Sometimes we make investing too hard. Value investing can be described as picking up the proverbial dollar for $.50. That sounds simple, but if you read enough about value investing it starts to become complicated. Investing guru's discuss investing in companies undergoing complicated financial maneuvers, finding competitive advantages and sizing up management all before committing a dime to an investment. While many of these types of transactions can be profitable, and many have a place in our portfolios it also is worth stepping back and doing the simple things well. Additional complexity opens an investor up to the possibility of making mistakes or errors of omission.
In the simplest case take a company worth $100 that's in liquidation and selling for $50 in the market. This type of investment is a true $1 for $.50, it's simple and barring an extended liquidation time frame is a reasonable investment. Not many errors can be made in this situation, some are possible, but not many. Now consider the type of investment many blog and articles write about, a company with a sustained advantage. The investment case rests on the ability of the company to keep their advantage for the next five, ten or 15 years. Predicting what anything will do in 10 or 15 years is difficult. As an example consider the iPhone. I saw a headline yesterday that to purchase the exact same computing power available in the iPhone 5S in 1991 would have taken $3.56m. In 1991 it would have been absurd to suggest that ~$3.5m worth of computing power would be in everyone's pockets with a touch screen, instantly connected to the Internet and only cost $199 (plus monthly payments). We have trouble understanding what the future would look like. We have incredible computing power at our finger tips, but no flying cars and have to prepare our own meals and clean our own bathrooms, a strange irony.
I talked with someone recently and he asked a very insightful question regarding my investment process for small banks. He asked whether I am able to size up a bank quickly given how many I've looked at. This has been something I've been thinking about extensively since our conversation. I've come to the conclusion that yes, when looking at a simple bank I can determine whether or not I want to invest fairly quickly.
Banking is the ultimate commodity business. From the smallest bank in the US to the largest, they are all doing the same thing, connecting people with money to those who want money. Borrowers don't care about the brand name on their loan. I have never heard of anyone say "I only borrow from Wells Fargo because their loans are more reliable." Being a commodity business the only thing banks can do to set themselves apart is offer differentiated service, niche products, or high touch customer service. These are the elements that win over consumers when they're considering which bank to keep their savings or a bank to borrow from.
It's within this context that I want to take a look at SouthFirst Bancshares (SZBI) an extremely small bank located in Alabama. I want to re-iterate that this is a small illiquid bank, it took me weeks to fill a small share order.
The attraction of SouthFirst is readily apparent, they are trading for $3.55 when their tangible common equity is $7.50 per share. They are selling for 30% of book value and 47% of tangible common equity value. But not only that, the bank is profitable as well.
As mentioned earlier the bank is small, they have slightly less than $100m in assets and $9.4m in equity. Given that they're trading for 47% of TCE they have a market cap of $2.5m. As I mentioned, this is a small bank only for only the most patient investors or those who are willing to have exposure to such a small bank.
The bank isn't perfect, they hit a very rough patch during the financial crisis, net income slipped from $642k in 2006 to a loss of $2.9m in 2011. Income has since recovered and the bank earned almost 10% on their equity in 2013.
In the intro I mentioned that I can size up a bank quickly, what I'm looking for is the following. A discount to either book, or relative value. Non-performing assets that are 3% or lower and either some sort of earnings, or the potential for earnings. And lastly a large gap between what an acquirer might pay and the market value of the bank.
At first glance one might think I could automate this criteria and invest in a bank like this in a quantitative manner. This might be true, but not every bank that matches what I'm looking for receives an investment. I like to buy banks that I think will either be bought out, are extremely cheap, or are showing some forward momentum. And lastly I'm very cautious regarding asset quality. A stretch of bad loans or reckless lending can sink a bank quickly. Some of these attributes can only be evaluated by a human, they need a small bit of intuition.
SouthFirst is both cheap and has forward momentum. Here is a chart of their ROE and ROA for the past few quarters:
As you can see the bank's earnings were marginal before the financial crisis, terrible during the crisis and have recovered since. Viewed in isolation the bank's ROA of .83 is quite respectable and their return on equity is approaching 10%, a seemingly magical number for bank investors. The question is whether the bank's earnings are sustainable at this level.
Profitability is important with a small company. If a company or bank is profitable it becomes easier to hold a very small stock because value isn't being destroyed quarter after quarter. When holding shares in a small company generating losses the investment becomes a race against the clock. When holding a small undervalued company earning money the investment becomes a test of patience.
With a bank the biggest indicator or danger to earnings is poor quality loans. The following graph shows the bank's equity to assets as well as two asset quality measures:
There are a few items of note from this chart. The first is that the bank's capital has been increasing over the past few years. Increased capital gives the bank a bigger buffer against potential losses. The second is that non-current loans to loans are slightly trending up, which the bank's loan loss allowance has remained steady.
The bank's non-performing loan increase is a result of an uptick in non-performing home equity loans and 1-4 family loans. The majority of these loans are considered non-accrual if the borrower doesn't pay will eventually migrate to foreclosure and other real estate owned (OREO):
The question when looking at loans is what's the worst case scenario? Let's presume that SouthFirst has to charge-off all of their non-current loans. This would be equal to a charge-off of $1.8m, except that 65% of those non-current loans have a reserve against them meaning their total exposure is $630k. In this total charge-off worst cast their equity would take a hit of $630k dropping it below $9m. Considering their market cap of $2.5m this worst case isn't catastrophic to the investment.
Banks selling for such large discounts afford large margins of safety for investors if one can actually get shares. A bank like SouthFirst is fairly simple, they are a dollar for $.50 or so. Like anything cheap maybe the bank isn't worth a full dollar, but even if they mark down their loans and only sell for half of book value an investor would do well to own shares at this level.
What one needs to realize when looking at a bank like SouthFirst is that they belong in a well diversified portfolio of a patient investor. This bank is unlikely to go on an acquisition spree, or grow earnings at 25% going forward. But it's very likely that they are worth more than their current valuation, potentially upwards of 1x book value in an acquisition. All an investor needs to do is purchase a small position and wait.
It's worth noting that I didn't conduct any complex analysis about the housing market that they serve, or dig into the details of management. The numbers tell the story, and at the price they're selling for some of those details are irrelevant.
Simple banks like this are a bedrock position in my portfolio. It took me longer to write this post than it did to research the company. I don't own a large position, but in aggregate a number of small positions at valuations such as this have done well over the years and make up a large part of my portfolio.
Disclosure: Long SZBI