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An Insider's Guide To The Community Bank Industry - 102 Banks Summarized

by: Jeremy Blum

I have reviewed and provided information on 102 community banks for this article.

Community Bank Stocks rallied 23.3% from the November, 2016 election through June 23, 2017, since then they are up only 4.1% despite a huge tax cut.

Community bank stocks are no longer overvalued as I determined in my last article in June, 2017, they are now fairly valued.

Community banks are as strong as they have ever been, and losses are likely to be much smaller in the next recession than they were in the last.

Author's note: This article is a follow-up to a similar one I published on June 27, 2017.

Community Bank Industry

I have defined community banks as those under $10 billion in assets. Regional banks are $10 to $50 billion, and money center or large banks are defined by the federal government as over $50 billion. For purposes of this article, I am reviewing the larger community banks, those with $1.5 to $10 billion in assets, an ROE of at least 6%, and at least four years as a publicly traded company. Value Line’s Small and Midcap Edition currently shows 102 of these. These banks are big enough to be liquid for most individual investors and have enough scale to be solidly profitable. The $1.5 to $10 billion size is a sweet spot, as these banks can grow faster than larger banks and with less regulatory oversight. Smaller community banks (under $1.5 billion in assets) often have an illiquid stock and are often less profitable due to lack of scale.

Community banks differ from large banks in that they mostly stick to a local geography that they know well. They are almost never involved in the riskier activities used by big banks, such as credit cards, derivatives, foreign loans and services, asset trading, and investment products like managing mutual funds, private equity, and hedge funds. Community banks, for the most part, stick to taking in deposits and making loans. Commercial loans are made to small and mid-sized businesses. Most also offer wealth management, and some offer insurance services. Knowing their geography is important. Commercial loan losses grow when the lender goes into a geography they don’t know well. Perhaps the biggest difference between community banks and large banks is that community banks are relationship-driven, while large banks are transactional. That means large banks focus on the profitability of each transaction, while community banks think longer-term. They may leave something on the table to keep the relationship.

Bank Performance Since My Last Article (June 23, 2017)

Because community banks have less risky activities, they recently have had a higher PE ratio than large banks. However, that spread is being compressed. Currently, the 102 community banks reviewed here have an average PE ratio of 14.1. This is similar to regional banks ($10 to $50 billion), which currently have an average PE of 13.8. It is above large banks ($50 billion and up) which currently have an average PE ratio of 12.2. For PE ratios of the larger banks, I compared the 2018 earnings estimates of banks listed in Value Line to the current stock prices. This is a big change from when I wrote my prior article in June 2017. Back then, community banks had an average PE ratio of 20.8, well above the PE ratio for regionals at about 16, and large banks of about 12.

Due to the much higher PE ratio of community banks in 2017, there were few acquisitions of larger community banks. Since I wrote my last article on June 27, 2017, only 11 of the 113 community banks I profiled have been acquired. Most bank acquisitions are done with stock, because using cash depletes all important capital. When your PE ratio is well below your target, you can’t use stock either. Meanwhile, larger community banks ($1.5 to $10 billion) have been feasting on smaller community banks. Many smaller banks (under $1.5 billion) are having difficulty competing with the heavy regulatory burden and increasing IT costs. Their numbers are rapidly decreasing.

Three items of note have occurred since my prior article in June, 2017. The biggest item was the tax rate cut effective January 1, 2018 reducing federal income tax from 35% to 21%. This has had a major impact on the earnings of banks. Most community banks were negatively impacted by tax adjustments in the fourth quarter of 2017. Since then earnings for most community banks have increased by 20-50% in 2018 from 2017 levels before the fourth quarter. Community banks have had a bigger boost from the Tax Act than most other industries. The second item is interest rates, after years of being at historic lows, have started to rise. This benefits more banks than it hurts, especially those with a lot of 0% interest demand deposits and long term FHLB Bank Advances. On the other hand, banks with a high level of fixed rate loans will likely face lower interest margins. Finally, as detailed below, a moderate regulatory relief bill was enacted in May, 2018.

The number of U.S. banks have been cut by 43% since 2000. There were 4,852 banks in the U.S. as of March 31, 2018, down from 8,458 on March 31, 2000. Almost no new banks have been granted charters since the last recession. However, the industry has gotten more competitive due to expansion of the remaining banks and competition from non-banks. Despite, all the mergers, there are still too many banks. Most larger and even mid-sized markets have at least a dozen commercial lenders and often hundreds of residential lenders.

The banking industry is one of the most heavily regulated industries in the country. I served as the Compliance Officer of a community bank from 1992 to 2000 and examined banks for compliance before that. There are literally thousands of pages of regulations banks need to comply with. Do you remember how high the pile of papers was last time you got a residential mortgage? Mine was about an inch thick. In 2010, a new regulatory agency, the Consumer Financial Protection Bureau was added on top of the others which include the Federal Reserve, the OCC, all 50 states, the FDIC, the SEC, and numerous non-bank regulators. Many smaller banks, below the $1.5 billion, are selling out simply because they can’t handle the regulatory compliance and don’t have the scale to be solidly profitable. Large banks have a whole other layer of costly regulations.

