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| 02/11/2010 |
The new decade is certainly off to an interesting start. After a strong rally finishing 2009 up more than 26%, the S&P 500 Index was down 2.3% in January despite the continued improvements in the economy and stabilization of the credit markets. The short-term decline is likely reactionary to what we are hearing from Washington and the press with regard to U.S. financial system reform. “Too big to fail” has permeated the financial vernacular and the proposed “bank tax” has garnered much political debate. But not all banks are created equally and we see great potential in regional and community banks.
The proposed regulations on large banks would affect those with $50 billion or more in assets. Meanwhile, the suggested “Volcker Rule” focuses on the sponsorship/ownership of hedge and private equity funds, and proprietary trading by banks that are also depositories. Unlike the “mega banks,” the banks we invest in do not rely on these activities to generate revenues.
One of Fenimore’s specialties is the analysis of financial companies – specifically banks and insurance companies. In the banking arena we are particularly interested in small- to mid-sized community and regional banks. These banks are more profitable and stable than their larger counterparts that continue to lose money and write-down assets. This is a testament to their prudent leadership guiding them before, during and after the credit crunch. The banks we follow exhibit similar characteristics. They possess: low-cost deposits, the ability to acquire competitors and/or failed bank assets from the FDIC, sound financials, significant capital, and wise executive managers who avoided the risky lending and investment tactics that damaged other banks.
The interest rate environment has also started to benefit bank earnings. The yield curve (difference between short- and long-term rates) is providing increased profits on the difference between what they pay to depositors in interest and what they earn on lending. We have been waiting for a couple of years for the rate environment to swing back in favor of traditional banks and we believe this will continue to be a tailwind through 2010.
The opportunity for investment in small community and regional banks hasn’t been this favorable for quite some time. As the big banks on Wall Street continue to work through self-inflicted problems, the banks that were aboveboard remain in their shadow of malfeasance; however, there is a silver lining. The insinuated levies on large banks should not apply to those we follow and, thus, not affect their profit margins. Most important, the depressed stock prices of the sound community and regional banks are providing us with the lower valuation levels we seek.
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