Banks come with a lot of baggage these days -- high regulation, heightened capital requirements, insane competition... and the list goes on.
One way to avoid many of these problems is to find small banks that fly under the radar of costly regulatory requirements and risky Wall Street-style business models.
Even better yet, many of these small banks love to pay their shareholders handsome dividends. Here are three such banks.
1. Trustmark Corp (NASDAQ:TRMK)
Trustmark Corp is a bank holding company that operates in five states in the southeastern United States. The bank has lending, deposit, wealth management, and insurance operations. Trustmark has $12.2 billion in total assets as of the second quarter and was the 82nd largest U.S. bank holding company the last time the Federal Reserve took count on March 31, 2015.
It also sports a 3.8% dividend yield.
For banks, there are a few keys to a sustainable dividend. Of course, there must be profits and cash to fund the dividend checks over time, but there must also be strong credit risk management practices protecting the bank from loan losses. Because banks use high leverage, a relatively small number of bad loans can quickly deplete capital reserves. Without a capital cushion, banks can't pay a dividend -- even if management wants to pay one, regulators will step in and prevent it.
Breaking that down at Trustmark, the bank's profitability is more or less in line with its peers. The bank returned 8.5% on equity in the second quarter, edging out the peer average of 8.4%. Trustmark lagged its peers in cost controls, however, reporting an efficiency ratio of 66% versus a 61% peer average. A bank's efficiency ratio is calculated by dividing its non-interest expenses by net revenue. A lower ratio indicates higher efficiency.
The bank's financial performance is neither outstanding nor unsatisfactory. It's instead close to average. How, then, does it pay a dividend that's 73% higher than the peer average? Simply by maintaining a higher payout ratio.
All companies must choose what to do with their profits. Reinvesting in the company, building capital levels, buying back shares, and paying dividends are the most common choices. Trustmark has simply chosen to allocate more of its profits to dividends than its peers. On a trailing-12-month basis, Trustmark is paying out 51% of its profits as dividends. Most banks pay out somewhere in the 20%-30% range.
On one hand, that's great, because who doesn't love a big dividend check every quarter? On the other hand, though, it makes the dividend less stable. If profits drop, or if loan quality declines, a dividend cut is all but a certainty.
As of the second quarter, Trustmark reported non-performing assets at 1.3% of its total assets. Non-performing assets are severely past due loans plus foreclosures. That's a pretty high level in today's environment -- about double the peer average. That is a key metric to watch for dividend investors; further deterioration could mean the end of the high dividend, while improvement could mean bigger checks in the future.
2. Valley National Bancorp (NYSE:VLY)
Valley National Bancorp, a $19.3 billion regional bank with offices in New Jersey, New York City, and Florida, is similar to Trustmark in that it pays out a higher than average percentage of its profits as dividends.
It's different, though, in just how much more it pays out.
On a trailing-12-month basis, the bank is paying out over 82% of its profits as dividends. That high payout is boosting its yield to 4.4%, but it also makes the dividend ripe for a haircut.
Making matters worse, Valley National returned just 6.6% on equity in the second quarter, driven by a below-average efficiency ratio of 69%.
Valley National relies heavily on its lending business to generate profits; 90% of the bank's revenue comes from net interest income. That high concentration puts the bank's dividend at greater risk, because other income can provide stability during downswings in the economy, when loans are more likely to go bad. Currently, the bank reports that just 0.4% of its total assets are non-performing, indicating that the bank's profitability problems are likely related to costs and not credit quality -- at least at the moment.
So, while the dividend does look a bit fragile, the steps to boost profits and make the dividend more stable should be fairly straightforward. Management needs to get costs in line and focus the sales force on cross-selling the bank's wealth management and other products to reduce the reliance on lending alone.
For investors looking for yield today, this stock could be a turnaround story worth watching.
3. Old National Bancorp (NASDAQ:ONB)
Lastly, Old National Bancorp rounds out our three small banks with its 3.3% dividend yield. Old National reported total assets of $12.1 billion as of June 30th. At last count, the bank was the 84th largest in the U.S.
Old National has a balanced income statement, with 63% of its income from interest, and most of the rest coming from its insurance and wealth management divisions. It posted a 7.1% return on equity in the second quarter, lagging the peer set because of its 71% efficiency ratio. Similar to Trustmark, Old National currently reports a high level of non-performing assets relative to total assets -- 1.6% as of June 30th.
The bank has paid out 51% of its profits as dividends over the past 12 months.
Unlike Trustmark and Valley National, Old National is doing an excellent job driving revenue growth. Annualized for the last 12 months, the bank has seen a top-line growth rate of 14.5% -- well above the peer set average of 5%.
Out-sized growth at banks can be a double-edged sword, as it is oftentimes indicates that a bank is lowering its credit standards in order to drive new business. In this case, however, the primary driver of revenue growth is the fee income businesses -- insurance and wealth management. Fee income increased from $39.7 million in the 2014 second quarter to $55.0 million in the 2015 second quarter.
None of the three banks here are perfect; each comes with its own positives and negatives, upside and risk. However, all three fall well below the increased regulatory scrutiny of the Dodd-Frank's key $50 billion threshold, all three operate simple business models in traditional banking, insurance, and wealth management, and all three have dividends well above those of most other banks.
If you're looking for dividends from an easy-to-understand bank stock, you could do worse than starting your search with any of these three.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.