Everyone's heard of the megabanks like Bank of America. A lot of investors have heard about big regional banks like Umpqua Bank (NASDAQ:UMPQ). But not too many have heard of Carter Bank and Trust of Martinsville, Virginia.

Does that lack of notoriety make Carter Bank, or any of the thousands of other small, community banks around the country, a bad investment? Or maybe it's just the opposite.

Host Gaby Lapera and special guest Tim Hanson think that small banks are not only an interesting niche in the investing markets, but one very much worth your time. What makes these banks small? Why should an investor even bother with the effort of researching and investing in them? What are the advantageous, disadvantages, and common mistakes investors make when wading into these waters?

What are the key checkboxes you must check off before clicking buy? The answers to these questions -- and more -- are right here in today's financials edition of the Motley Fool's Industry Focus podcast.

A full transcript follows the video.

This podcast was recorded on March 1, 2016.

Gaby Lapera: Marcia, Marcia, Marcia, or talking about the banks we usually ignore.

Hello everyone, welcome to Industry Focus, financials edition! Today is March 14th, 2016. This week on Industry Focus is interview week. Joining me today in studio is Tim Hanson, one of The Motley Fool's heads of the product team and a former portfolio manager here. Thank you very much for joining me.

Tim Hanson: It's my pleasure Gaby. How are you doing?

Lapera: Really great, thank you. It's really exciting to have someone actually in the studio with me for a change.

Hanson: I'm glad I could make it, then.

Lapera: Today we are going to talk about bank stocks that we normally gloss over. Small banks, which the rumor is around the office that you are super into small banks.

Hanson: I do love my tiny banks, yes.

Lapera: Let's start with a super-basic question. What makes a bank a small bank?

Hanson: Its size. Its size is what makes it small. Generally speaking, small banks -- community banks as they're widely known as, or regional banks -- you're talking banks that have assets of ... certainly less than 10 billion dollars in assets, and generally speaking, less than a billion is where it starts to get quite small; but that's among the most-fertile hunting grounds for interesting ideas in this space.

Lapera: Cool. I don't know. I think the smallest bank that we have talked about on the show might be Astoria Financial because they merged with New York Community Bank.

Hanson: Mm-hmm (affirmative).

Lapera: Other than that, I don't think we get much smaller than that.

Hanson: No, it's a pretty overlooked sector. That's why it's a good place for investors to go looking for ideas. You've got 50, 60, 70 people, hundreds of regulators, thousands of investors looking at things like J.P. Morgan and Wells Fargo  every day. The opportunity to find a mispricing there is probably pretty remote, where as if you're the only investor in something like Carter Bank & Trust in rural Virginia, or Suffolk Bancorp down on the east end of Long Island. If you're literally the only person looking at the numbers, then the opportunity to find a mispricing is that-much-more significant.

Lapera: Yeah, I feel like that's probably the greatest appeal of a small bank over a larger bank.

Hanson: I would say there are a couple points that make them more appealing to look at certainly from an analyst standpoint -- both a return and learning perspective. First, they're a lot more simple, they're a lot easier to understand, they don't have huge slush funds on their balance sheets that are just like "Other" or "Derivative contracts." Those are categories you have no idea. You look at some of those things, and there's notional value in the tens if not hundreds of billions of dollars on some of these bank balance sheets, and you don't know what's inside of it. Where as small banks are a lot easier to read from a balance sheet perspective to see what they're doing with their assets and their liabilities.

Secondly, good luck getting Jamie Dimon or someone like that on the phone, where as if you're looking at a community bank, particularly a bank in your community -- which is one of the best places to go looking for them -- the opportunity to go in and talk to senior level leadership, even if you're just an individual investor, is probably pretty good. There's no better way to get to know a management team than to actually get to know them over a cup of coffee.

Lapera: That is incredible, that is something that has never occurred to me, that is possible to do.

Hanson: Yeah, we're right here in northern Virginia, and northern Virginia is a pretty rich environment with regards to small banks. You've got Burke & Herbert, which is a big name in Alexandria. Access National, there's Carter Bank & Trust, there are a number of the ... and literally, you can pick up the phone and call these folks and they'd be happy to talk to you because they want to talk about their business. Like any entrepreneur, the guys that run these companies want to talk about their books, and so on and so forth, and showing some interest in getting to know them is a great way to accomplish a bunch of things as an investor: (a) maybe get some return, and then (b), become a better investor, learn about a company really from the bottom up.

