Opportunities abound for savvy community banks

While bank valuations have increased recently in general, we believe certain banks, community banks in particular, still represent deep value. We think those banks exhibit stable performance, operate in stable markets, have solid deposit franchises, are increasing their adoption of technology, and are executing creative solutions to growth.

We remain positive on the industry as a whole and believe certain institutions are poised for outperformance.

Take a close look at your own turf

Community banks have proven their stability and are here to stay, but current market prices present an interesting disconnect to valuation, some of which is skewed by geography. Some management teams have become frustrated by this dynamic, but with broad frustration comes select opportunity.

When looking at local markets, one must look deeper than simple demographics. Successful banks not only know their market well and have deep relationships, but they also execute strategies that are differentiated and tailored to their markets. They find distribution channels that others miss and manage their risks properly often by utilizing deep customer relationships and local knowledge.

One specific trend we seek when investing in a community bank is the population migration of its market. We like to see a healthy portion of the population growth being the “young professional.” They have disposable incomes and are big consumers.

If a bank is seeking growth, then so should its clients.

Some banks fear the young consumer, as they are more “tech” driven. But delivering to these clients isn’t that difficult. While they value technology, they also value their local community and “social network.” They prefer what is rendered just around the corner rather than on Amazon.com and are willing to pay a premium for premium service. They tend to distrust the Wall Street crowd, so the idea of banking local resonates quite well.

In banking, nearly everyone offers the same products and services. What is different is the delivery model of how the bank connects and stays engaged with its most profitable customers.

While difficult to swallow, the majority of a bank’s customers are not profitable. Profits are driven by a subset of the customer base and institutions that capture the most profitable clients are truly best of breed.

It’s not just customers, it’s managing risks

One key risk area facing banks today is interest rate risk. Rate risk today is exacerbated by a low rate environment and tepid loan demand. With a lack of demand for loans, many banks have utilized a larger percentage of securities, some of which may have greater durations to compensate for low yields. This may present risks to capital and earnings if rates shift meaningfully upwards.

We analyze whether banks are stretching for yield by increasing portfolio duration. Long dated, fixed-rate assets will exhibit greater price volatility and could contribute to material realized losses if they are sold in a higher rate environment. If a bank uses securities as a temporary means to generate income, the duration should be short. The bank will earn less today, but will also take on much less risk.

What about the loans, you ask? Being just seven years removed from the start of the recession we have run more than a full credit cycle (based on 4.5 year average loan duration). Credits are improving due to conservative underwriting policies.

However, we are careful to note an increasingly competitive environment and want to highlight the importance of maintaining credit standards and appropriate rate levels. The yield on a loan is the compensation for the risk taken, and even a “good” credit at too low of a rate can be risky.

The risk is asymmetric … an annual upside of 5% for the downside risk of losing 100%.

Don’t save yourself into irrelevance

As an investor, we look at net interest margins. It is no secret that strict control of non-interest expenses is an important driver, but we often find that draconian expense control is hindering franchise growth.

For example, wouldn’t you be shocked if you walked down the jetway on your next flight and saw the aircraft to be a 40-year old plane with seat fabric that looks like a suit your dad wore in the 1980s?

How would you feel about that experience? 

What lasting suppositions would you make about this airline based on the look and feel of the plane? In any business, a company must invest in itself. That is a likely reason why your business customers borrow from you. Banks shouldn’t fear capital expenditures but should find those opportunities that create the “most bang for the buck.”

This means having attractive branches and websites, delivering functional online and mobile banking capabilities. This will allow the bank to compete in a crowded market.

We don’t believe that banks offer “products,” we believe they offer “services.”

And the key to any good service is the user experience.

Every aspect of the relationship—from the look of a statement to the tone of communications to the colors of paint in a branch—creates an experience. Banks should create a warm and enjoyable experience for the customer—tired looks and outdated equipment makes for a poor customer experience.

Look beyond common stock

So if you want to invest in your bank, or make an acquisition, or repurchase shares, you need capital. In 2008, the trust preferred security effectively disappeared. This instrument was successful because it came at a “cheap” cost, was non-dilutive to ownership, and was readily available from institutional sources. More than 1,600 banks used trust preferred securities to enhance their capital structure, and roughly 1,200 banks used the capital responsibly.

When the trust preferred opportunity was ultimately “put to rest” by the Collins amendment in the Dodd-Frank Act, community banks shifted back to their traditional capital providers, local common equity investors. The board may have passed the hat or maybe it was a local advisor who completed a raise.

Local shareholders are a great source of capital. They are invested in the community and as such, the cost of capital is often relatively low because the investor derives other utility value from their investment. However, local common equity investors can only invest so much. The local capital well is not infinite. And sooner or later the well runs dry and new investors will be needed.

So what else is available?

A bank can have a much more developed capital structure than just common equity—even under Basel III. There are trade-offs but improvements in earnings and book value may be immediate by utilizing preferred stock and/or subordinated debt.

We believe that banks likely to outperform will have diversified capital structures that include a mix of common equity, preferred equity, and subordinated debt. If you haven’t considered these in the past, talk to your peers, ask your regulators, or speak to your advisors.

For some institutions, a purely common equity capital structure may work just fine, but many may find the numerous benefits the other securities offer to be valuable. And just because you can issue common stock at a premium to book value, doesn’t mean it is truly at a lower cost. If you think the price of your stock will rise, even selling shares at a premium to book value can cost more than you think if you think the stock will be at an even higher premium to book in the future, plus a compounding growth of book value.

A bumpy ride, but the destination’s promising

We at StoneCastle Financial Corp. feel fortunate to invest in community banks. We are humbled by the longstanding relationships we have created with community bankers. Through those bankers, we are proud of the business and jobs we have helped to create and the people we have helped to buy their homes and send their kids to college. We have shared the ups and the downs of those bankers’ journeys and are grateful to be a part of their endeavors.

The path forward may not look perfectly paved, nor perfectly straight. Yet that path leads to many opportunities. We are excited to be partnering with great bankers and look forward to continuing the journey together.

Disclosure: The views expressed are the opinions of StoneCastle Financial Corp. and are not intended to predict or depict performance of any investment. All information contained herein is for informational purposes and should not be construed as investment advice. It does not constitute an offer, solicitation, or recommendation to purchase any security. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Past performance does not guarantee future results. These views are as of the date of this publication and are subject to change.