Incidentally, commercial lending and commercial deposits, the core activities of a community bank have not been affected much by the internet. These are relationship based businesses and customers and bankers want to see each other. However, the internet has sped some things up like communications, deposit processing, payments and sending in financial statements.

Choosing Bank Stocks

In choosing bank stocks, I look for the following:

1. Loan growth - Anything over 10% a year is exceptional assuming the underwriting is good. You need to be careful here. Often the banks that blow up in a recession were the fastest growers.

2. EPS growth - Again, anything over 10% per year is strong, 5% more the norm.

3. Lots of 0% demand deposits - In a rising rate environment, these stay at 0% which helps pop open bank interest margins.

4. Return on Equity - The average ROE increased from 8.7% in my last article (June, 2017) to 11.5% now. This increase was mostly due to the tax cut. Avoid the low ROE banks unless they change management. They tend to stay underperforming and have less cushion to absorb losses in a recession.

5. Market growth - Banks in higher population growth states have more new loan opportunities.

6. Loan mix - Avoid banks that have concentrations in higher risk loans such as auto lending, construction and development loans, and energy production. Look for a more balanced mix. Commercial real estate is most often the biggest category.

7. Red Flags - Avoid those with regulatory enforcement actions.

8. High cost deposits - Avoid banks with a lot of high cost deposits such as brokered deposits. The industry term for that is “hot money” and it is addictive like a drug and painful in a recession.

9. Performance last recession - Consider those banks that sailed through the last recession. I have shown those on my list. Recessions prior to the last one are not a good predictor, as the 2001 recession wasn’t particularly bad for banks and 1990-1991 recession is too far away.

10. Outside market loan operations - Avoid banks with a lot of loans outside their market where they have branches. Usually out of area banks only get the loans that the local banks passed on.

Regulatory Reform

The regulatory pendulum is starting to swing community banks way. On May 24, 2018 a new law was enacted which reduces the regulatory burden. A summary of those items helpful to community banks is below.

If banks with assets under $10 billion maintain 9% tangible net worth to assets ratio, they are exempt from other more detailed and burdensome capital requirements.

Banks with assets under $10 billion can form hedge funds in their name and hold trading assets of up to 5% of assets.

Banks file a “Call Report” quarterly with the FDIC. This is a very detailed financial statement. If assets are under $5 billion, they can file a much simpler Call Report twice a year.

Banks with assets up to $3 billion that meet other requirements can hold more debt as part of a merger than larger banks. This threshold is being increased from $1 billion.

Bank exams for satisfactory performing banks under $3 billion are being extended from every 12 months to every 18 months. My first job was as a Bank Examiner. The 12 month rule has been around forever.

Banks can now use an online image of a drivers license or other government ID to open an account.

Banks that originate less than 500 mortgages a year are exempt from disclosure requirements added in the Dodd-Frank Act in 2009.

Banks under $10 billion in assets, that have originated 1,000 or fewer loans secured by a first lien, are exempt from Truth-in Lending Act escrow requirements.

Capital requirements are eased on riskier commercial real estate loans if the project is complete and cash flow is sufficient to meet debt service.

As a whole, these provisions provide a moderate level of relief. Based on how many regulations banks have, the improvement is less than 5% of the burden in my opinion.

Community Bank List

All 102 banks of $1.5 to $10 billion in asset banks shown in Value Line’s Small and Midcap Edition, with an ROE of at least 6% and have been public for at least four years, are shown below. Only a couple were excluded for having an ROE under 6% as most community banks are doing very well in this economy. The last column rates earnings per share and organic loan growth 1 to 5 with 5 being the best. The second to last column rates how well each got through the last recession. Those rated 1 barely made it. Those rated 5 had little trouble.

Community Bank Stock Prices

Community banks had a historic rally after the election on November 8 th 2016. The 113 banks I reviewed last time rallied 23.1% on average through June 27, 2017. Since bank earnings normally increase about 5-8% a year on average, that is 3-4 years of stock increase in about 7 months. Most of that happened within two months of the election and then flatlined since. That rally was on top of another 10% rally from June to November, 2016. The rally increased their average PE to 20.8 from about 17 at the election and 15.5 in November 2015. The PE of 20.8 was historically very high for banks, the highest I have ever seen. The price to tangible book value was 213.8%, also at historical top end. Remember, this is a slow growing and cyclical industry. I mentioned in my last article I expected this elevated PE ratio to steadily revert to a more normal mid-teen level.

Since my last article in June, 2017, what I predicted has happened. The average PE ratio has declined from 20.8 to 14.1. The price to book value has declined from 213.8% to 185.7%. Despite both of those declines, the average stock price of community banks ($1.5-10 billion) increased by 4.1% during that period. The primary reason for the stock price increase was the tax cut which took place in the first quarter of 2018. Banks benefited from the tax cut as much as anybody. Earnings instantly increased 20-50% across the board.

