Your Christmas Roadmap to the Market's Most Hidden Profits

Happy Holidays, everyone!

I hope this newsletter finds you in great spirits, enjoying the festive season with your loved ones. This year, Christmas coincides with the first day of Hanukkah, a rare alignment that adds even more reason to celebrate.

While Thanksgiving remains my favorite holiday, Christmas holds a special place in my heart, and today, I want to give you a gift that will resonate well into 2025 and beyond: a roadmap to becoming a better investor by exploring a highly underappreciated corner of the market – community bank stocks.

Now, before you roll your eyes and declare this the dullest idea ever, let me assure you: while index funds and flashy AI stocks dominate headlines, community banks represent one of the few remaining inefficiencies in today's highly efficient market.

Let me show you.

In fact, Charlie Munger himself hinted at this path during a meeting years ago. He emphasized the need to seek opportunities in less-liquid, inefficient markets, areas where institutional investors fear to tread. This, my friends, describes community banks to a tee.

My Journey into Bank Stocks

My introduction to community bank stocks came about almost by accident while I was working for a small regional firm in Annapolis, Maryland.

This firm specialized in making markets for community banks and trading municipal bonds. A colleague in our office, a local legend of sorts, always seemed to have the Midas touch. He would stroll in at 9:29 a.m., just before the market opened, and was out the door well before happy hour began. Despite this seemingly casual approach, he was incredibly successful, with clients who were fiercely loyal to him.

Curious about his secret, I asked him one day how he managed to achieve such stellar results. His answer was simple but eye-opening: he traded local bank stocks.

This was back in the days before Regulation FD, when trading volumes were thin, and spreads were wide. A stock might be quoted at 10 bid and 12 offered. With a solid trading desk, you could buy at 10, sell at 12, and pocket the difference.

It was a lucrative business.

But the real magic came during the aftermath of the S&L crisis in the early 1990s. These bank stocks often traded at 40%, 50%, or 60% of tangible book value. Then came the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which kicked off a wave of banking consolidation. Larger banks started snapping up smaller ones at premiums to book value.

Suddenly, these undervalued stocks became acquisition targets, creating significant returns for investors.

That's when I realized the immense potential in community bank stocks, a fascination that has stayed with me ever since.

Why Community Banks?

Let's start with the backdrop.

Community banks have been consolidating for decades, and the trend is far from over. We've gone from roughly 18,000 banks in the 1980s to about 5,000 today, yet that number is still too high for the industry to function efficiently.

Scale matters in banking. Larger banks enjoy better returns on assets, higher returns on equity, and a lower cost of regulatory compliance. This creates a continuous cycle of mergers and acquisitions, with about 4% of banks being acquired annually over the past 20 years.

Recent years have seen this pace slow, largely due to the anti-M&A stance of the Biden administration. Lengthy deal approvals and increased regulatory scrutiny have held back consolidation, but this has created significant pent-up demand.

With regulatory conditions poised to become more favorable, the pace of M&A activity is likely to accelerate, setting the stage for significant opportunities in the sector.

The Double Compounding Opportunity

Community bank stocks often trade below tangible book value, creating a margin of safety for investors.

Currently average around 1.28 times book value, but during peak M&A cycles, multiples can reach as high as 1.75 or even 2 times book. This sets up a double-compounding scenario where book values grow as securities portfolios recover, and takeover multiples increase.

Here's the kicker: many of these banks are well-capitalized, profitable, and run by disciplined management teams. They're sitting ducks for larger, better-capitalized banks looking to expand their market footprint or diversify their loan portfolios.

The inefficiencies in this market are staggering, and investors willing to do the work can reap outsized rewards.

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Four Community Banks to Watch

1. Eagle Bancorp (EGBN): Based in Bethesda, Maryland, Eagle Bancorp operates in the lucrative Washington, D.C. market. The stock trades at just 70% of tangible book value, primarily due to concerns over commercial real estate exposure. However, the bank's portfolio leans toward higher-quality assets, and its market position in D.C. makes it an attractive acquisition target. With plenty of capital and a healthy 5.57% dividend yield, EGBN is a textbook example of value waiting to be unlocked.

2. Capitol Federal Financial (CFFN): Operating out of Topeka, Kansas, this is the epitome of a conservative bank. With 80% of its loans in single-family mortgages and non-performing assets at just 0.11% of total assets, CFFN is rock-solid. It trades at 79% of tangible book value and offers a 5.56% dividend yield. Insiders have been buying, and the bank's capital position is among the best in its peer group. This is the kind of quiet, sleepy bank that makes for an ideal acquisition target.

3. RBB Bancorp (RBB): Royal Business Bank, based in Los Angeles, serves a niche market within the Asian-American community. Its branches span strategic locations, including D.C., Chicago, Las Vegas, and Hawaii. With a strong loan portfolio and loyal deposits, RBB trades at 93% of tangible book value and offers a 2.98% dividend yield. This bank's focused strategy and profitability make it a highly attractive target for consolidation.

4. Northfield Bank (NFBK): Headquartered on Staten Island, Northfield operates 38 branches across the New York area. It trades at 75% of tangible book value and pays a 4.35% dividend. Despite past acquisition talks falling through, the bank's solid fundamentals and prime location ensure it remains a viable target. Non-performing assets are just 0.57%, underscoring its financial health and operational efficiency.

The Road Ahead

The inefficiencies in the community banking sector make it one of the last bastions of true value investing. As M&A activity picks up and interest rates stabilize, the opportunity to profit from these overlooked gems will only grow. The double-compounding effect of increasing book values and higher takeover multiples could generate returns that far outpace the broader market.

So, this holiday season, consider giving yourself the gift of patience and discipline. Ignore the noise of instant experts and trendy stocks. Instead, focus on the quiet, undervalued corners of the market where real wealth is built. Community bank stocks may not be glamorous, but they offer something far more valuable: the potential for outsized, long-term gains.

Happy Holidays, and here's to a prosperous 2025!

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Photo by Yiorgos Ntrahas for Unsplash