By Tim Melvin
It comes as no secret to long-term investors that the stock market is on the high side of fair value right now.
The Shiller PE ratio is currently 25.9, which gives a forward return projection of less than one percent over the next five years. Ned Davis Research pointed out recently that the Price-to-Sales ratio for the S&P 500 is as high as it has ever been, and the return going forward from this level is likely to be negative for the next five years.
However, running away and hiding is not the best course of action. Overvalued markets can keep going higher for an extended period of time before finally collapsing. Investors still need to find a way to get money to work in situations that can offer high returns, but will not destroy capital when the market does finally reprice to rationality.
The best way to achieve these seemingly incompatible goals right now is to go banking.
Conditions in the community banking sector are perfect for long-term returns that are substantially above average, and many of them are priced to offer a margin of safety. One of two things is likely to happen to the financially-sound community banks over the next few years.
First, is that many of them will be acquired as the costs of regulatory compliance and the lack of organic growth opportunities make it unwise to remain independent. The second is that others will muscle up, perhaps engage in a merger of equals with a similar size institution, and aggressively market against (and take local market share) from the unloved big banks that dominate the banking industry.
Either outcome is likely to lead to much higher stock prices for these little bank stocks.
Investors should focus on sound banks that are trading at low levels when compared to their book value.
In addition, investors can tip the odds in their favor by focusing on those banks that have activist investors and very smart people as owners of the stock.
The big three among bank stock activists are Lawrence Seidman, Joseph Stilwell and PL Capital. These investors have a fantastic track record of forcing banks to vastly improve their results or sell the bank to someone who can.
Related Link: 5 Keys To Spotting Value Stocks
Both aforementioned outcomes will likely lead to much higher stock prices, and when you see one of them as a major shareholder of a cheap bank stock, the odds of a favorable outcome go way up. When all three of these investors are in a stock, it's akin to being able to bet on a favorite with long shot odds.
One stock that all three activists own is Prudential Bancorp (NASDAQ:PBIP), a small bank that just converted from a mutual thrift to a stockholder owned institution.
The offering has left the bank awash in liquidity and the equity to assets ratio is over 17. The Philadelphia-based bank has seven branches with about $514 million of assets and has a solid loan portfolio.
Nonperforming assets topped out to over three percent of total assets, but have steadily improved and now account for just 1.43 percent. Not only do all of the big three activists own this stock, but investors with solid track records like Michael Price, EJF Capital and Firefly Value Partners also own the stock.
Post conversion, the stock is trading at just 75 percent of book value right now and is a bargain with the potential for huge long-term returns.
Charter Financial (NASDAQ:CHFN) finished the conversion process back in 2012 and still has plenty of excess capital with equity to assets ratio of more than 19.
The bank has about $1 billion in assets and 16 branches in Georgia, Alabama and the Florida Panhandle. The bank is in sound financial condition and NPAs currently are just 0.59 percent of loans, not covered by a loss sharing agreement with the FDIC.
Related Link: 6 Books Every Value Investor Should Read This Summer
The bank just finished up its first buyback program since the conversion and announced another one for approximately 10 percent of the outstanding shares. Two of the three activists, Lawrence Seidman and PL Capital, own shares of Charter and so do some very smart investors like EJF Capital, Michael Price, FJ Capital and Paul Isaac's wildly successful hedge fund Arbiter Partners. The stock is trading at just 86 percent of book value and yields 1.82 percent at the current price.
All three activists own shares of Westbury Bancorp (NASDAQ:WBB).
The West Bend, Wisconsin-based bank has 12 branches with about $520 million of assets. The loan portfolio is sound, with nonperforming assets at just 1.05 percent of total assets, and it has adequate capital, as demonstrated by a equity-to-asset ratio of 12.58.
In addition to the activists, two other successful bank stock funds, FJ Capital and Castine Capital Management, own shares of the bank. The stock currently trades at just 75 percent of book value, and the board just announced a buyback plan for 4.9 percent of the outstanding shares.
The community banking sector has a very attractive risk reward setup regardless of what the overall stock market does over the next several years. You can further increase your odds of success by investing in those little banks that have strong activists and smart successful investors as your partners in the bank.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Disclaimer: Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation.