Have you heard? The number of banks in the U.S. is dropping. 

You may already know that, since everyone from the Richmond Fed to Barron's has been writing about it for years. 

According to the Federal Deposit Insurance Corp., the total number of commercial banks in the U.S. at the end of 2019 was 4,519. At the end of 2009, it was 6,829, and at the end of 1999, it was 8,582. That's a drop of close to 50% in 20 years. 

You can blame the decline on rising compliance costs, declining credit quality, and even the internet. The real question is: How can we, as investors, take advantage of the situation? 

The answer, for aggressive investors, is to seek banks that are ripe for an acquisition. Let's take a look at how to find them. 

Buy cheap and small banks

Interestingly, while the number of banks fell by over 4,000 from 1999 to 2019, the number of bank closures was 568. This means most of the drop is the result of mergers and acquisitions. So we want to buy the banks that are ripe for an acquisition. Here's what we'll target: 

  • Cheap: Big banks want to get bang for their buck, so we'll stick to banks trading for under 2 times book value. 
  • Small: The smaller the bank is, the more likely a bigger bank can pull off the acquisition, so we'll look for banks with a market cap below $2 billion. 
  • Capitalized: We want banks that have equity amounting to at least 10% to 15% of assets. Capital requirements are up since the Great Recession for all banks, so we want our candidate to be in a good position.
  • Loan Performance: We want nonperforming loans, or loans that are 90 days past due, to amount to less than 2% of total loans.

I ran a screen for U.S. banks that pass our value and size criteria. We'll look at a few that passed and see if they fit the other two criteria as well.

Before we get started -- thinking about what makes a small bank an attractive acquisition candidate is a good exercise for everyone. That doesn't mean these stocks are the right fit for your portfolio. If you often allocate small positions to higher-risk opportunities, this could be a special situation for you. If you prefer to buy to hold forever on all your positions, you can still learn something by riding along. 

Provident Financial Services

Metric

As of March 19, 2021

Market Cap

$1.8 Billion

Price/book ratio

1.09x

Equity/Assets

12.53%

Nonperforming Loan Ratio

0.89%

Data source: Provident Financial Services.

Provident Financial Services (NYSE:PFS) passes all four of our criteria, implying it could be a good acquisition candidate. At 1.09 times book, it's pretty cheap. Let's try to figure out why. 

The bank has plateaued in recent years. Total interest income was up under $4 million over the last two years, while total non-interest expenses were up $35 million. 

What caused the massive increase in operating expenses while interest income mostly stayed the same? A $19.5 million increase in compensation expense and a $6 million increase in data processing expense. Those are the types of expenses that a big bank thinks it can cut using economies of scale and synergy. Just imagine how excited a bank analyst is somewhere to throw those numbers into a pitch deck. 

We may be teetering on the edge of speculation territory here; Provident isn't exactly a bank that I'd want to buy on its own merits. But, it's been around a long time and seems relatively undervalued. Worst case, shareholders can enjoy the 4.4% dividend yield while waiting for it to be acquired.

First Commonwealth Financial

Metric

As of March 19, 2021

Market Cap

$1.4 Billion

Price/book ratio

1.34x

Equity/Assets

12.00%

Nonperforming Loan Ratio

0.80%

Data source: First Commonwealth Financial.

First Commonwealth Financial (NYSE:FCF) isn't quite as cheap as Provident, but it still passes each criterion with room to spare. Like Provident, its operating expenses have grown faster than its interest income over the past two years. 

Interest income is up $8 million while operating expenses have grown by over $20 million. First Commonwealth also had fruitless growth in salaries and benefits, which grew by $14 million. It did take a $6 million charge in 2020 for branch consolidation and early retirement payouts -- both one-time expenses. 

We're seeing a theme emerge: small banks that have stalled revenue-wise but are still seeing expenses creep upwards. The market has depressed the stock, but a big bank may think it can extract some value. 

Customers Bancorp

Metric

As of March 19, 2021

Market Cap

$1.03 billion 

Price/book ratio

1.13x

Equity/Assets

6.01%

Nonperforming Loan Ratio

0.45%

Data source: Customers Bancorp.

Until recently, Customers Bancorp (NYSE:CUBI) was the cheapest of the three, and for good reason: Its equity/assets ratio is well below our low threshold of 10%. That may be too much of a red flag for a prospective buyer. 

If we dig a little deeper into the numbers, $4.6 billion of the assets are PPP (Paycheck Protection Program) loans receivable. These are fully guaranteed and funded by a $4.4 billion credit facility from the Federal Reserve. If we exclude those loans, the ratio is a more manageable 8.05%. That's still below what we're looking for, but at Customers' recent valuation, it could be an amount that a big bank may be OK with.

What should you do now? 

There are all kinds of ways to take advantage of the drop in banks. For special-situation veterans, one of them is to buy five to 10 small banks like the ones described above. Over time, this will net you at least a few profitable acquisitions. For more risk-averse investors, keep an eye on smaller regional banks. If you keep running this screen, you'll eventually find a few that are worth buying on their own -- and may have a built-in catalyst. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.