The Trade of the Decade

I often refer to the trade of the decade. Several readers have asked exactly what I mean by that, and I realized I haven't written about this in a while.

Let me explain: The trade of the decade is going to be in the small bank stocks, many of which have been punished in the real-estate crisis and are trading well below tangible book value.

They still face tremendous head winds -- the real-estate overhang is far from resolved -- but the time it getting very close to load up on these stocks. I recently bought two bank stocks for the first time in nearly five years because they appeared too cheap not to own at current levels.

A little background. The aftermath of the Savings and Loan crisis in the late 1980s and early 1990s was the most fun I have ever had in the financial business. I was a broker for a regional firm that made markets in most of the regional banks in the mid-Atlantic. We would buy stocks at a fraction of tangible book value and watch them get taken over at two and three times book in just a few short years. Most of them also paid dividends, so we got paid to wait. It was impossible not to make money in the sector. I believe the same thing will happen as this crisis winds down.

I prefer the smaller banks to larger ones in this trade. They are usually run by local business people with deep ties to the community. Peter Lynch used to call these the Jimmy Stewart banks, referring to the Bailey Building & Loan Association of "It's a Wonderful Life" fame.

It has been my experience that these banks have insights into the local economy and people that larger banks never will. They know the developers and likely buyers for individual projects in their marketplace. They know the likely success or failure of projects in search of financing.
I look for banks that trade below tangible book value with plenty of excess capital on the books. I also prefer banks with a very low percentage of nonperforming assets -- generally speaking, I like this number to be below 2% of the total. I also want to see that the reserves for loan losses exceed the value of nonperforming loans. This combination of capital reserves and low loan losses creates a cheap and safe situation that I can buy with a high degree of safety.

On occasion, I make an exception when the amount of excess capital is so great I believe the bank can withstand its loan problems. That's the case with my latest bank investment, Abington BancsharesNasdaq" PRIMARY="NO"/>. This stock came to my attention when it showed up in the portfolio of value-investing legend Charles Brandes.

Abington's construction-loan portfolio is a disaster, to put it kindly, with 21% of the portfolio considered delinquent. The other real-estate-owned section of the balance sheet has exploded, as it was forced to repossess properties in the past year. Nonperforming assets exceed 4% of the total, well above my usual threshold.

However, the equity-to-assets ratio is over 17%, so it has a lot of room for error. It has been using excess capital to buy back shares at less than tangible book, which should pay off for stockholders in the long run. At 70% of tangible book value, I consider the bank a special situation, where the rewards more than offset the risks for long-term investors.

The trade of the decade is setting up right now. We are seeing bank failures continue along the pace set last year. A lot of weaker hands are leaving the marketplace. Some of the larger regional banks are going to be in search of high quality assets to shore up their balance sheets. It will make sense to buy smaller competitors with quality assets on the books. Some banks, such as Abington, may have problems, but they have more than enough capital to survive, and their shares will rise when the economy and real-estate markets recover.

I am tip-toeing into this trade. I suspect that by the end of the year, my portfolio will be more than 50% small banks, but right now I only own two, Abington and Shore BancsharesNasdaq" PRIMARY="NO"/>. I also consider Towne BankNYSE" PRIMARY="NO"/> a buy, but I haven't entered orders yet. I expect to do so in the next market decline. I view this opportunity as my retirement trade over the next 10 years

By Tim Melvin, RealMoney.com Contributor , On Wednesday March 3, 2010, 2:00 pm EST

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