Buy Where You Bank: Investing in Small Bank Stocks

Investing in small banks has been an incredibly profitable activity for decades now. I first realized the potential of these tiny stocks back in the 1980s when I was studying the track record of Peter Lynch and his legendary performance of the Magellan Fund. Mr. Lynch famously advised investors to buy what you know but he probably should have changed that buy where you bank. If you scour through his holdings during his years at the helm of the fund he owned almost every small bank and thrift in the country. He had money on deposit at most of the mutual savings banks so he could participate in their conversion to a stockholder owned bank. Much of his enormous returns came not from growth stocks whose products he loved but from small community and regional bank and thrifts.

When I became a stockbroker in the late 1980s I found that this was not an easy sector in which to invest. Most of my clients in Modesto, California could care less about a small bank in Ames, Iowa or Columbia, Missouri. The OTC trading desk at Dean Witter didn't have time or interest in fooling around with some new brokers 500 share order for an $8 bank stock in Jackson, Mississippi. The spreads were enormous, they were hard to buy and no one had much interest in them. In order to succeed in my new career I had to put the little banks behind me and work with stocks people would actually buy.

That changed when I moved back East to Annapolis, Maryland. I joined a small regional firm that made markets in most of the Mid Atlantic Banks. By this time we were on the back end of the S&L crisis and these stocks were dirt cheap. Quality banks with two or three branches sold for a third of book value. They had no junk bonds or South American loans but they were painted with the same brush as their larger brethren. By the middle of the 1990s the M&A wave was in full swing and our investors were cleaning up as banks that were purchased at a fraction of book value sold for a multiple of that number just a few short years later. It was the most fun I ever had as a broker. To a lesser extent the fire sale was repeated following the LTCM blow up in 1998 and again in 2002 when the whole market basically blew up in the internet meltdown.

It has happened again as a result of the credit crisis and real estate collapse. Small banks that had no special purpose investment vehicles or toxic ALT-A and no doc loans saw their balance sheet and income statements hit just as hard as the big guys. Most of their loan collateral was real estate and the value collapsed. People walked away from their homes when the value went well under the loan value. Developers went bust and forfeited their loans on commercial projects. Many were closed down by the FDIC as they simply had too many bad loans to survive. Small bank stocks saw their prices back at valuation levels similar to the early 1990s.

Since the depth of the crisis in 1990 conditions have slowly improved. Real estate has stabilized to some degree and the economy, while far from good, is at least better. Larger bank stocks have recovered some of their decline but many of the smaller banks have not at this point. Investors tend to focus too much on earnings and a lack of loan demand and narrowing net interest margins have kept a lid on earnings. However the asset side of the ledger has improved substantially and we once again have small banks trading at a fraction of their tangible book value.

Most of the banks that are going to fail have already done so. The survivors will see one of three things happen to them. They will muddle along until the economy recovers, profits grow and investors are attracted to these shares again. These banks also will have an opportunity to take market share from big banks as the crisis has heightened many people's distrust and dislike of big banks. Some of them will become aggressive buyers of cheap assets and grow at a fairly rapid clip by buying up competitors. These banks will move from community banks to mid-size regional institutions by acquisition. The remaining banks will be purchased by competitors at a premium to their tangible book value. All of these are good for those investors who buy small banks now and this is the reason I frequently refer to small banks as the trade of the decade. An enormous amount of money is going to be made by small bank investors over the ten years and Banking on Profit was created to help you be one of those investors.