Burke & Herbert's Long-Term Deposit

My regular readers (thanks, but you three can sit down now), are aware of my fondness for banking and financial stocks, especially those that pay solid dividends. Of course, since you've been earning a big fat quarter of a percent on your deposits down at the local branch -- if that -- you probably don't share the sentiment.

Fortunately, there's a better way to get paid by a bank than to deposit your money in one, as many bank stocks pay favorable dividends in addition to often being low-volatility firms with solid earnings growth.

In focus
I tend to favor regional banks over the large multi-nationals. There are a few reasons for this, but mostly it's because there's virtually no chance that the regionals will be blown up by their lending relationship with an Enron or a WorldCom, or get hammered by defaulting Argentinean loans.

Certainly the Citigroup's (NYSE: C  ) and the J.P. Morgan Chase's (NYSE: JPM  ) of the world have their advantages, but frankly, there are some pies out there that I simply don't want my bank putting its fingers in. I suppose the bottom line is that I feel the strongest regional players often paint a better risk/reward picture than their larger brethren.

Though part two of this series, which will run next week, lists several banks, today I'm going to focus on just one. I'm doing that for a couple of reasons: One, it's my favorite out of all those that we'll discuss. And two, this is a company with a lot of history, and there are just a lot of good, and interesting, lessons here for us to carry forward.

Over hill and after Dale
Speaking of history, I can't claim to have discovered this bank all by my lonesome. You see, long before I made my Foolish writing debut, former Fool analyst Dale Wettlaufer proved very prescient when he spoke of his fondness for Burke & Herbert Bank and Trust (OTCBB: BHRB) back in June 1999.

It seems he discovered the oldest bank in Virginia the same way that I did: Their main branch is located just a few blocks from the Fool's offices in historic Old Town Alexandria.

The bank's stock has performed phenomenally well since Dale highlighted it, having risen about 250% in little more than four years -- in a stock market that's seen far uglier times, no less. But there's more to this bank's success than its stock price, so, I'll get on with the show.

As I detailed in a recent article on Synovus Financial (NYSE: SNV  ) , some of the best banking firms in the country succeed because the art of customer service is not lost on their organizations. Burke & Herbert could be the epitome of the successful employment of this philosophy.

Bank president, chief operating officer, and fifth-generation leader of the company, E. Hunt Burke, whom I sat down with last month, describes the heart of this business practice with simple eloquence: "We've made a commitment to serving our community at every level. Every [customer] at Burke & Herbert has a personal banker."

Chairman and CEO Charles Collum adds, "Everything here is built on relationships. Our customers might see the same person behind our counters for more than 10 years. We serve them well because we know them well."

Indeed, the bank's retention rates and its 91% customer service rating -- a figure achieved by a mere handful of banks in the United States -- demonstrate the bank is putting its money where its mouth is, or perhaps simply where its handshake is. Again, Mr. Burke put it best: "For 81 years this bank ran on a handshake. [Our branches] have a family atmosphere that people can both see and feel."

In these days of impersonal service, exorbitant fees, and few apologies, Burke & Herbert's slower pace of life coupled with its cutting-edge services and products are attracting scores of new customers. Don't get the wrong idea here, as the bank is only old school when it comes to the level of respect that it provides to its customers. The firm still offers all the products and services you'd expect, including online banking.

The difference is really just that the bank doesn't shove those new offerings down your throat in every way, shape, and form. Says Mr. Burke, "We can't stand the hard sell here, and we know our customers don't respond to that. Because of our relationships and our level of efficiency, we can afford to offer a lower rate [on loans] and a higher rate [on deposits] and still generate the kinds of returns we expect for our shareholders."

Get a load of this one: The bank actually picks up the phone and calls its customers to let them know when they're going to bounce a check, giving them time to get the funds into their account and avoid a fee. Has your bank done that lately? Can you even imagine your bank doing that?

OK, I know you're getting the idea here. Its customer service is good, but this is my favorite company factoid, so I've got to toss you a bone: Though this sounds more like what you'd expect from PETsMART (Nasdaq: PETM  ) , and Burke & Herbert has picked up a lot of imitators, the bank has been offering dog biscuits to customers of the four-legged variety for over 30 years. That just might make them the inventor of the practice, but, in any case, it was well before the pet-friendly policy became a marketing gimmick for other firms.

