The Tremendous Opportunity in Small Banks

In football, sometimes it makes sense to give the ball to the big man, and sometimes it makes sense to give it to the little fast guy. When investing in today's bank stocks, the latter players seem better equipped to make the biggest plays.

In the midst of a banking crisis the International Monetary Fund (IMF) calls the worst since the Great Depression, small banks present a tremendous opportunity.

Why not give the ball to the big man?
After reeling from the subprime crisis, many of the largest banks have already begun to stabilize. Some predict that we may already be through the worst of the credit crisis. Isn't it best to buy stocks when they're still cheap and out of favor? Aren't these banks essential to the function of capitalism in the U.S.? Therefore, won't they come back?

Not so fast
Sure, they'll come back. But it may take a while. Recent events have seriously diminished the present and future propensity of many large banks to generate the level of profits they enjoyed before the bubble.

For one thing, most of the nation's largest banks are in the process of deleveraging their balance sheets. More leverage meant higher profits during the boom years. Less leverage will mean lower profits going forward.

Also, noninterest income had come to represent the majority of earnings for banks such as JPMorgan Chase (NYSE: JPM  ) , Citigroup (NYSE: C  ) , and Bank of America (NYSE: BAC  ) in the robust years. Much of the highly profitable noninterest revenue associated with mortgage fees and the repackaging of loans is gone, and it won't return for several years.

In addition, as many major banks use enormous quantities of their capital to cover subprime losses and shore up capital reserves, they hoard cash that can no longer be used to generate loans and revenue. When they pull back on business activity, they pull back profits.

Prices of most major banks probably already reflect credit-crisis angst. But do the prices fully reflect the reduced earning power going forward?

An end sweep with the little, fast guy
Many smaller banks are not burdened by the problems of the big banks, and will enjoy unprecedented opportunities. Here are some reasons to like smaller banks.

  • As the bigger banks pull back on business activity, they pull back competition for smaller banks.
  • The recent Fed actions, and the resulting increase in the spread between short- and long-term interest rates, have made it easier for banks to earn net interest income, the primary source of revenue for most small banks.
  • Smaller banks as a group have much less exposure to subprime loans, and subsequently have stronger balance sheets. This makes them fit to prowl for opportunities while competition is weakened.
  • Many smaller banks focus on limited geographical areas. The housing market may be suffering nationwide, but in certain nooks and crannies, it's just fine. Regional players in such markets can still generate great business.
  • Prices of many small banks have tanked along with the big banks. The market tends to throw the baby out with the bathwater in a tough market, and certain small banks are selling cheap.

As always, be selective in choosing your investments. It's generally wise to stick with banks that have strong balance sheets and good business models, and operate in promising markets. Here are a few.

Northern Trust (Nasdaq: NTRS  )
This Chicago bank has been providing financial services to wealthy individuals for more than a century. Its private banking unit serves roughly 20% of the Forbes 400 megarich. The bank has experienced 13 straight quarters of operating earnings-per-share growth.

Bank of the Ozarks (Nasdaq: OZRK  )
This bank operates primarily in Arkansas, North Carolina, and Texas, where the real estate market has held up well. It has a large construction development portfolio with many high net worth developers.

Texas Capital BankShares (Nasdaq: TCBI  )
This bank provides financial services in Texas to middle-market commercial and high net worth customers. According to Andy Stapp, a senior banking analyst for B. Riley, this bank has a sound balance sheet and operates in a strong market.

Although there are certain large banks that are attractive now, and certain smaller banks that are treacherous, this Fool believes that the better general opportunity is with the smaller banks. Similar to what occurred with retail stocks several years ago, I believe the smaller, niche players present the best opportunities for the sector's next phase.

Related Foolishness:

JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters free for 30 days.

Fool contributor Tom Hutchinson holds no financial position in any companies mentioned. The Motley Fool has a disclosure policy.


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