Two Small Banks (Bore Port) June 18, 1999

<THE BORING PORTFOLIO>
Two Small Banks
Not Fancy, But Good

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (June 18, 1999) -- Since banks have been on my mind over the last week, I thought I'd write about that today. I don't really have any highly unified theories to offer up, just some interesting things you might want to put on your watchlist if you follow banks and financial services companies. I'm not saying any of these are a buy -- they may or may not be -- but they are companies you might want to put on your own watchlist.

First up is Bank of Granite (Nasdaq: GRAN), a Granite Falls, North Carolina bank holding company with 14 branches and nine mortgage banking locations as of the end of Q1 1999. This has been on my radar for a while, having been mentioned by Warren Buffett at the Berkshire Hathaway (NYSE: BRK.A) annual meeting a few years ago, but I've never really gone into it that deeply. I guess this is the one that got me to writing about banks today, because what I found in looking at it nearly sucked my eyes right out of my head.

This is one of those great small companies that you really don't hear much about unless you live in its market area. Get a load of this company's performance ratios, though. In comparison to 200 of its peers with $500 million to $1 billion in consolidated assets in the Fed's database, Bank of Granite scores in the top quintile (Q4:1998) in a ton of key areas of performance, including the following as a percentage of average assets:

• net interest income (taxable equivalent basis)
• pretax net operating income
• net operating income
• net income

As a percentage of average earning assets:

• interest income (taxable equivalent basis)
• interest expense (bottom quintile, which is most favorable)
• net interest income

Overhead expenses as a percentage of assets is middle of the road, but given the company's great net interest margin, that puts the company's efficiency ratio (noninterest expenses as a percentage of revenues [net interest income before provisions + noninterest income]) of 37.7%, which is just ridiculously good.

From the 10-K, look at these performance metrics over the last couple years:

                   1998    1997    1996    1995    1994  
Return on 
 average assets    2.39%   2.81%   2.76%   2.70%   2.47%
Return on 
 average equity   13.35%  16.21%  16.98%  17.42%  16.94%
Average equity to
 average assets   17.90%  17.36%  16.24%  15.50%  14.56%
Dividend payout   28.97%  23.15%  22.89%  21.82%  21.87%
Efficiency ratio  37.70%  36.74%  35.94%  36.47%  42.75%

These are absolutely amazing numbers. With the company's excellent cost controls, it doesn't take much leverage to translate a high return on assets into a return on equity (ROE) result that beats its cost of equity. As of the end of the year, Bank of Granite's tier 1 capital ratio to risk-weighted assets was 25.1%, which is a phenomenally unleveraged bank. The prospect of share buybacks under such a scenario is very high, especially if marginal lending opportunities meeting the company's standards don't show up. Its excess capital could also be used for acquisitions or expansion, as well, if the right opportunity comes up.

For the fourth quarter, assets grew 14.58%, equity capital grew 10.74%, and net loans and leases grew 8.03%, which is middle of the road for the industry but reflects a more circumspect growth and credit control plan. At 2.6 times book value and 20.7 times trailing earnings, the forward-looking return will depend upon marginal returns on equity and the company's growth rate, of course. This is neither ridiculously attractive nor overpriced. But it's definitely a good one to keep on the watchlist. For more on the company, check out Forbes' 1996 article titled "The Best Little Bank in America?" or the Bank of Granite homepage.

Now for one in my stomping grounds. Warning, this thing trades by appointment over the counter. It's totally illiquid, so I'm just suggesting this as a watchlist candidate. I own neither of these companies, by the way. But they are on my watchlist. Alright, getting past the disclaimers, it's Burke & Herbert Bank & Trust Company (OTC: BHRB).

This company was founded in Alexandria, Virginia nine years before federal troops stormed into town at the outset of the Civil War (or War Between the States, whichever you prefer) and is still run by members of the Burke family. Though there's no narrative text in the annual report, to the best of my knowledge the company has 12 branches, as the main branch isn't listed in the Fed's database of branch locations.

Like Bank of Granite, this is an extremely well capitalized company, with a year-end ratio of tier 1 capital to risk-weighted assets of 18.4%. That's three times what regulators want to see.

Also like Bank of Granite, this is pretty much a plain vanilla, low-cost community bank. Here is the company's performance report for the fourth quarter.

Burke & Herbert is in the lowest decile for interest expense as a percentage of average assets, a position it maintained for three of four quarters in 1998. Noninterest expenses as a percentage of average assets was in the 13th percentile or lower throughout the year. It's not a high-risk sort of lender, so its interest income as a percentage of assets is lower than its peers, but given its funding costs and low overhead profile (46% efficiency ratio in 1998 and 43% in 1997), the company's pre-tax net operating income is regularly in the top 10-20% of its peers.

Last year, return on assets (ROA) was 1.67 and ROE was 15.6%, implying an average leverage ratio of 9.3%, or about 10.75 in assets to equity. That's about 1 1/2 to two times the rest of the banking universe and its tier 1 leverage ratio is in the top 12% of its peers.

Demographically, Alexandria and Northern Virginia is a very attractive area for growth in banking. Incomes are growing, and the economy is growing and diversifying. In addition, the collateral backing many of the company's loans in Alexandria and Old Town itself is very solid, as this is a very desirable city to make a home. In Old Town itself, the bank wouldn't have any problems with collateral in anything but a very severe downturn.

It's not a fancy company, but it's a solid one. The challenge will be to invest retained capital. Without any additional equity issuance, owners' equity increased 12.8% after a 30.2% dividend payout ratio. A more aggressive use of capital would be to buy back some of its shares, which are trading at 11.2 times 1998 earnings (implying an 8.9% earnings yield) and 1.65 times shareholders' equity. Given the growth prospects in this area and what I think is poor customer service on the part of the big banks, the company could also choose to continue expanding its branch locations.

In any case, these are two examples of the many excellent smaller banks that can be found all over the country. You just need to look around a bit. Hopefully, I've been of some use in introducing you to the excellent tools provided by the Fed website.

I'm open to questions, comments, and reasonable flames on the Boring Portfolio board.

Good luck to the Sabres in game six tomorrow. I hope my short verse below doesn't bother anyone.

Through the travails of games one to five,
our beloved Sabres are still alive
ready, willing, and able for game six
our team will prevail, pucks leaving their sticks
through the defense our shots will pour
the Sabres will shoot, the Sabres will SCORE!

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