Stalking the Small Banks
By Tim Melvin, RealMoney.com Contributor
On Wednesday September 16, 2009, 11:26 am EDT


I've had several discussions with friends and associates about banks recently, including with my ambitious and talented young friend Lt. Corban Bates, a recent West Point graduate. Readers may remember the excellent work he has shared with me on net-net stocks in recent months. He, along with several readers, asked me what my criteria were in compiling a list of community and regional banks to buy for the long term.

A caveat or two: All lists and screens are starting points. They are where you should start your research, not end it. Also, I am not ready to buy banks yet. I think there is another shoe to drop, but I will leave it to you to make your own timing call. Naturally, I will sound a trumpet here on RealMoney when I am ready to buy the banks.

First and foremost in my laundry list of bank-stock criteria, the bank has to sell below tangible book value. Just as in any other industry, I want to buy the assets cheaply. Takeovers in the banking industry are usually done at a multiple of book value for a healthy institution. Not only does buying healthy assets at a discount give me a margin of safety, it creates tremendous upside potential because small banks will usually trade up to a small discount to the takeover multiple currently being used. I have seen the multiple of tangible book value get as high as 3 in a merger wave.

Second, the bank must have a tangible equity-to-assets ratio of at least 5%. That is the number Peter Lynch set out years ago in his book, and assuming he is a bit smarter than I am, I use that level to find banks with adequate capital. I have used this number for years, and it has worked very well over time. Higher is better with this number. The more equity relative to assets a particular bank has, the larger my margin of safety becomes.

To further add to the safety of my position, I want to see a quality loan portfolio. I am looking for the Jimmy Stewart bankers who made reasonable loans with good collateral. I look for those banks that have a nonperforming-loans ratio well below the industry average. When I am screening, I use 2% as a top-end cutoff. In practice, I want that ratio as low as possible. Right now, given the turmoil in the industry, this is a little harder to find because loan-loss ratios have spiraled upward as collateral values have collapsed. There are still some, however, and I am fortunate that I do not have to buy them all. I am not constrained by institutional mandates or asset allocation policies, so I can buy only those that have a desired combination of upside and safety.

I also want to see realistic and conservative management. I need the loan-loss reserves being set aside to be at least as much and preferably more than the net charge-offs at a given point in time. If it turns out that loan losses improve, excess reserves can always be brought back into the income statement in the future. I love positive surprises, but negative news about loan losses exceeding reserves by a large amount can ruin my whole day.

Those are the minimum criteria for the small-bank stocks I follow. Once I have a list, I start looking at the qualitative matters. Are insiders buying or selling stock? Persistent insider selling in a small bank is a huge negative, and I will avoid the stock because of it. How old are the CEO and president? The older they are, the more likely they would be open to a takeover offer. How much stock do insiders own? I want management sitting on the small side of the table as I am. Is the bank overly concentrated in commercial loans?

I should have known better than to give young Corban my criteria for bank stocks. Apparently, his days are 34 hours long, and over the weekend -- in addition to whatever duties the Army assigned him and to watching every sports event broadcast -- he assembled a spreadsheet of about 400 small banks, with the appropriate ratios and details. Of the banks he included, only 35 of them meet all of my criteria. In my mind, this reinforces my thought that it is too soon to be a big buyer of small-bank stocks.

I want to take a minute to point out how at least two of the stocks that fit the screen have done during the banking crisis. National Bankshares, out of Blacksburg, Va., has an equity-to-asset ratio of over 11, loan losses of just 0.77% and a loan-loss-reserves ratio of 1.4. The stock is actually higher today than when the crisis began in 2007. If you waited to buy until the stock dipped below tangible book in October of 2008, you are currently sitting on profit of more than 50% and still own a cheap, safe stock with room to go higher.

Danvers Bancorp did a mutual-to-thrift conversion in the depths of the crisis in early 2003. The company has an equity-to-asset ratio of more than 12, loan losses of just 0.75% and a reserves-to-charge-offs of 1.42. The stock is up more than 30% since the conversion and still trades below tangible book value.

I have used this screen for small regional and community banks for a long time, and it has worked very well for me. I look forward to the day when I come in and find that 20% to 30% of the small-bank stocks pass all four initial tests. I think that will be sometime in early 2010, and when it happens, I will sound the alarm and back up the truck.