Do Small Banks Have A 'Buy Or Die' Ultimatum?

In the last week of January, one of the most important investment conferences of the year was held in Phoenix, but no one covered it and most investors do not even know it happened.

Bank Director, a publication and website for bank officers and directors put on a conference titled 'Acquire or Be Acquired 2014'.

The conference was aimed at bank offices and directors and addressed the subject of bank merger activity and pricing.

There is a real opportunity for individual investors to earn enormous returns by investing in small bank stocks as many think a merger and acquisition wave is going to hit the industry as a result of increasing regulations and capital requirement in the industry.

The managing directors of Austin Associates, a Toledo based consulting firm serving community banks and those of Stinson Leonard Street, a Minneapolis law firm specializing in financial services, put on a presentation at the conference titled the M&A Case Studies for Banks Under $1 Billion.

In the report, the firm pointed out the conditions are ripe for takeovers to pick up steam across the community banking industry.

The study makes the point that the smaller banks are having a tougher time generating profits as the expenses of regulatory issues is too high compared to their asset base. This is more than reflected in the performance of the stock as the return from smaller banks stocks lags well behind the S&P 500 and larger banks.

Since the market bottom in 2009, the big banks have seen their stock price rise by about twice as much as the little guys.

It is reflected in their valuation as well as the smallest banks traded at about 92 percent of book value at years while the biggest were fetching about 155 percent of book value.

The presentation says that we are starting to see the great thaw of community bank M&A activity. Asset quality is improving across the industry so buyers are no longer facing the prospects of buying a collection of bad loans and repossessed assets. We are seeing banks in better financial condition put themselves up for sale and fewer distressed banks or FDIC assisted transaction so the quality of attractive candidates is much better than it has been the past few years.

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Banks are also seeing a lack of organic growth opportunities and are still dealing with low net interest margins as a result of monetary policy. The rising compliance costs are forcing banks to consider increasing their asset base so as to spread the costs and reduce the hit to the bottom line.

Regional banks are looking to increase their footprint and profits and the only way to grow the bottom line right now is to buy smaller banks.

The larger banks are in the drivers seat as the valuation gap makes it possible to swap their more expensive shares for those of the cheaper smaller bank shares and gain asset and earnings growth cheaper and faster than they could organically.

In his presentation Curtis Anderson, a managing director at investment bank Sheshunoff & Co. Investment Banking pointed out some interesting results form a survey of community bank executives. Seventy-two percent of them think banks nee dot reach certain size in order to remain viable. Seventy-one percent of executives have discussed buying another bank in 2014. Thirteen percent have had discussions about selling their bank in the last year. More than 70 percent think the right PE ratio for a top performing bank should be between 12 and 16. Sixty-five percent think the best community banks should trade between 1.25 and 1.75 times book value.

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In the presentation, titled "What is Your Bank Really Worth?," Mr. Anderson goes on to point out that the top four banks in the industry hold almost 48 percent of the nation's banking assets.

JP Morgan JPM alone has almost as much in assets as all banks below $10 billion in assets combined. Big banks are growing in asset size and market share and the only way to effectively compete for most banks is going to be to grow via acquisition. The bigger than bank in terms of assets the more you can control expenses and increase returns on assets and equity.

The report also points out in its conclusion that “most bankers are looking to cure profitability challenges through some kind of M&A activity “and that banks with” low loan-to-deposit ratios are finding few alternatives better than selling to a larger bank with a better profitability profile.” He also pointed out that the northeast and metro Atlanta areas have seen the fewest deals and are ripe for increased takeover activity in the year ahead.

The conference saw little to no press coverage and Wall Street didn't pay much attention to it either. However for individual investors who wish to a part of the Trade of the Decade in small banks it was the most important gathering of the brand new year.