Time To Bottom Fish For Small Banks?

Financial stocks have understandably led the market down during the recent credit-related correction. But the group has also recently led in another area: insider buying.

In July and August, executives and directors in this much-beleaguered sector snapped up a massive $250 million worth of shares at big banks, small banks, mortgage REITs and specialty finance companies. These are just the stocks most investors have been running from, but maybe they should reconsider. After all, buying by inside executives and directors is usually considered a decidedly bullish signal. Who knows the true health of any given business better than those who run it day to day?

Most of the negative attention has been focused on such high-profile financial companies as Goldman Sachs, Bear Stearns and Countrywide Financial. And rightly so. (Countrywide, which accounted for one out of five mortgage loans in the U.S., is the poster child for the credit market's current swoon.) But, obviously, those companies are not the only ones in the sector. While they were busy meeting margin calls, executives at lesser-known regional banks — perhaps some operating in your town — have been buying shares of their own firms. If the insiders are right, this could be a great time to buy shares of stocks unjustly punished by the recent sell-off.

Like Catching A Falling Knife?

To be clear though, it's difficult to find a banking analyst ready to sound an “all clear” on the final impact of the current credit crunch. To the contrary, most believe that the storm is just beginning. “Credit problems take a while to sort out,” points out Terry McEvoy, an analyst at Oppenheimer & Co. “Particularly real estate-related credit problems.” Just how long? James Abbott of Friedman Billings Ramsey & Co. compared the credit crisis to a hurricane. “I don't even think we've reached the eye of this storm yet, and there are still big waves after a storm passes,” Abbott says.

Damage from this credit tempest should start showing up in third-quarter financial results in the form of increases found on the “non-performing loans,” or “loan loss allowances” lines on banks' balance sheets. As loan values are officially written off, you can count on a hit to earnings too. So even though estimates at many banks have already been coming down, investors expect more downward earnings revisions for most banks starting next quarter, and possibly lasting through 2008.

Why consider buying into this sector before the long confession period even begins? Because many bank shares have already come down in price enough to offset a worst-case scenario hit to portfolio assets and future earnings. The vast majority of commercial banks have more than enough capital to survive, and analysts don't expect the present storm to cause a wave of bank bankruptcies à la the savings and loan crisis of the late 1980s (or even 1907; see related story on page 111). If they are right, the downside risk to most bank stocks may not be as bad as some fear.

Again, it appears that insiders at numerous small and regional banks regard the sell-off as a buying opportunity (see table on page 96). Most of these stocks came down hard in July when the sub-prime mess really started to build. Some remain heavily discounted despite recent bounces, due in part to the expected federal funds rate cut in September.

Important metrics to watch in bank stocks as the turmoil progresses include their percentage of non-performing assets, Tier 1 capital ratios, and valuations on tangible book value. What about yield and earnings estimates? These are only useful metrics in good markets. In bad times (e.g. now), fundamental value and financial stability metrics are likely more reliable ways to judge and compare bank stocks.

Performance Anxiety

Jeff Davis at FTN Midwest Securities says that non-performing assets equaling around 1 percent of a bank's total should “raise eyebrows.” He also thinks that any bank with 1.5 percent or more of non-performing assets would have to sport a very cheap stock (say, trading at or just above tangible book value) to give enough margin of safety to justify bottom fishing. Either way, Davis argues that investors should still make sure a bank has a Tier 1 capital ratio of 8 percent or better to feel comfortable betting on its shares.

In fact, many of the stocks in the table do have eyebrow-raising levels of non-performing assets. However all still show Tier 1 capital at or above safety levels, and many are looking pretty reasonably priced — some trading for less than two times the book value. Of course, the concern is what all these numbers will look like in a few months; the insiders could be wrong, or trying to show confidence — and their firms could still be vulnerable to asset writedowns.

To be sure, bottom fishing on banks right now is not for the faint of heart. “It can be painful to be too early,” reminds Mr. McEvoy. “Some banks were off 20 percent some months ago, and looked cheap then. They're now off 40 percent.” While insider buying at your local bank doesn't mean the bad news is over, it should add comfort that another large cascade in share price is less likely.

BANKING BUYS?

A Sample Of Bank Stocks With Significant Insider Buying In July & August(sorted by market cap)