) Generally, the most stable community banks and thrifts have a low percentage of commerical and construction loans. Good old mortgages and mortgage-backed securities have done S&L's well over the years.

2) The income statement - Ironically, the income statement and balance sheet are all you need to evaluate a bank, since the FDIC will put the hammer down on a bank long before the cash runs out.

a) Return on Assets (ROA) - This is my favorite profitability metric for banks (and for most other types of companies as well) because leverage is taken out of the picture. Anything greater than 1% is excellent for a small bank.

b) Net Interest Margin (NIM) - Represents the "spread" between loans and deposits, before ops costs. A higher NIM gives the bank some wiggle room in the cost department. A low NIM can hurt two ways a) Obvious compression in profit margin. b) Falling interest rates accelerate prepayment of mortgages, so the bank has to work hard just to maintain loan volume.

c) Efficiency ratio - Represents non-interest expense (ops cost) divided by revenue. Anything less than 60% for a small bank is OK. Improving efficiency ratios go straight to the bottom line, so watch the trend closely.

3) The price - Of course the price! There are a variety of ways to value a thrift. People who look at it as a long-term going concern use the dividend discount model, since most small banks pay solid and rising dividends. For example, if I demand an 8% return, and I look at a bank with a 2% yield, I would need to expect that bank to raise its dividend 6% per year for the forseeable future. Other people add in stock buybacks (another common practice for well-funded thrifts) to the "yield", since there is an implied, but deferred return from taking shares out of the market.

People who think that the bank will be acquired will look at the expected premium over one of two metrics 1) tangible book value 2) deposits, and back into a maximum multiple of current value, based on an estimated take-out year. These days, thrifts are being bought out for 2-2.5x book value, so look for one that trades at <1.6x book (<1.7x if you like the growth rate of book value). Banks with good branches can fetch as high as 25% of deposits, so don't ignore that factor, either.

After I re-read my copy of the excellent Beating the Street by Peter Lynch, I immediately set out to build a time machine in my garage to take me back to 1991-1992, when solid, growing thrifts were selling as low as 50% of tangible book value! The market is a little frothy right now, especially in regions with a lot of M&A, such as Florida and New England, so you need to be a little picky. Exceptionally well-run larger banks such as North Fork (NFB), Commerce (CBH) and TCF Financial (TCB) trade at well over 3x book value.

Looking around the country, I semi-randomly surveyed some Massachusets thrifts, and found two rather attractive ones. Not raging, pound-the-table buys, but two banks that can offer some pretty good returns in what I see as an increasingly overvalued market:

Woronoco Bancorp (WRO) is a quaint little thrift in Westfield (just outside of Springfield.) It has 9 branches and mainly makes residential 1st and 2nd mortgage loans. Their CEO has been around since the mid-1980's, and they haven't shown any of the warning signs of obvious incompetence:

1) Tangible Equity/Assets is in the 8-9% range.
2) NPA/Loans is a microscopic 0.01% (yes that's one basis point!)
3) Their expansion plans consist of opening new branches and buying a small insurance brokerage.
4) ROA is 0.82% and has grown every year for 3 years.
5) Both deposits and loans are growing nicely
6) The efficiency ratio (67%) has been improving.
7) They consistently raise their dividend (currently just over 2%).

The price isn't bad - about 1.7x tangible equity. I built a little model which assumed 8% EPS growth, 13% dividend growth and a 2x book buyout at year 5 and got back a nice 11% IRR. Not a bad return for a 5 year "bond," and the numbers get better if the buyout happens sooner. Of course there are no guarantees of a buyout, and the IRR drops to 8% without an acquisition.

Brookline Bancorp (BRKL) is more interesting. It sits in affluent Brookline, and recently finished the 2nd stage of a mutual to stock conversion, which really fattened its balance sheet. In fact, at the end of the year, it had about a 39% tangible equity to assets ratio! This kind of balance sheet spells opportunity! It can do many things with all that equity:

1) It can increase the dividend (Projected 2004 yield: 4.7%)
2) It can buy back huge amounts of stock.
3) It can issue more loans (currently at 1% ROA)
4) (Perhaps the best part) It can sell out to another bank who will make those loans!

The price is even better than Woronoco's - the low return on equity (from low leverage) makes it trade at 1.5X tangible book, so a 2x book takeout is even more profitable. Its fat balance sheet and prime location also make it an inviting target.

These two small banks are just the tip of the iceberg. Do some digging. Look at your own hometown bank. You might be pleasantly surprised!