Lapera: That's really interesting. The other thing that I thought was really interesting that you said was knowing what's actually in these portfolios. I recently watched The Big Short, which was maybe the most stressful movie for me of all time even though I knew how it was going to end. I feel like that's how people in 1996 watched The Titanic. That's how it felt watching this movie. One of the things, the collateralized debt obligation ... say that three times fast.

Hanson: CDOs.

Lapera: CDOs. A lot of people have no idea what's actually in them. That was one of the premises of the movie. That these people had these giant portfolios and no one actually knew what was inside any of them.

Hanson: There are so many messed up things about that situation with regards to the financial industry. You had myriad businesses whose job was originators. What does an originator do with a loan? It simply makes the loan, and then sells the responsibility of the loan to somebody else. In many of those cases, the people buying it would pick those loans apart, and sell different portions of them. Really what was leftover from a financial product standpoint bore little-to-no resemblance to what had been created in the first place. The person creating the loan downstream could not care less about what ended up happening to it upstream. Where, as a value play at that point, and that's where you end up getting so many poorly written, underwritten loans.

One of the things about community banks is they are community banks, which means that they're lending footprints tend to be in the region or area that they're doing their business. If you want to go back to Burke & Herbert here in Alexandria, the bulk of their business is being done in northern Virginia with northern Virginia homeowners, northern Virginia businesses, so on and so forth. Generally speaking, when they originate a loan, they're much more likely to keep it on the their own books. The incentive is there for them to only originate loans that will remain money good for the lifetime of the loan. That level of personal responsibility is something that I think you find in smaller financial institutions that has sort of been lost as financial institutions have become too big to fail, so to speak.

Lapera: That's such a great answer, I'm just so impressed. Thank you so much! We have these small banks. We've talked about why you like them, why you have convinced me to like them, but do you have to assess small banks in a different way than you do big banks?

Hanson: Yes, absolutely. Starting with a small bank in the environment we're in today, there are two real core criteria that I look for first. One is a loyal, low-cost deposit bank. One advantage that community banks have, they have very strong footprints in their communities, and the people who have their money stashed in them are unlikely to be very price sensitive. If you look at some of the Internet banks that are around today, generally speaking, they compete very vigorously on interest rates.

If you look at Bankrate.com, and you look at Bank of Internet, and First Internet Bank of Indiana, and all these names -- they advertise pretty attractive interest rates to try and lure deposits into their balance sheets. Community banks don't have to do that. They get deposits simply by virtue of being a community pillar. If you look at Suffolk Bancorp or some of these others, Cascade Bancorp (NASDAQ:CACB) out in Oregon, their cost of funds is literally somewhere around 12, 15 bips right now, basis points.

Lapera: That's crazy.

Hanson: Way less than 1% or 2%, or so on and so forth. Obviously, it's a low-interest-rate environment, but even though the interest rates that they're giving their customers are so low, customers aren't taking their money out. That's a really big advantage to have in any environment. You can sort of test the loyalty of a deposit base by looking back through at the financial crisis and say, hey, when these banks were threatened, as many of them were because it was a tough time to be a small bank, did the depositors start to flee, or did they add money to the bank? If you've got a loyal, low-cost deposit base, that's a really nice place to be.

The other thing is a low loan-to-deposit ratio -- which is just to say how much of the capital on the liability side of your balance sheet have you loaned out in the form of assets? If you have a relatively low -- there's no blanket vanilla statement that all community banks are conservative or some are -- it'll depend from geography to geography and management team to management team; but if you can find a low, low, low-cost funds and a low loan-to-deposit ratio, which you expect to expand, generally speaking, their loans should reprice more rapidly than their deposits as interest rates rise. That's when you'll see some extra juice show up on the earning slide.

The third piece to look at after you find those two criteria are what region does the bank operate in? Unlike Bank of America, which could take a deposit that you make here in Virginia and loan it to a homeowner in Seattle -- ostensibly, Burke & Herbert takes a loan from you here in Alexandria and generally speaking has to find somewhere else in Alexandria to deploy that capital.

Different parts of the country are in different economic circumstances. DC, the government is always hiring. That's the big joke around here. DC's usually a pretty attractive place to think that a bank can grow its balance sheet. Flint, Michigan, probably not a place where the local bank has a lot of opportunity for growth. After you look at the characteristics of the bank, you certainly want to look at the characteristics of the environment in which it's operating, and make sure that the opportunity exists there for some growth probably.