150 years of good stuff
Burke & Herbert is the model of what a community bank should be, but it ought to be pretty good at this stuff after surviving for 150 years. The company now manages a little over $1 billion in assets across its 15 branches. It is one of only a few banks with rating agency Weiss' top rating, and is listed as one of its "10 safest."

For a top-quality bank, I generally like to see a return on equity (ROE), or how efficiently the bank uses shareholder money, approaching 20%, and a return on assets (ROA), or how efficiently the bank uses its assets to generate earnings, of over 1.5%, ideally working its way towards 2% over time. Burke & Herbert has an ROE of close to 19% and a phenomenal ROA of over 2%.

As Dale pointed out, the company is extremely well capitalized, with its ratio of tier 1 capital to risk-weighted assets still hovering at about 20%, or more than three times what regulators seek.

Burke & Herbert keeps its interest expense as a percentage of assets well below that of competitors, and it's an extremely conservative lender. Though that means its interest income as a percentage of total assets is often lower than peers, it keeps funding costs low and its efficiency on the expense front keeps net operating income in the top 15% of peers.

The demographics in its core market remain very attractive, and the bank continues to conservatively expand its branch network in high-growth sectors that are also commensurate with the attributes demonstrated by its customer base.

When you throw in its current 1.6% dividend yield, and consider that it's paid one in one form or another since 1933, you've got another reason to like this company. And don't worry; the bank's conservative payout ratio of 32.3% leaves plenty of money to continue growing this business. If the yield were a little more robust, this is exactly the kind of company that I would consider for Motley Fool Income Investor.

Housing boom
As you might suspect, its mortgage division has been contributing solid gains in the past year, but the white-hot market can't continue forever, particularly as rates begin to rise. However, Burke & Herbert will suffer less than many other banks as rates sneak higher because they've been weighting a good deal of their mortgage portfolio in floating-rate products. Because the bank is a low-cost provider, and the D.C. housing market can see above-average turnover, adjustable rate mortgages, or ARMs, have seen high demand, and that number should continue to grow as spreads between ARMs and 30-year fixed-rate mortgages increase.

Basically, as interest rates increase, the rates on the bank's loans will largely increase right along with them, and overall mortgage income will see a benefit from a decrease in prepayment rates as well. This will help to maintain solid profits for the division, even when higher rates cause the inevitable slowdown in demand for new mortgage loans.

The catch
Now, you know there has to be a catch, as it's just the way of the world, and you're right. These shares can be a bit difficult to get your hands on, as they trade over the counter (on the OTC bulletin board) by appointment only. That's a fancy way of saying that the stock is very illiquid. At a current price of nearly $2,000 a stub, it doesn't take that many shares to build a decent-sized investment, but still, broker waiting lists are not uncommon for folks who would like to purchase these shares.

What we've got here, however, is a very solid company that isn't going to fall off a cliff tomorrow, so if you're serious about becoming a shareholder, a little patience won't hurt you. But, because of the illiquidity, which can mean large spreads at times, you should consider this stock to be a very long-term investment indeed. In fact, I wouldn't purchase the shares with anything less than a five-year time commitment in mind.

The Foolish bottom line
Even when I write of top-quality companies, it's rare that I sound as much like a cheerleader as I do today. But to be honest, there's very little not to like about this bank. Certainly, a bit more liquidity would add a certain level of comfort. All in all, however, it's just plain refreshing to see a company with such a commitment to its customers while also managing its business honestly and participating in its community -- particularly after what's been such a drought of ethics among so many publicly traded firms.

Be sure to tune in next week. Now that we've done a lot of the heavy lifting, I'll offer several more small banks that fit into this niche of above-average growth, service, and quality.

Fool On!

While he was visiting branches for research purposes, Mathew Emmert was pleased that the folks at Burke & Herbert didn't think he was casing the joint. He owns shares of Synovus. He also writes the Motley Fool Income Investor newsletter, where he searches for companies like this week in and week out. The Motley Fool has adisclosure policy.

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