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The obscure sector of financials few research or invest in
Good morning everyone. Hope everyone had a great Presidents Day and took some needed time off from market news.
For newcomers, every week I write about off the beaten path investing ideas. I like to invest in bombed out industries. Stocks no one else is talking about. And companies Wall Street hedge funds can’t touch. My favorite stocks are the ones trading at multi-decade lows with one last puff.
Today I am continuing to write about community banks. A sub-sector of financial industry that are so tiny and obscure that many investors don’t even know they exist. But before we get into community banks, first a word from today’s one of my favorite newsletters…
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It’s a tough market for value investors. Valuations are back to lofty levels. The beaten down and broken businesses had a killer first two months of 2023. Anything that was trading at a low valuation saw its share price increase dramatically in January. February has been a mixed bag, but valuations have continued to hold strong.
From my vantage point there isn’t many industries that looks extremely compelling. The only one that appears to be optically trading at a low earnings multiple is the energy industry. But I am a bit cautious here as you typically want to buy cyclical stocks like energy when trailing earning multiples are high and not low. I am still very long energy, but I am also well aware the dangers of a cycle turning again.
No matter the valuations, there is always something to do as a value investor. In times like this you just have to look harder for investment opportunities. Search in different places few frequently travel too. Go off the beaten path and turn over a rock that hasn’t been touched for ages.
A place where few frequently travel is the land of community banks. I’m not talking about small regional banks that control the deposit base of an entire state. I am talking about 5-10 branch banks that no one knows exists unless you live in that small little town where that bank operates.
The community banks I have been digging into are sub-$100 million market cap companies. Most under $50 million market cap. And even some under $25 million market caps. Nano-cap financial companies that have operated their franchise for decades. Predictable returns, strong deposit bases and boring little business models.
Community banks are obscure. They are incredibly illiquid. There is almost zero research on 90% of them. And the stock prices of these small community banks have started to fall.
There are a few of reasons for the valuation drop in banks. Two have to do with rising interest rates. The other one is a broad concern over a recession and future downturn that could impact borrowers and increase the rate of nonperforming loans. I think the biggest reason why bank stocks have begun to fall is from rising interest rates impacting other comprehensive income.
For those who don’t read financial statements for a living, other comprehensive income falls below the net income line. Changes in other comprehensive income doesn’t impact GAAP EPS. Other comprehensive income is a catch-all classification for the items that cannot be included in typical profit and loss calculations because they do not stem from the company's regular business activities and operations.
For community banks, changes in other comprehensive income come from the banks security portfolio, typically consisting of bonds, which have fallen in price due to rising interest rates. Hence, as interest rates increase, bond prices decrease, resulting in a large non-cash loss calculated in other comprehensive income.
So, when bond prices fall, banks take non-cash losses in other comprehensive income, which then impacts shareholders equity, a key valuation metric investors use to value banks. As bond prices fall, shareholders equity decreases, resulting in a lower stock price. Since 2022, almost every community bank is posting a large loss in other comprehensive income as their bond portfolio decreases in value.
The second way rising interest rates are impacting bank valuations is due to deposits becoming more expensive. When interest rates increase banks are forced to raise the interest rate for their depositors to stay competitive in the market. For the first time in decades, individuals can get a 4.0-4.5% risk free rate. Community banks that don’t have the resources to raise rates as fast as larger competitors are seeing their deposit base decrease as their customer moves money to a bank that can offer a better rate.
This is a double edged sword. Bond portfolios are decreasing in value, directly impacting shareholders equity and the deposit market is competitive for the first time in decades. Finally, investors are also worried about a potential recession, which would likely increase nonperforming loans, leading to a whole host of issues. Given these three macro related issues, community banks have seen their stock prices fall.
If you have been reading this newsletter for a while, you probably know I am a sucker for stocks that no one else wants to own. The more illiquid the better. The smaller the company the better informed I can be than anyone else on the name. Community banks fit this bill. They are extremely small. They are very illiquid. And we are starting to see valuations come down.
Over the next few weeks expect more valuation analysis on these small obscure banks. I’ve already written up one (which I have personally been buying) and have written a primer on thrift stocks, an area I am going to focus on within the community bank sector.
The community banking space fascinates me and I think I can get a real competitive advantage in the industry, generating strong returns. If my hypothesis on the community banking sector proves to be successful, I may toy with the idea of launching a fund or special purpose vehicle (SPV) specifically for the community banking industry. I think there is a lot of value out there in these small banks and I think an activist investor focused on capital allocation could do extremely well for their investors.
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