Lapera: Yeah, we were chatting a few episodes ago about how small banks that are dependent on the oil patch are doing right now. It's a hard environment for them, I don't think anyone expected oil to go so low. Actually we talked about that last week; no one expected oil to go as low as it did.

Hanson: No.

Lapera: It's really interesting because some of these banks have these century-long balance sheets, so they've really ridden the up and down of that, and managed to survive. Then you have other small banks that maybe started out 20, 30 years ago, and it's a little bit more uncertain for them.

Hanson: It's tough, too, and if you look at some of the banks operating in Houston when the energy patch was booming, they were getting book value multiples of two or three times, which is pretty rich, right? In this space, generally speaking, you want to pay around book value if you can. The other interesting point that energy brings up, sort of oil sector or banks that are tied to the oil sector, whether it be a community bank in North Dakota or Oklahoma or Texas, is loan concentration. If you're 100% concentrated in energy, E&P company loans, they may not have gone bad yet, but you've got a pretty big risk on your hands. Certainly there's a lot of... just as there was in the residential mortgage crisis, a lot of extend and pretend, which means to say that you moderate the terms of the loan so that the borrower does not go into default, and then everybody just sort of pretends that nothing's wrong. Eventually, the chickens come home to roost on that, and you have to write it down. This is true whether it's a big bank or a small bank: You want to look for banks who, on the loan side, are pretty equally, not necessarily equally weighted, but diversified across the different types of loans you can make.

Those would be lines of credit for people and individuals, residential mortgages, commercial mortgages, C&I, which is commercial and industrial, which just means loans to businesses and then, obviously, you can get into agricultural loans in some of the places like Iowa, and so on and so forth. If you saw an Iowan bank that was 95% in agricultural loans, that would be a little bit more of a red flag than an Iowan bank that was 40% agricultural, and then had a sort of an even mix of the other categories.

Lapera: Is that something of an advantage that big banks have over small banks, that they are able to kind of, like, hedge so effectively?

Hanson: Yeah. It could be an advantage. Your greatest strength is also your greatest weakness, right? The ability to slice up loans into packages that don't look like loans anymore, and to try and hedge out risk -- it probably gives more of an illusion of safety than a real reality of safety. A good rule of thumb for investing is, is it complicated? No, and is it expensive? No. Then it's probably a good investing decision. If it's either complicated or expensive, it's probably a bad move.

Lapera: Yeah.

Hanson: Hedging for the most part is both complicated and expensive.

Lapera: Right.

Hanson: There are very few people who do it well. Most people I think do it and ...

Lapera: It'll cut down on your return, right? Because if you're hedging then you're betting something's going down.

Hanson: That's why it's expensive, yeah, exactly. Some of them do it for regulatory reasons, but as we saw during the mortgage crisis, no amount of hedging really helped them. That illusion of security probably was more painful than actually being able to see transparently what was on the balance sheet, and then make a decision with facts rather than sort of gut feel. I think certainly big banks have an advantage with regards to being to take deposits from one place and deploy them in another. Small banks are trying to do that, replicate that, which is why there has been a lot of consolidation in the sector recently, among other reasons. I think there's something always to be said for having to be 100% accountable for the business you're doing, and not hiding behind the series of complicated, national transactions.

Lapera: Yeah, that definitely, for me anyway, makes me feel better as an investor when I stand behind a business.

Hanson: Actually know what's going on? Yeah.

Lapera: I won't get into this, I don't think I should just be naming companies that I think are morally wrong.

Hanson: No, go for it.

Lapera: Maybe another show. Maybe I'll just do an entire show about it.

Hanson: Morally objectionable companies?

Lapera: Morally objectionable companies.

Hanson: That'd be a good one.

Lapera: Sure, you're invited. Make a list.

Hanson: Awesome. I have strong feelings about more than a few companies.

Lapera: That's good. You mentioned a little bit earlier that merger-and-acquisition activity has increased.

Hanson: Mm-hmm (affirmative).

Lapera: The Fed actually released a paper on this a little while ago. Post-financial crisis, smaller banks have kind of been gobbled up by bigger banks. Do you have any insights into why that's happening and why that's continuing?

