Description

I remember after the “dot com bust” reading a quite convincing article arguing that my generation (I’m 43) will would never see another bubble again.  That turned out to be untrue.  Similarly, shortly after the “great financial crisis” of 08/09 nearly everyone still left standing was quite convinced that the days of bank stocks trading at 3 times book value were “over forever.”  That has turned out to be untrue as well: deals are happening now at 3 times book value.  Pacific Continental in Oregon just broke through that barrier in a deal with Columbia Banking System.  Banks are back baby! 

Why?

Mr. Market has decided that small banks are going to benefit substantially under Trump’s plan to lower corporate taxes.  Small banks are entirely domestic enterprises with no foreign location to stash cash. There is not much PP&E to depreciate or inventory to write off.  Accordingly, with fewer tax shields available, Mr. Market thinks they should get a disproportionate benefit from a lower tax rate.

Trump is also going to peel back some of the heavy handed language of Dodd Frank.  Seriously, who can read a book with 2,300 pages in it?  Small banks were the most poorly positioned to navigate “Frankendodd.”  Mr. Market thinks these revisions will be good.

If that weren’t enough, Mr. Market has also decided that the Trump era is going to feature inflation and higher interest rates.  Trump can do what the Federal Reserve and their 4 trillion in helicopter cash can’t: create inflation with a single tweet.  And inflation means higher interest rates, which will directly benefit banks by creating higher net interest margins.   (For those hesitant skeptics out there, still in doubt, I suggest you watch the episode of Celebrity Apprentice in which he fires Gary Busey.)

How do you capitalize on this golden opportunity?  Well – to essentialize what seems to be the common view – since nobody can actually analyze a bank, don’t overthink it: just buy an ETF that has banks inside it.  The fees are lower and they are tax efficient and they are liquid and transparent!

Murray Stahl and Steven Bregman recently referred to the ETF phenomenon as the “Indexation Vortex.”  I don’t know if that phrase is original to them, but I agree with it.  What I have noticed is that banks in an ETF are priced substantially higher than the pissant ones that were excluded based on size.   I think it is logical to assume that this inflated currency is going to accelerate some deals.  Big banks (“ETF Banks”) with jacked currency will start scooping cheap banks whose stocks have been left behind.

So which one do you pick?  I recommend a basket approach, but specifically I am recommending shares of Pathfinder Bancorp, symbol PBHC and hereafter referred to in this report as “Pathfinder.”  With total assets of approximately $700 million, Pathfinder is headquartered in Oswego, NY.  The stock has a small market cap, but does trade occasionally with decent daily volume.  Still, this idea is perhaps only interesting to small funds.  At a slight premium to book value, I think it offers an attractive risk reward.

I’m a West Coast guy, so I have watched with envy from the sidelines as mutual depositors put deposits in old thrifts and then reap the benefits when they demutualize.  There is only one left in California, but there seems to be an unending supply.  There seems to be an endless amount in New England, most of them founded long ago by some group of jolly pilgrims that looked like Ben Franklin.  There are essentially two ways to make money on a demutualization.  The first way is to be a depositor and then subscribe for stock on the IPO.  The second way (which is much less reliable) is to do the “2 years & 10 months” trade.  One of the rules regarding a demutualization is that the institution can’t sell until after the three year anniversary.  So let’s take a look at the class of 2014:

I had to take a few columns off of this table so that it would fit.  Hopefully it formats correctly.

As you can see, Pathfinder completed their second step conversion on 10/17/14, which would allow them to sell on 10/17/17 – their anniversary date.  So this isn’t exactly a 2 year / 10 month trade, but my VIC idea is due soon. 

Pathfinder stands out in a number of notable ways.  They are fully levered up relative to their peer group.  Banks don’t get paid more than dollar for dollar for their excess capital.  They also have the lowest P/E in this group.   

Directors and Officers as a Group own 17.35%.  Pathfinder ESOP owns 9.88%.  The Bank adopted a Defined Contribution Supplemental Executive Retirement Plan on January 1^st 2014, which is triggered following a change in control.  Check.  Check.  And Check.

Let’s say that an acquirer wants to move into Onondaga and Oswego County…

I don’t think I have ever been to Onondanga or Oswego County, and I’m pretty sure I can’t pronounce it.  But if I look at the chart above, Pathfinder seems to have a decent market share while still being bite sized.

I think the 2 year 10 month trade has merit.  Why else would a bank president give up the cushy role as president of a mutual and take on accountability to shareholders?  I think that could be especially true now.  Banks that might have an interest in something like Pathfinder have some very rich currency.  I’d specifically point out CBU, which at this point trades at approximately 4 times tangible book value per share.  I think that if you are a bank with that type of currency, you should do as many stock acquisitions as possible, at least while the good times last.  To a lesser extent, I’d point out more modest valuations in BHLB and AROW. 

In conclusion, my main point is that larger banks that are either more liquid or part of an ETF have benefitted from the current top down investment themes and in the last few months have appreciated considerably.  The smaller targets haven’t really benefited as much.  So I think taking a close look at potential targets is sensible, and a timely basket of targets to analyze would be the 2014 class of demutualized banks.  When I look at this group Pathfinder jumps out as reasonably priced and potentially a good candidate to sell.

Catalyst

Possible acquistion target