Think Small Banks For Big Profits

The banking industry avoided the attention of activists, for the most part, as the industry was still recovering from the financial crisis and the regulatory outlook was very uncertain.

Buyers were unwilling to step up to the plate, absent some clarity of what the future would like from a regulatory point of view. But according to a recent Harvard Law School forum, that is all about to change.

A post from William Sweet, partner and head of the Financial Institutions Regulation and Enforcement Group at Skadden, Arps, Slate, Meagher & Flom LLP stated that, “with resolution of some of these uncertainties, and some improvement in the bank M&A environment (which is becoming more active among smaller community banking institutions), banking organizations can expect greater attention from activist investors.”

Related: The Global Search For Cheap Investments

This could be a real boon for investors in the smaller community banks and thrifts. In a presentation at the recent Balue Investing Congress in Las Vegas, Richard Lashley of activist investing firm PL Capital pointed out that industry fundamentals have almost returned to pre-crisis levels, but the stock prices of the smaller banks are still very cheap when compared to tangible book value.

He also noted that we've had a cyclical consolidation wave in the industry for some time. with the number of U.S. banks dropping from 18,000 in 1984 to less than 7,000 today. And according to Mr. Lashley, we are going to see a cyclical surge in bank M&A deals that should last another three to five years, at least.

PL Capital and other investors, such as Joseph Stilwell and Lawrence Seidman, are experienced activist investors who have specialized in community banks with a great deal of success over the years. They have forced the management of these sleepy little banks to focus on shareholder value by adding buyback plans with the stock trading below book value.

In many cases they have forced the outright sale of the bank to a larger competitor, at a large premium to the prevailing stock price. They have been focusing on those banks that are too small and, as Mr. Lashley pointed out in his presentation, cannot justify remaining independent.

Investors would be wise to piggyback with these investors, as there is an enormous amount of money to be made in the sector over the next few years -- as the small banks sell out to larger regionals banks that need to buy growth in a slow economy.

Chevoit Financial Corporation CHEV is a great example of the type of bank these activists are focusing on right now. The branch bank in Hamilton County, Ohio has 13 branches with about $589 million in assets. The bank has plenty of capital, and has equity to asset ratio of 13.78, well above the industry average of 10.54. The loan portfolio has shown steady improvement, and nonperforming assets are just 1.87 percent of total assets,

In spite of the improving conditions the bank is trading at just 77 percent of book value, and all three of the activists have a stake in the bank. The stock pays a 3.41 percent dividend, so you get paid to wait for the activists to push the stock higher over the next few years -- or force an outright sale of the bank to a larger competitor.

Tracking the activists in the smaller banks around the country requires a lot more work than just turning on the television to see what Mr. Icahn or the other big activists have been buying. You will to dig through 13d and 13f filings on a regular basis, but you should be very well rewarded for your efforts.