As investors hunting for the best stocks to buy, we often get so caught up in the big names of the day that we miss a powerful opportunity right in our community.
I'm talking about community bank stocks, and they're about to offer you one of the biggest profit opportunities of the next few years.
In fact, patient long-term investors could see profits similar to those enjoyed in the 1990s as banks recovered and consolidated.
Stocks to Buy: Why It's Time for Small Banks
Community banks usually have just a few branches and less than $1 billion in deposits. They have seen their stock prices fall dramatically over the past few years from the peaks reached in the 2006 boom days.
Between 2006 and the depths of the credit crisis, the NASDAQ Bank Index plunged by more than 60% and has not really recovered. Some of the poorly managed ones lost it all and were liquidated by the Federal Deposit Insurance Corp. (FDIC).
Those that are left should benefit from the eventual recovery of the real estate markets – but the truth is most of these banks won't be around that long.
That's because as the credit crisis unfolded legislators and regulators were quick to react – or overreact. They applied new rules and regulation not just to the large institutions that caused most of the problems, but also to the smaller community banks.
With literally hundreds of new banking regulations on the way, many smaller banks simply will not be able to comply and still operate profitably. It will also be difficult for smaller banks to access the capital markets to raise the money needed to grow.
The most logical course of action will be to sell out to a larger institution.
The Looming Consolidation Wave in Banking
The slow recovery has given banks a reason to look to merge with peers or acquire smaller institutions. Loan growth has been, and is expected to be, anemic for some time to come.
In addition, many non-bank financial institutions like hedge funds and business development companies have emerged as lenders to mid-size businesses, an important customer for smaller community banks.
The only way to grow the deposit base and grow earnings for many banks is going to be via merger or acquisition.
We have seen this happen before.
We had a similar situation in the aftermath of the savings and loan crisis of the late 1980s and the weak economy of the early 1990s. Bank stocks fell by more than 50% as earnings and asset values plummeted.
This touched off a wave of M&A activity that eventually led the bank stocks to appreciate by more than tenfold over the next decade.
The same scenario is getting ready to play out once again and investors who think "small" can see the same powerful profits as a result.
How to Find Small Bank Stocks to Buy Now
The key for investors is to look for those little banks that trade for less than tangible book value, have low loan losses as a percentage of assets and plenty of capital on hand.
Investors want small banks that are cheap enough to be an acquisition target, but are also strong enough to grow and take market share from larger competitors over time. Takeovers and mergers will happen at a multiple of book value so the potential profits can be quite high as the consolidation wave strengthens.
At the height of the post-S&L crisis, takeover multiples were more than 2.5.
Community bank stocks are so depressed right now that we are seeing takeovers occur at more than 50% on average of the target bank's previous closing price.
One such institution is Westfield Financial Inc. (Nasdaq: WFD), the holding company for Westfield Bank.
The bank has 12 branches in Massachusetts and total assets are just $1.3 billion. The bank's shares trade for less than 90% of tangible book value and the balance sheet is rock solid. The total nonperforming loans are just .50% of total loans, well below the industry average.
The best liquidity measure is the tangible equity-to-asset ratio and Westfield's stands at more than 16. This tells us they have plenty of capital to implement growth plans, pay dividends or buy back shares at the current depressed price.
Another little bank that fits the small, cheap and strong profile is Berkshire Bancorp Inc. (Nasdaq: BERK).
The bank has 12 branches in New York City and Northern New Jersey with just $862 million of assets. The shares trades for just 95% of the tangible book value and loan losses are just a miniscule .16%.
BERK has plenty of capital on hand as shown by the tangible equity-to-asset ratio of more than 14.
The New York market is already heavily over-banked and it would make a lot of sense for the bank to be acquired. Insiders own 81% of the shares so any deal will be done at a price that is more than fair for shareholders.
For another report on stocks to buy ahead of 2013, check out these three hot biotechs.
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