It should be no secret by now that when it comes to the stock market, my favorite things are special situations, private equity replication strategies, and small bank stocks.
At the same time, I know most people think investing in small banks is boring stuff.
What can I say? They're quite correct.
Investing in small banks is incredibly boring. It can be as boring as watching golf on television or trying to read a James Joyce novel for the second time. There is going to be zero action most of the time. So, when everyone is bragging about the crazy, exciting high-stakes trades they made that day, all you'll be able to say is, "I hung on to the same bank stocks all day again today!"
Then one day, excitement comes to town. It always does.
You see the news that one of your banks that you bought below book value is being bought out, and the buyer is paying several times your original purchase price.
So, yes, it is boring when you buy small banks the right way and hang on to them. It's also often wildly profitable.
I've got all the records to prove I haven't closed a losing small bank stock position since 2013. In fact, I'm pretty sure I've never closed a losing small bank stock position, but the written record is only for the last nine years.
Of the 40-plus small banks in my portfolio right now, exactly two of them are down - and the average decline is less than 2% from my purchase price as I write this.
Today, I'm going to show you how you can replicate some of my success, and I'm going to name a stock to get you started. It's a special situation strategy and my favorite way to buy these small but powerful bank stocks.
Why Small Banks Are Boring, Amazing Investments
A "thrift bank," or just "thrift," is a small local bank that takes in deposits and makes mortgage loans - for the most part. Most of their depositors are individuals rather than corporations and businesses. A mutual thrift is a thrift bank that is owned by its depositors. Thrifts usually have a significant portion of their assets in securities like municipal bonds - "munis," Treasuries, and mortgage-backed securities.
From time to time, one of these mutual thrifts decides that they want to grow their business and get into more commercial banking - maybe the executives want an opportunity to sell the bank and cash in a few years down the road. Whatever the driving reason, the thrift board decides to convert to a stockholder-owned bank with more flexibility and growth potential than a thrift bank.
They then pull off a mutual conversion IPO. These are incredible wealth-creation events - like the "Big Bang" but for stocks.
I'll use some nice round numbers to show you how this works.
Let's say our bank has $10 million in equity. It sells 1 million shares to the public for $10. Each share, when purchased, has an equity value of $10.
Now imagine the bank has taken in $10 million in the IPO. Add that to the original $10 million, and the equity value is now $20. So each share we bought for $10 is - overnight - now worth $20!
The depositors get the first crack at buying shares, so you and I won't get IPO shares unless we have cash in the thrift before the deal is done. But I'm here to tell you: I've usually been able to buy them at 70% to 80% of equity value during the first few days of trading.
Inevitably over time, these stocks will drift toward the equity value. But, of course, that equity is usually growing, so it's trying to hit a moving target.
That's one source of gains - but not the only one.
See, these newly public banks have a funny way of getting acquired - bought - once the three-year change-of-control restrictions expire. The chances of such an acquisition are very high.
There has been a flurry of mutual conversion IPOs in the last year, and a few of them are still attractive candidates at current prices.
These Are the Two Small Banks to Play Right Now
I am a huge fan of Northeast Community Bancorp Inc. (NASDAQ: NECB), out of White Plains, N.Y. It did an offering last year, and we can still get shares at just 71% of book value. Unlike most thrifts, which are single-family mortgage lenders, Northeast Community has carved out a niche for itself doing multifamily construction in the Hudson Valley and parts of the New York City area - some of the priciest real estate on the planet.
It's very good at what it does; it has no delinquent loans right now. Zero. In addition, it has an enormous amount of equity, so unless the United States approaches "Mad Max"-type levels of disaster and insanity, the bank will be very safe financially.
I truly believe Northeast will eventually get taken over - and at several times the current stock price of around $12. You definitely want to be strapped in before that happens.
I also like William Penn Bancorp (NASDAQ: WMPN). This is another thrift that went public last year, and the stock is still cheap enough to make sense at the current level of $12.50. It does business in the Philadelphia and South New Jersey markets, which have seen a lot of consolidation over the past few years. A few years from now, I suspect William Penn will join the list of banks taken over, and that should happen at a price much greater than the stock is changing hands at today. William Penn has more than enough cash and equity to withstand almost anything short of the apocalypse.
The stock is trading at about 90% of book value right now, so there is tremendous upside potential in the stock, with average takeover valuations running at about 160% of book value right now.
Yes, owning small bank stocks is boring - the excitement comes from deciding what to do with all your profits.
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About the Author
Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.