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3 Key Ratios for Small Bank Investing

By Tim Hanson and Gaby Lapera – Mar 21, 2016 at 12:00PM

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Before you invest in a small bank stock, make sure you check these three boxes.

Smart investors wouldn't analyze a retail business in the same way they would a construction company. Nor would they think that a megabank with more than $1 trillion in total assets should be analyzed the way you would a small community bank with less than $1 billion in total assets. Yes, the two companies are fundamentally in the same business, but that doesn't mean the same forces will drive their stock prices higher or lower.

In the video below, The Motley Fool's Gaby Lapera and Tim Hanson break down the three more critical considerations to determine if a small bank stock has the potential to be a winner over the long term. 

A transcript follows the video.

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This podcast was recorded on March 14, 2016. 

Gaby Lapera: 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?

Tim 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 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 (SCNB) or some of these others, Cascade Bancorp (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 their 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 home owner 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. D.C., the government, is always hiring. That's the big joke around here. D.C.'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.

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 BofI Holding. 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.

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