Hanson: Yeah, the first would be regulatory costs have gone up pretty dramatically. One of the banks that I own personally, which I mentioned earlier, was called Carter Bank & Trust. Mr. Carter continues to run Carter Bank & Trust, and he has in his annual letters to shareholders, has various tirades that you can check out about how ... specifically, the cost of regulation has gone up the past few years. Obviously, the reasons why that cost has gone up -- and it's not solely without merit, but when your fixed cost of doing business goes up, if you're a small company, the very first, logical thing to do is to sell. Try to spread that base, that cost base, over a larger breath of operations. That's been driving some people to sell. Additionally, as larger banks have needed more capital, particularly tier 1 capital, the low-cost loyal deposit bases that community banks have start to look pretty attractive.

Lapera: Mm-hmm (affirmative).

Hanson: Being able to buy those for 10, 15 cents per deposit dollar can be a pretty good deal for some of those. You've seen players like Umpqua Bank and some others try to go after regional rivals to make their balance sheets a little bit bigger. Thirdly, like I said, having the scale in what has been a pretty tepid economy the past few years, being able to be a little bit more geographically diversified so you're not quite as tied. If you're Bank of Flint, Michigan, you're not just Bank of Flint, Michigan. Maybe you could be bank of the entire upper Midwest or something. That gives you more opportunities.

Lapera: Right.

Hanson: You've also seen just a ... more evidence at that point. A lot of recent strategy for some of these smaller banks is to just open loan production offices in larger cities. Cascade Bank, which is in Bend, Oregon has a loan-production office in Portland now, and they want to open one in Sacramento. They're not going to take deposits in those markets, but they want to be able to make loans in those markets. Similarly, Suffolk Bank, which I mentioned earlier, has opened some loan production offices closer to New York City, where the economy is a little bit more dynamic than it is out on the east side of Long Island. I think the trend toward consolidation will continue, and that can be a good thing for investors because, generally speaking, something will get acquired at a premium to its market value.

The other idea here is that, in the world of community banking, there's still this ideal of the gentleman banker. There are no hostile takeovers in community banks. Mr. Carter, for example, will probably have to make it known that he's interested in retiring before any offers will materialize for Carter Bank & Trust. It can be a little bit slow moving, even though that trend is certainly accelerating.

Lapera: That's really interesting. I remember reading about. I want to say it was M&T Bank was trying to acquire a smaller bank, I think in Maryland. It ended up being a disaster for them -- it took them five years because there was money laundering happening at that bank. The Federal Government was like, "You have to make sure that this doesn't happen again." The amount that they were laundering, it wasn't huge amounts. It wasn't like $50,000; it was like $10,000 or something, which I know sounds like a lot, but for banks, that's not a lot of money. It's definitely an interesting proposition for larger banks.

Hanson: Certainly you want to know what you're buying.

Lapera: Yeah. That came out of the blue for them

Hanson: That's true, that's certainly. You hope internal controls at any bank are strong, because bank failures, whether they're small or big, are uncomfortable for lots of different people involved.

Lapera: Yeah.

Hanson: There are a couple hedge funds that specialize in trying to do activist campaigns against small banks. Stilwell is one, for example. They, for example, make sure that, whenever they try to be hostile or activist with a small bank, that there are no large insider shareholders or community shareholders, because it's very hard to get them to vote against. In the same way, they're loyal to the deposit base, they're loyal to the bank. They spend a lot of time tactically finding votes, counting votes, figuring out how many shares they need to buy to actually exact change at an actual meeting. It is a chummy sector, which is kind of an interesting dynamic that you don't find in a lot of places in the stock market anymore.

Lapera: Yeah, definitely not. One of those places is the tech field, right? That's very shark eat larger shark, if possible.

Hanson: Is that an analogy?

Lapera: That was a really bad metaphor. Our sound guy is probably not going to edit that out. Sorry guys. Anyway, it's very dog eat dog, how about that? I think that was the metaphor that I was going for.

Hanson: I like shark eat shark.

Lapera: Shark eat shark.

Hanson: Shark eat larger shark?

Lapera: That's the goal, right? You want to eat a larger shark, then you have plenty to eat. Technology is a really rapidly evolving sector, and we've talked about it a few times on this show that technology is changing the financial sector.

Hanson: Sure, oh yeah. Absolutely.

Lapera: The question is, how is it affecting small banks? I was reading a 10-K, I think earlier in 2015, and on a small bank's -- like in their little announcement section at the beginning -- they're like, "We just released a mobile banking app." It was 2015, and I was like, how?

Hanson: It's a fair point, I should have mentioned that earlier. That's another thing driving up costs for ... driving up fixed operating cost for smaller banks that they would seek to spread that cost across a wider asset base. Because having your own mobile app is expensive. I was laughing not long ago, Carter Bank, I think their big triumph in 2014 or 2015 was introducing telephone banking.

