This article is part of our Rising Star Portfolios series.

My favorite sector of the market for good deals encompasses the smaller players in the banking space. Perhaps it's just because banking is my primary area of expertise as a stock picker, but I like delving into smaller-cap bank stocks. They're regulated and have similar business models to their larger counterparts. To some extent or another, they all take in deposits and make loans, pocketing the interest rate spread.

The danger with banks is that you never truly know what's on their books. You can see past history, and you can see general metrics on "bad loans" and capital cushions, but truly assessing the risk on a bank's balance sheet would require a granular look at each loan and security.

Fortunately, the smaller we go, the less exotic the banks tend to be. Knowing this, I patiently wait for good prices on smaller banks, and try to maintain a portfolio of them to diversify lone-bank risk. Today, I'm seeing two small banks that fit my screening criteria (i.e., they pay dividends and appear profitable, cheap, and conservative). I'm going to add each to the real-money portfolio I manage for The Motley Fool.

They are:

  • Oklahoma-based BancFirst (Nasdaq: BANF)
  • Arkansas-based Simmons First National (Nasdaq: SFNC)
  • Kentucky-based Republic Bancorp (Nasdaq: RBCAA)

Each of these pays out a reasonable dividend yield of 2.6%-3%, each trades for a reasonable multiple of tangible book value (1.0 time to 1.5 times), and each also trades for a reasonable to low multiple on earnings (less than 15.0).

And each appears to be a reasonably conservative lender that doesn't make too many bad loans and provisions for those they do make (though Republic is a little low in this department, but I like its other stats a lot):

Company Name

Bad Loans/Total Loans

Provisions/Bad Loans

BancFirst 0.84% 155%
Simmons First National 1.14% 149%
Republic Bancorp 1.28% 91%

Source: Capital IQ, a division of Standard & Poor's.

These numbers may or may not seem impressive to you in total. So let's compare these against a few banks -- all larger (and perhaps more well-known) than these three -- that failed my screen.

  • Georgia-based Synovus (NYSE: SNV)
  • New Jersey-based Hudson City Bancorp (Nasdaq: HCBK)
  • Los Angeles-based commercial bank Cathay General (NYSE: CATY)
  • Michigan-based Flagstar Bancorp (NYSE: FBC)

Let's take them down in line:

Synovus hasn't had the loan discipline of my three (its bad loan rate is four times the average of mine) and, not surprisingly, isn't profitable. 

Hudson City has recently gone through a balance sheet restructuring, so its lack of profitability could be temporary. Still, its nonperforming loan rate has crept higher in recent years. Perhaps there's an opportunity in the chaos, but I'll just continue to monitor the situation for now.

Cathay General, as a commercial lender, has also seen higher rates of nonperforming loans. Perhaps I could look past that given the right circumstances, but its dividend yield is a nominal penny a quarter, and its multiple on earnings isn't especially cheap.

Flagstar adds to the lack of loan discipline parade with a monstrous 6.5% rate of bad loans as of March 31. Of course, that's down from 13.9% as of December 2009. No profit or dividend here either.

So come Monday, I won't be buying shares of Synovus, Hudson City, Cathay General, or Flagstar in my real-money portfolio. Instead, I'll be buying shares of BancFirst, Simmons First National, and Republic Bancorp. Follow along as I continue to scour the banking universe for more of these small banking plays.

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