Below are the reasons I gave in June, 2017 for my expectation if a decline in the PE ratio, and the status of those reasons now:

The spread between the PE of community banks and large and Regional banks was historically high. This makes it difficult for the latter two to acquire community banks. While banks under $1 billion are being bought left and right by the larger community banks, community banks over $1.5 billion do not have a potential sale premium right now.

As shown above, the spread in PE ratios between community banks and larger banks is mostly gone now. I expect this to result in more community banks being bought by larger banks.

We are getting late in the cycle. This business cycle has already gone eight years which is longer than most. Banks are cyclical. Many through strong underwriting are able to avoid large losses in a downturn, but in a recession loan growth turns into loan shrinkage which stalls are reduces earnings.

This is still the case, even more so.

Banks are maxing out on what they can do with their loss reserves. Loss reserves cannot go much lower unless balance sheets start to shrink.

Still the case; loss provisions remain very low.

The yield curve is shrinking. This not only indicates economic weakness coming, it directly leads to less profits for banks who fund their assets with liabilities that generally have a shorter duration.

The yield curve has shrunk more, though is still not inverted. Many economists believe an inverted yield curve is a sure sign of a recession coming.

Long term interest rates are falling. This also directly impacts the interest banks receive on the bulk of their loans which are tied to longer term rates.

Long term and short term interest rates are increasing. This will help more banks than it hurts as banks tend to be more asset sensitive than liability sensitive.

Loan growth was slowing.

Loan growth for community banks is now at normal levels, about 5-10% right now. This is above that of larger banks who are more 0-5%.

The financial sector is nearing historical highs in market cap weighting.

Financials have lagged some recently. Since June 23, 2017, the S&P 500 has increased 13.3% versus 8.6% for the S&P Financial Index.

The farther away from a recession you get the more competitive booking commercial loans get. This leads to lower interest margins and looser underwriting.

This will remain true until the next recession.

How Banks Will Likely Fare in the Next Recession

While few can predict when the next recession comes, the risk of one is starting to rise. The economy is now in a position where it has to move forward with no more pent up demand and no fiscal or monetary stimulus. The following is a discussion of what to expect from banks in the next recession.

The banking industry is in its strongest position it has been in…well probably ever. As shown in my list of community banks, the average bank has a net worth of 10.7% of assets, which is probably a record. Only one of the 102 banks on my list is even under 7.5%. The minimum capital requirement to be considered well capitalized is 5%, though there are other capital requirement measures. As noted above there is a new 9% rule to avoid more burdensome capital ratios.

Bank credit quality is as good as it gets, there are very few community banks struggling with problem loans right now. As shown in the chart below, there have been almost no bank failures this year and last.

Source: FDIC

The 1990 and 2007-2009 recessions were real estate related and were very hard on banks. Both were the result of bubbles in real estate. In 1990-1991, it was a bubble in commercial real estate of most types. In 2007-2009, the bubble was residential and commercial real estate. The 2001 recession was from a stock market bubble and didn’t hurt banks anywhere near as much. I do not see any significant bubbles out there now. There are a few trouble spots, listed below, but few impact community banks.

Retail real estate and businesses are closing thousands of stores as shopping moves more online. Secular headwinds there have been temporarily eased by a strong economy, but should increase as things cool down. The Miami condo market appears to be overheated again. The crypto-currency bubble is popping. Some overseas economies are cooling. There is moderate overbuilding in multi-family real estate in some markets. There are other industries in secular such as newspapers, coal, for profit colleges, terrestrial radio, paper, and non-cloud IT services.

With the exception of retail real estate , community banks do not have much exposure to anything listed above. Community banks also have few subprime loans.

One of the biggest truisms in banking is memories of bad loans fade the farther away from the last recession you go. This results in underwriting standards and pricing steadily eroding as you move away from the recession due to competition. Since the last one was so harsh, memories still remain fresh and underwriting appears to still be relatively good.

Based on what I see, I do not expect banks to be hit anywhere as hard as the last recession in the next one, unless something happens to make it worse than the last one, which was one of our worst. This gives bank stocks some support. However, any recession will still bring elevated loan losses, loan shrinkage and lower interest rates. All these are negative for bank earnings. Also, once its clear we are going into a recession, bank stocks are likely to get sold as memories of the severity of the last one remain, until it becomes apparent the banks are holding up.


As I predicted, the average PE ratio has fallen by 32% from 20.8 to 14.1 since my last review in June, 2017. I no longer think community bank stocks are overvalued. They appear appropriately valued now. The Tax Act has significantly improved earnings. Earnings have increased by 20-50% for most community banks immediately following the Tax Act. This increase more than offset the lower PE ratios resulting in a small increase in community bank stock prices since my last article. Banks are as strongly capitalized and prepared for a recession as I have seen. For this reason, I do not expect a high level of bank failures in the next recession. Banks received some moderate regulatory relief in May, 2018. However, with the Democrats winning the House of Representatives, significant more relief is unlikely at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.