Good Banks Make Good Loans: 3 Under-the-radar Bank Stocks to Buy Today and Hold Forever

Posted by – September 26, 2013

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Last year, we wrote one of our first newsletters addressing the changing dynamics for investors in the banking industry. The following week we highlighted First Republic Bank (NYSE: FRC), a California-based bank that represented what we thought to be the future of the industry – conservative underwriting, community bank service, avoiding the labyrinth and expense of modern day regulations for larger institutions. Since that time, First Republic’s stock has appreciated more than 45%, beating the S&P 500 by more than 20%.

The appeal of an investment in a bank may not be obvious today, a brief five years after the Financial Crisis. While the herds denounce banks, savvy investors should be hunting for opportunity. The combination of strong loans, a conservative balance sheet, and experienced management can generate steady profits, stock buybacks, dividends, and consistent stock price appreciation for the long term value investor.

Below we take a look at three banks that we think fit the bill; we think an investment today could generate market-beating returns for the next 5, 10, or even 20 years.–The Flaneur

Good Banks Make Good Loans: 3 Under-the-radar Bank Stocks to Buy Today and Hold Forever

Before we dive into the specific banks, let’s take a moment to review some fundamentals of bank investing. To do this, we will turn to the wisdom of Carl Webb, a more-seasoned bank investor than us here at The Wall Street Flaneur.

Webb is the second-in-command at bank buyout firm Diamond A Ford (a company that has propelled founder Gerald Ford to #296 on Forbes’ list of wealthiest Americans. Check out this Bloomberg.com profile of Ford for some context on his success and investing acumen).

Webb puts it, quite succinctly:

“Banks get in trouble for one reason: They make bad loans”

We can unpack this wisdom into a few key takeaways.

  1. Credit quality first. The bank’s equity, our investment, is reinvested into loans. If those loans are not paid back, our investment is not paid back. It’s just that simple.
  2. More fundamentally, banks are a business and therefore must be profitable. Our objective here is long term capital appreciation, an impossible outcome without net income. This industry and these companies are not high flying tech companies like Twitter or Tesla (NASDAQ: TSLA), where user growth or future market potential can drive equity gains. An investment in a bank today is an investment in that bank’s profits tomorrow and in the years to come.
  3. Banks are in the business of making loans, so the best banks find ways to make loans (without forgetting takeaways #1 and #2). The banking industry has been consolidating for decades and continues to do so today. If a bank is not growing—revenues and assets—then it is dying. Asset growth fuels higher revenue in any interest rate environment. Asset growth adds scale to drive better efficiency, higher profits, and higher return on equity.

Sound familiar? Soundness, profitability, and growth. The three-legged stool made famous by John Medlin, the renowned former CEO of Wachovia.

3 Banks with a Community Model and Significant Upside

The financial crisis was challenging for the entire banking industry, and the community banks were no exception. Banks can be excellent long term equity assets with reliable dividends and stock appreciation, selling a product that never goes out of style (money).

These three banks were hit hard during the recession but have bounced back stronger for it. We think they still represent a bargain for the long term.

Hanmi Financial Corp (NASDAQ: HAFC) is a community bank, but not in the sense you are probably thinking. Rather than define its target community by geography, Hamni seeks to serve the Korean-American community throughout the bank’s physical footprint.

Hanmi reported a very strong second quarter – the loan portfolio is growing, core deposits are expanding, and margins are improving from top to bottom. Non-performing loans decreased to 1% of total assets. Earnings are up 78% year-over-year. The margin between what the bank earns in interest versus what it pays for deposits increased 24 basis points to 4.10%. And the loan portfolio grew to $2.1 billion from $1.9 billion at June 30, 2012. Soundness, profitability, and growth.

A positive result of these solid fundamentals: the company restored its dividend last quarter, declaring a cash payout of seven cents per share. We expect this dividend to continue and grow in the quarters to come.

And the kicker, CEO Chong Guk Kum recently purchased over $300,000 worth of shares, increasing his personal holdings of company stock over 35% in one transaction. No one is more familiar with the company’s prospects than its own CEO, and he’s buying.

First Interstate Bank (NASDAQ: FIBK) is a holding company that owns community banks servicing Montana, Wyoming, and parts of western South Dakota. Like Hamni, First Interstate’s recent change in dividend policy drew our attention.

For the second time this year, the Board of Directors voted to increase the bank’s dividend, this time to 14 cents per share. Why?

First, because the quality of the loan portfolio has been improving dramatically of late, with non-performing assets declining over 30% year over year for the second quarter. Second, the company reported an increase in earnings of 77% to $21.5 million year over year for the second quarter. The loan portfolio grew quarter over quarter and year over year.

First Interstate has been profitable every year for the past 25 years.  We expect that trend to continue.

BBCN Bancorp (NASDAQ: BBCN), more so than any of the other bank’s we’ve highlighted here, speaks to the opportunities still out there buying quality companies still recovering from the financial crisis. For BBCN today, that means improved credit quality, growth, and a return of the dividend (a dividend we think could still have room to grow).

Since 12/31/2009, BBCN has nearly doubled its loan portfolio to nearly $4.5 billion. Net interest income has grown by a factor of 2.5, driving to a nearly $90 million swing in net income from $(6) million to last year’s $83 million profit.

Credit quality, by any measure, has improved night and day over the same period. Non-performing assets as a percentage of total assets stands at 1.54% today versus 3.66% at 12/31/2009.

BBCN is unique among the banks profiled here in that there are more ongoing credit quality issues yet to be dealt with. The stock currently trades at a price to book ratio just north of 1.4, which is certainly not cheap. As a long term investment we like BBCN, however short term we feel that the combination of credit issues and high price to book precludes an investment. Our plan is to keep a close eye on this bank, biding our time for a better entry point.

With banks, stick to what works

Our thesis here is very similar to the one we posited last year – find banks with strong fundamentals, a conservative credit culture, and experienced management, and buy them for the very long term. As you conduct your own investment research, look to the banks with new or growing dividends, those with insider buying, and those with healthy and growing loan portfolios. Soundness, profitability, and growth – it worked for the legends in banking, and it will work for you too.

Take your investing to the next level

Make no mistake, we try to keep it simple here at The Wall Street Flaneur. But that doesn’t mean there aren’t other, more advanced techniques that have proven successful in the markets over the years. If you’re interested in learning advanced, Wall Street techniques, check out this course, “Credit Spread Surgery – Bear Call and Bull Put Mastery” covering the ins and outs of options trading taught by a Columbia University MBA (the same Columbia University that has produced investing legends like Benjamin Graham and Warren Buffett).

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