I've found a bank stock that could potentially double, thanks to the vagaries of something called a loan-loss provision. But before I reveal that bank's identity, here's a quick provision primer.
Believe it or not, loans aren't always repaid. (OK, that's pretty easy to believe.) Knowing this, banks maintain a loan-loss reserve. In anticipation of charge-offs from rising defaults, banks "feed" this reserve account with a loan-loss provision expense. Making these provisions ultimately counts against a bank's net income.
During the "Great Recession," banks' profitability suffered as they scrambled to compensate for increasing default rates by feeding their loan-loss reserve accounts.
The good news for the banks? When the economy stabilizes and charge-offs decrease, they'll need smaller loan-loss provisions to replenish their reserve accounts. The end result: an increase in net income.
Banks are already reaping the benefits from this shift. Recently, JPMorgan Chase (NYSE: JPM ) reported a huge spike in earnings, primarily thanks to decreasing loan-loss provisions. In recent quarters, Citigroup's (NYSE: C ) profit has surged for similar reasons. Regions Financial (NYSE: RF ) ? Same story. Lower loan-loss provisions primarily drove Regions return to profitability in Q4.
Shrinking provisions create a great investment opportunity for savvy investors, particularly when it comes to small-cap regional banks. Why? The investing community doesn't closely follow these tiny institutions. Therefore, future downward adjustments in loan-loss provisions, resulting in higher earnings, most likely aren't priced into these banks' stocks.
Great potential
Great Southern Bancorp (Nasdaq: GSBC ) provides a good regional bank play. Currently, Great Southern has $1.9 billion in outstanding loans; the provision for loan-loss in 2010 was $36 million. That's a ratio of approximately 1.9%, compared to a historic average of approximately 0.3%.
Without any other substantial changes to the income statement, what happens to Great Southern's earnings and share price if loan-loss provisions return to anything near their prerecession levels?
Let's be conservative, and look at the effect of a loan-loss provision somewhat higher than the historic average of 0.3% -- let's say 0.5%:
2010
| Loans |
$1.9 billion |
| Current loan-loss provision rate |
1.90% |
| Current loan-loss provision |
$36 million |
Projected
| Loans outstanding |
$1.9 billion |
| "Normalized" loan-loss provision rate |
0.50% |
| "Normalized" loan-loss provision |
$10 million |
| Increase to after-tax income |
$16 million |
| Shares outstanding |
14 million |
| Increase to EPS |
$1.14 |
| Current P/E Ratio |
14 |
| Increase to share price |
$16 |
| Current share price |
$20 |
| Potential share price |
$36 |
That's a potential 80% return. Not bad. And who's to say the "normalized" provision rate won't return to historic levels? If it does, Great Southern's stock has even more potential upside.
If the recovery is real and loan portfolios recover, banks are back -- and the regional banks will be the best place to be.
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