Lapera: What?

Hanson: Which was years behind the mobile apps phase. Mobile banking, Internet banking, payment processing, Apple Pay -- those are all things that are interesting and hard for small community banks to adapt to. They're certainly trying, it's table sticks stuff now. In order to compete and hang on -- I mean, those deposits are probably loyal only to a point where they want to be able to take a picture of a check and deposit it, or use their fingerprint to buy something, or so on and so forth. There's an interesting company in Austin, Texas called Q2 (NYSE:QTWO), and it's a public company Q-T-W-O, Q2. They do outsourced mobile app and Internet banking design for community banks.

Lapera: Mm-hmm (affirmative).

Hanson: It's been very fast growing for them, because they sort of have an out-of-box solution, they can customize the design. They're hoping that by gobbling up or getting business from a lot of small banks -- as the small banks get acquired, their technology would get adopted by larger and larger banks, and they get paid on a per-user basis. Obviously, having more users would be very good for them. No small bank is going to have an IT department of 100, 200 people, so certainly the outsourcing and development of those sorts of things is driving costs up, and is another thing pushing consolidation.

Lapera: That's really interesting. This is kind of an ongoing conversation on this show, about how financial tech is changing the sector. We had a pretty long show about Apple Pay the other day, as well. It's interesting to think about. I don't want to call them bit players, but people you just don't normally think about and how it is going to affect them. Because J.P. Morgan and Bank of America obviously they have huge buy in on these kinds of things but ...

Hanson: This is a little bit farther field from small banks, but it's a fascinating point. Apple Pay. Apple takes a huge cut if you buy with Apple Pay, but the data that I've seen from their side is, if you install Apple Pay in your app, the take rate on whatever you're selling goes to three to five or even 10 times, which you would get without having Apple Pay.

Lapera: That's insane!

Hanson: You make it up in volume, which you lose on commission; but it's sort of like, it's almost like a deal with the devil, right? You're like, "Ahh, I've got to give away 30% to Apple? Maybe I don't want to sell a million units, maybe I do." That's the math problem at the end of the day. Ultimately, one would expect prices to come down in that space.

Lapera: Eventually.

Hanson: Yeah, in the ecosystem.

Lapera: There are competitors with Apple Pay. There's the ... I can never remember if it's the Goggle Wallet, Android Pay, or if it's flipped ... It might be the other way.

Hanson: No, yeah. When you look at the commissions that Apple Pay is getting, it's certainly incentive to complete.

Lapera: Mm-hmm (affirmative). Of course there's Wal-Mart with their MCX payment plan, which is eventually going to get rolled out; so we'll see what happens with that since they have so many major retailers in it. We are getting farther field and we are running out of time so let me finish up with one last question.

Hanson: Sure.

Lapera: Which is, what is the single most-important consideration for you when you are investing in a small bank? If you had to choose one, which is hard.

Hanson: Picking one... ultimately, if you check the box and all the sort of financial criteria and all the geographic criteria ... this is true probably for banks and other companies. You want to get a sense of management, and make sure that they're honest people who consider all stakeholders when making strategic decisions. Whether it's the small bank or a tech company, or what have you. If you fundamentally have ignorant or dishonest management, the wheels are going to come off at some point. In the world of small community banking, where loyalty and honesty are still important factors, the quality of the management team is pretty critical. They've got to keep an eye on their deposit base, they've got to make sure they're underwriting standards remain high, they've got to keep costs down and they've got to maintain a strong presence in their community. Like I said earlier, if you're interested, probably start with your local bank. Look around and say, "Hey, who's my community bank?" They're probably public, and if they're not public, you can even access their filings via the FDIC. Take a look, study them, give management a call, see if they'll talk to you. I think that's a great way to get started.

Lapera: Awesome, thank you so much for joining us!

Hanson: It's my pleasure, Gaby.

Lapera: You're definitely coming back on the show. As usual, people on the program may have interest in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy based solely on what you hear. Contact us at industryfocus@fool.com, or by tweeting at @MFIndustryFocus. Let us know what you think about Tim, let us know what you think about small banks, and everyone have a great week!

Gaby Lapera has no position in any stocks mentioned. Tim Hanson has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple, BofI Holding, and Wells Fargo. The Motley Fool has the following options: short May 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. 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.