The best reasons to buy regional bank stocks

Regional banks rebound
Regional banks rebound   

Regional bank stocks have bucked the bank-stock trend this year, and not in a good sense. Every Keefe, Bruyette & Woods (KBW) financial services index is generating positive returns year-to-date, except for two: the KBW Regional Banking Index and KBW Mortgage Finance Index.

The regional banking sector has been the real dog, down more than 6 percent this year through Oct. 3, but analysts expect the regional banking stocks to rebound, arguing that the recent regional bank-stock retrenchment has made them an even better target for investors.

The reasons are twofold. Smaller, regional banks are fighting for a bigger piece of a shrinking universe. The strongest banks will thrive and snap up weaker ones, analysts argue, fueling higher profits and dividends.

Second, while large U.S. banks make up 80 percent of the market, they are hampered by post-financial-crisis regulatory issues, making them less nimble when it comes to acquisitions that could add value.

black and white bank scene, community bank, bank teller, bank
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Others argue that a recent reversal in regional banks—the stocks were up a modest 1 percent in September—reflects a growing belief that rising interest rates will benefit the regional banks next year, and investors should place their bets on the regional bank stocks now.

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"The last five years have been brutal on banks," said Tim Melvin, publisher of "Banking on Profit." "So we're in the second inning of a consolidation wave. Regional banks will keep growing through acquisitions by buying smaller-growth banks, since there's not a lot of organic growth." Banks also want to spread out their expenses over a larger asset base, he said, adding, "The future looks bright for smart acquirers."

In 2007 there were 7,284 commercial banks, compared to just 5,876 in 2013, according to Federal Deposit Insurance Corporation data. That's the lowest number of banks since the Great Depression, though deposits are rising. The banking consolidation is set to continue, analysts said, and at the smaller end of the banking spectrum, smaller, regional banks struggling with high regulatory costs and slow revenue growth will be among the targets.

"Big banks are saddled with regulatory baggage," said Nicholas Galluccio, president of Teton Advisors. "They're still paying huge fines. But regional and community banks are the catalyst for mergers and acquisitions, which is going to pick up dramatically in the next few years.

"There's a big separation between the haves and have nots among smaller banks. And the best banks will rise to top, since some banks haven't been able to find loan growth." -Matthew Olney, Stephens analyst

Melvin believes that regional banks will also be a good place to fish for dividends over the next five years because the banks are, by and large, better capitalized and have de-risked their balance sheets. "When we're talking about the prospects for appreciation, smaller is better," Melvin said.

Two regional banks that Melvin gives high marks for acquisitions strategy are North Carolina-based HomeTrust Bancshares, which is trading at 83 percent of book value, and Indiana-based First Merchants, which has a solid loan portfolio, he said.

Chris Marinac, director of research at boutique broker/dealer FIG Partners, which specializes in financials, said that smaller, regional banks are largely undervalued. "Dividends have increased, and more are coming," he said. "That's a big plus."

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Marinac likes Tennessee-based First Horizon National Corp., which has offices in 21 states. "The company has bought branches from Bank of America and is growing through acquisitions, while the stock also pays out a 1.7 percent dividend.

New Jersey-based Investors Bancorp, which has grown through a string of acquisitions, is another Marinac pick. It has taken away market share from other banks in New Jersey and New York and also has a strong balance sheet, he said. MB Financial is another solid regional bank on the acquisition trail. The Chicago-based bank offers a 1.8 percent dividend yield.

"Regional banks are making more money," Marinac said, adding, "They're in the early innings of a profit comeback, as loan credit quality continues to grow." Analysts said this added earnings power will help finance more acquisitions.

Regional bank-stock performance year-to-date

  • First Horizon National: 5.2 percent
  • First Merchants Corp.: -10 percent
  • HomeTrust Bancshares: -7 percent
  • Investors Bancorp: -3.5 percent
  • MB Financial: -14 percent
  • IberiaBank: 0.1 percent
  • KBW Regional Bank Stock Index: -6.1 percent
    (performance through Oct. 6, source: Google Finance)

Matthew Olney, Stephens analyst, said the regional banks are undervalued, including Louisiana-based IberiaBank, which has exposure to new markets through a sting of out-of-state acquisitions. IberiaBank's dividend, currently 2.1 percent, has also been rising. The business climate in Louisiana is pretty healthy now, so the bank is becoming more profitable, Olney said.

"There's a big separation between the haves and have nots among smaller banks," Olney said. "And the best banks will rise to the top, since some banks haven't been able to find loan growth."

And the biggest stock-specific factor driving consolidation will continue: antsy shareholders. "There's pressure from shareholders for improvement," Olney said.