While my livelihood is earned working as an investor outreach and financial communications consultant serving small public companies, including community banks, I truly enjoy spending time conducting fundamental research on equities and locating undervalued companies.  As value investors know, there is nothing more rewarding than finding a truly underappreciated company.  It just so happens today that many underappreciated companies are in the banking industry.

If you were to do a screen of community banks trading under book value with positive earnings two years ago, you would likely find just a handful of companies.  More likely than not, these were probably companies with float constraints, non-SEC reporting, or any number of other concerns.  When you pull an identical screen today, you will locate dozens of community banks with positive earnings and trading below book value.  Does this mean most community banks are undervalued?  Maybe.  But it is also highly likely that the continued housing and related economic crisis (and margin compression due to interest rate adjustments) will continue to severely impact bank earnings and asset quality.

The community banks hurting the most seem to be ones that invested heavily in mortgage backed securities, made loans in markets they did not serve through traditional banking means, and/or had terrible luck in operating in real estate markets that bubbled and crashed beyond imagination (well, some predicted it).

With the above statement out of the way, I can say with full confidence that there are many high quality community banks that have been dragged through the mud along with their higher risk taking counterparts or larger regional banking competitors. 

I’ve located a few community banks through fundamental screens and by way of more extensive research that have the following characteristics:

a)      Trading at or below book value (or at a 52-week low)

b)      Making money (strange thing these days, eh?)

c)       Made loans only in markets they know and understand

d)      “Well-capitalized” by regulatory standards

Eagle Bancorp (EGBN), Benchmark Bankshares (BMBN), Centrix Bank (CXBT), First California Financial Group (FCAL), Old Second Bancorp (OSBC), Stonegate Bank (SGBK) represent a few community banks that caught my attention this week. 

I can’t claim to pick winners all the time, but I do know that many quality banks (like the ones I mention above) run by experienced and conservative bankers have been hemorrhaging in the stock markets and may deserve a really close look by savvy value investors with a long-term investment horizon.

Eagle Bancorp is particularly interesting because the company meets all of the above criteria and yet also operates in a very efficient manner as demonstrated by their low efficiency ratio.  Typically, community banks in a growth phase have very high efficiency ratios (meaning overhead is high) as their costs balloon with the opening of new branches and even through acquisitions.  This demonstrates management’s ability to operate their bank network in a lean manner and still produce earnings growth.

Benchmark Bankshares intrigues me for a different set of reasons.  I have watched as many community banks, especially under the $500 million of assets “benchmark” have decided to cease filing with the SEC.  This appear to be a growing trend, as small community banks can be overwhelmed just dealing with the FDIC and state bank regulators – which audit and control banks anyways.  Essentially, some find SEC reporting too burdensome and costly (upwards of $500,000 per year).  Benchmark no longer files with the SEC, however, earnings are growing (buffeted by a reduction in SEC reporting expenses) and the company currently pays a healthy dividend to shareholders.

Centrix, Stonegate, and First California are all small business focused banks.  This means limited to zero exposure to residential mortgages, particularly risky loans which have caused many of their competitors' undue grief.  Small businesses need credit right now in order to operate, perhaps more so than ever. Healthy banks without tarnished balance sheets should benefit from this. 

I can’t claim to pick winners all the time, but I do know that many quality banks (like the ones I mention) run by experienced and conservative bankers have been hemorrhaging in the stock markets and may deserve a really close look by savvy value investors with a long-term investment horizon.

By Jacob Eisen

Disclosure:  The author does not own stock or provide consulting services currently to any of the companies mentioned in this article.