The big banks tend to grab most of the headlines, but there are some good reasons to look at the smaller end of the banking spectrum. Not only do smaller banks have more room to grow, but they also have some other advantages, such as lower compliance costs. Three smaller banks that three of The Motley Fool's contributors think are worth a look right now are BofI Holding (AX -0.67%), Sandy Spring Bancorp (SASR -0.10%), and Western Alliance Bancorporation (WAL -1.41%).
Big cost advantages and lots of room to grow
Matt Frankel (BofI Holding): Online-only bank BofI Holding, short for Bank of Internet, is down by roughly 10% since reporting its recent earnings. The reason? Despite posting double-digit earnings growth, the bank missed analysts' expectations on both the top and bottom lines.
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From a long-term perspective, missing expectations for a single quarter is quite meaningless, so now could be a great time to get in on this rapidly growing but still tiny bank stock at a discount.
BofI still has a tremendous competitive advantage in that it doesn't have the overhead associated with operating physical branches. Just to name a few key metrics, most banks would be happy with an efficiency ratio below 60% -- while BofI's is below 40%. Its full-year return on assets of 1.68% and return on equity of 17.05% are well in excess of the industry standards of 1% and 10%, respectively.
Furthermore, with roughly $10 billion in assets before a just-announced acquisition of about $3 billion in deposits from Nationwide, BofI is still a small bank. To put that into perspective, it makes BofI about 5% of the size of SunTrust Bank and about 8% of the size of Regions Bank, in terms of assets. With rapid growth, a massive addressable market, and a cost-advantaged business model, BofI could be worth a look for long-term bank investors after its recent dip.
A small-cap stock you can bank on
Sean Williams (Sandy Spring Bancorp): Sometimes you really have to dig into the weeds to find hidden gems, but it can be well worth the effort. If you're digging for your own under-the-radar gem, why not give Maryland-based Sandy Spring Bancorp a closer look?
Sandy Spring Bancorp, which is a fixture in the greater Washington, D.C., region, as well as parts of Virginia and central Maryland, has been doing a stand-up job of connecting with its local customers and growing its bread-and-butter banking metrics for years. Organic loan growth averaged 11.3% between 2014 and 2017, with commercial real estate making up about half of the company's existing loan portfolio. Meanwhile, deposit growth has averaged close to 5% since 2015, with Sandy Spring boasting the second-lowest deposit cost of comparable Baltimore-Washington community banks.
What makes this bank even more intriguing is its January closure of the $447 million all-share acquisition of WashingtonFirst Bankshares. WashingtonFirst, aside from simply complementing Sandy Spring's products in the greater Washington area, offered improved penetration to Northern Virginia. The combined company, which now boasts $8.2 billion in assets, should benefit from that expanded market share, as well as save money via cost synergies since their business goals and financial products were very similar.
In addition, Sandy Spring Bancorp is also going to be a beneficiary of tax reform and ongoing monetary tightening. Following the passage of the Tax Cuts and Jobs Act, and the closing of its WashingtonFirst acquisition, the bank now expects its internal rate of return to be 600 basis points higher (21% overall) than when the deal was first announced. Tack on higher interest rates, which have the potential to lift its net interest margin, and that should lead to a healthy bump in earnings per share.
According to Wall Street estimates, Sandy Spring could see nearly 60% EPS growth between 2017 and 2021, all while paying out a yield of 2.8%. With costs well under control, and the company bolstering its market share, it looks to be a small-cap bank worth investors' while.
Growth is far from over for this small bank
Jordan Wathen (Western Alliance Bancorporation): With nearly 5,000 commercial banks in the United States, banking is highly commoditized, as there is no shortage of institutions that can make a simple mortgage loan, underwrite a car note, or put together a line of credit for a small business. When looking for bank stocks, it pays to find banks that do something different.
Western Alliance's focus on unique lending verticals enables it to earn above-average returns for its investors. It underwrites loans to local governments, homeowners' associations, and hotel franchises, among other loans other banks will simply pass up. In less competitive corners of the banking world, Western Alliance can earn higher loan yields while also building relationships that help it bring in piles of low-cost deposits.
As of the end of the last quarter, nearly 44% of its deposits were non-interest-bearing, meaning it doesn't pay a dime in interest on these deposits, allowing it to keep all of the interest income generated by lending the money back out.
The bank's loan portfolio, which yielded about 5.8% at the end of the second quarter, is far from risk-free, given that it yields far more than the average bank its size. But management is paid to grow the bank profitably and prudently, as it uses multi-year earnings-per-share targets as a key factor in determining long-term incentive compensation. Insiders and directors also own about 7.5% of the $6 billion bank, further aligning their interests with shareholders.
Though shares are far from cheap at 14 times the consensus earnings estimate in 2018, and at 2.8 times tangible book value, double-digit deposit and loan growth should enable it to quickly grow into its above-average valuation.
