Would you rather have a 60% or a 100% return on an investment?
The obvious answer is 100%. But this answer ignores an important factor: How long will this investment take to reach this amazing return?
That's exactly what's happening with financial services stocks this year. Big banks have posted huge returns compared with the same period last year, with Bank of America (NYSE: BAC) up 60%, JP Morgan Chase & Co. (NYSE: JPM) up 18%, Citigroup Inc. (NYSE: C) up 20% and Wells Fargo & Co (NYSE: WFC) up 24%. Enthusiastic investors are fueling this bullish movement by taking advantage of share prices that are still far below the peak levels from 2008. Take a look at the market-beating gains below.
But even though it's been a great year for big banks, the bigger gains in the long run lie in another segment of financial services: Small regional banks. These banks are producing record earnings and sitting on record amounts of cash, both powerful weapons to drive growth.
Small banks have emerged from the financial crisis with incredible growth potential. That might not sound super glamorous at first glance, but there are more than a few reasons the group is uniquely positioned to benefit from the changing landscape in financial services.
Record cash in hand
Small banks are sitting on record cash positions. That's because the group was able to avoid huge losses from toxic assets and mega-derivatives trades gone wrong that wreaked havoc on the big banks in the middle of the past decade. Instead, small regional banks kept it simple and stuck to their core banking business of lending and capturing interest rate spreads. A lot of small banks didn't boom as hard as the big banks, but many didn't crash as hard either. The end result shows up in record cash positions after avoiding big losses on risky bets.
That cash position is important for two reasons. First, it enables small banks to increase lending volumes and grow revenue. Second, it presents an opportunity to acquire smaller rivals. Growth through acquisition is an incredibly powerful force in banking services because new customers and deposits require little variable expenses in the very scalable banking infrastructure. The big banks have historically led the way on acquisitions, but with the group dialing back on risk and building reserves, it has left an opening for the smaller banks to take advantage of value creation through acquisition.
In the longer term, if the big banks continue to grow stronger, then regional players will once again become targets of acquisition, putting another potential bid into these mid-level players.
Small regional banks also usually pay a dividend, with yields frequently topping 2%. This safely beats the 1.7% return on the 10-year Treasury bond and is still a solid return in a low-yield environment.
Now that we've identified why small banks are in great position to grow, here are my three favorite picks from the group.
1. Texas Capital Bancshares Inc. (Nadaq: TCBI)
Texas has one of the strongest regional economies in the country, providing more support for this Dallas-based bank with a $1.8 billion market cap. The strong Texan economy has fueled Texas Capital to huge gains in the past 12 months, with its share price more than doubling. Earnings have been rising too, helping to keep the valuation picture in check. If Texas Capital returned to its average forward price-to-earnings (P/E) ratio of 18 in the past 10 years, then shares would jump 13%.
2. Old National Bank (NYSE: ONB)
Indiana-based Old National Bank is another strong regional player, with a market cap of $1.3 billion. Its earnings are on pace to grow 33% this year and another 10% next year, with full-year earnings in 2013 projected to come in at $1.11 per share. This has Old National Bank trading at just 13 times forward earnings, a discount to the average of 16 in the past 10 years and far below the high of 41. If Old National returned to only half the previous high, then shares would jump above $21, a 54% increase from current levels.
3. Regions Financial Corp. (NYSE: RF)
Based in Alabama, this is one of the largest regional banks out there, with a market cap of $10 billion. The bank has had a great year, posting an average earnings surprise of 61% in the last four quarters that has fueled a 74% gain in shares. But earnings estimates have also been on the upswing, helping to keep the valuation in check. As it stands, Regions Financial trades at 10 times forward earnings. If shares returned to the average price-to-earnings (P/E) ratio of 14 times in the past 10 years, then Regions Financial would climb 40%.
Risks to Consider: Bank stocks are particularly sensitive to fluctuations in economic growth. They also carry exposure to credit losses and lending risk, a lingering threat during times of high unemployment.
Action to Take --> Regional bank stocks are a better way to play the financial industry than bloated behemoths like Bank of America and Citigroup. Small-bank stocks have record earnings and growing cash positions, both of which will drive earnings and support future growth. The three regional banks I mentioned above are particularly well suited for huge gains in the near future.