The Double Edged Sword of Small Bank Stocks during Booms and Busts

No one predicted the price of oil would drop as much or as fast as it has over the past 18 months. Similarly, very few predicted the housing market would crash in 2007 and 2008. For banks, these sudden and unexpected changes in the economy can be devastating.

Some banks cite their large size and wide geographic footprints as key  mitigating factors that protect them from such risks. Others point to their robust hedging portfolios based on complex math and derivative contracts. However, some banks -- typically small, community banks -- have been able to produce stellar returns over time in highly concentrated niches with a limited geography to work in.

In this segment from the Motley Fool's Industry Focus: Financials podcast, host Gaby Lapera and bank stock guru Tim Hanson look for some answers to this question. They dig into the realities of loan concentrations across different economies, talk about how booms and busts can impact valuations, and seek to determine whether small banks or big ones have the advantage when it comes to concentration risk. 

A transcript follows the video.

This podcast was recorded on March 14, 2016. 

Gaby Lapera: 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.

Tim 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. 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 -- 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 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 financial 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.