I know myself; in my pursuit of perfect I miss what's good. This happened to me when I looked at Japanese net-nets. I wanted to find the best net-nets. The net-nets that were the greatest companies, yet also the absolute cheapest. What happened? As I pushed numbers around in a spreadsheet the market rose and I didn't participate as much as I would have liked. There were many good net-nets that I wish I would have owned. The good net-nets did as well as the great net-nets.
It seems like there is always a country that's selling at a low multiple, or a sector of the market selling with depressed valuations. The areas of concentrated low valuations are what I consider pockets of value. These pockets of value need to be mined quickly before they disappear. There can be issues with this approach. Critics always have a myriad of reasons to avoid these pockets, many of the reasons are compelling if not convincing. Second mining pockets of value can result in a portfolio that's heavily concentrated in a hated area of the market. It's a tough sell for clients when all they see on CNBC are dire predictions about a portion of the market you're concentrating their portfolio in.
Financials were one such pocket of value coming out of the financial crisis. Most of the surviving financials are much better capitalized, and should do well going forward. Some of the larger financials are still cheap, but that pool of opportunity is quickly shrinking. As larger financials have drifted higher they've pulled small bank stocks up with them. It's almost as if investors cycle out of larger stocks into smaller and cheaper stocks. Then when those small bank stocks rise investors go even cheaper. What we're left with is around 100 or so banks selling below book value.
M&F Bancorp (MFBP) is one of those banks selling for less than book value, quite a bit less. The letters in the bank's name stand for Mechanics and Farmers, which is also the name of their bank subsidiary. The bank is located in North Carolina and has seven branches located in the major metropolitan areas of Charlotte, Raleigh, Durham and Winston-Salem.
On the bank's website they have a page describing their corporate mission. The bank's mission contains 13 things they are focused on, the last bullet point is profits. This is a fitting placement, the bank is profitable, but they clearly aren't working to squeeze profits from anything possible. The bank is profitable and trades for about 8x earnings, and while that's nice what's even better is their discount to book value.
The bank has a market cap of $7.6m against tangible common equity of $24m and a book value of $36m. They bank is selling for 30% of their TCE which is low, especially for a profitable bank.
I mentioned in a previous post that I try to break an investment thesis down to a few simple pivot points. We first need to ascertain whether M&F Bancorp is on the edge of extinction, if they aren't then we can proceed to establish a value for them.
There are two interrelated things that can kill a bank quickly, bad lending and too much leverage. A bank can operate through good years with a lot of leverage if they don't engage in reckless lending. Bad lending will destroy any bank, and it'll destroy banks with a low capital cushion much quicker. A bank with a higher capital cushion can weather a bigger storm, but if enough of their loans are bad the bank will eventually be taken over by the FDIC.
In the case of M&F Bancorp much of their depressed valuation can be traced to their lending quality.
The above picture shows the holding company's asset quality statistics for the last six semesters. Non-performing assets as a percentage of total assets were at the elevated level of 6.22% in 2011. In general I try to avoid investing in banks with NPA/Assets much higher than 3%. Although exceptions can be made, especially when the bank's portfolio is moving from troubled to normalized.
Here's another more extended view of their non-performing loans going back nine years:
The company's problem loans peaked at 8.09% of total loans in 2010. I dug further into the bank's loan portfolio to determine where they struggled with lending. It's not uncommon for a bank's non-performing assets to spike if one or two of their large commercial loans run into issues. Commercial loans are riskier than residential loans, and if business conditions are difficult it's not unusual for a company to default or defer interest on a loan. Business loans are larger than residential loans as well. A business might need to finance a million dollars for expansion, whereas a million dollar residential loan is rare.
M&F Bancorp's lending issues weren't related to commercial lending, they were with real estate loans unrelated to individual borrowers. The details of their actual issues aren't public, but it looks like they might have done a lot of lending for multi-family residences which ended up facing issues. The loans never went bad, they were eventually restructured and the loans are now performing.
The bank has been continuously profitable for the past nine years, and coupled with the sizable capital cushion of 10% core capital, and 15% Tier 1 I think we can safely establish that the bank isn't going out of business any time soon. And with their loan portfolio under control they aren't heading for a capital injecting anytime soon either.
With that we've established the first pivot point for this investment, that they are a viable company and should continue as a going concern. The second task is figuring out what they're worth. This is a much simpler task.
My general rule of thumb is that a profitable bank with an average loan portfolio should be worth at least book value. When I first started writing about banks I was taken to task over this presumption. I received comments and emails justifying why 50% of book value is a fair value for a profitable bank. I still disagree with that assessment, and the market does as well. As I mentioned above the pool of banks selling for less than 1x book value is quickly shrinking. Secondly the bank M&A market seems to be firmly established around the 1.5x TBV metric for acquisitions.
The great news is that M&F Bancorp is selling at such a depressed valuation that even if it were only worth 50% of TBV that would mean a 50% gain for investors buying at current levels. I suspect that this bank is worth much more than 50% of TBV, but to get the numbers to work we don't need an optimistic scenario.
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Disclosure: Long MFBP