Opinion: 5 clues to find bank stock bargains, from two pros who consistently make money in the sector

It often pays to buy stocks when everybody hates them. Given how fearmongers continue to warn of a banking disaster that is not likely to happen, the bank sector is a good place now to look for the unloved.

To find out how to buy quality bank stocks, I checked in with two experienced portfolio managers, Ian Lapey and Anton Schutz, who know the financial services business and whose mutual funds have outperformed the sector over many years, according to investment researcher Morningstar.

Lapey, who runs the Gabelli Global Financial Services Fund GFSIX,
has bested the Morningstar bank stock index by six percentage points annualized over the past three years. That’s impressive, given that the majority of active managers typically lag their benchmarks.

Schutz, manager of RMB Mendon Financial Services Fund RMBKX,
has beaten the Morningstar bank index by two to five percentage points annualized over the past three-, 10- and 15 years.

Both are convinced that fears about the bank sector are exaggerated. “I don’t think we are going to see a lot more bank failures,” says Lapey, citing implicit guarantees of uninsured depositors by regulators.

Schutz agrees. “I don’t think this is going to be a crisis,” he said. “We will look back and say there were a few poorly positioned companies, and that was not indicative of the industry.”

By this he means the three banks that recently failed — SVB Financial Group’s Silicon Valley Bank, Signature Bank, and Silvergate Bank, a unit of Silvergate Capital.

Each of these institutions had similar problems that got them into trouble. They had large amounts of uninsured deposits. Deposits were concentrated in risky areas that came under pressure, including technology startups and cryptocurrency. They owned a lot of longer-term debt securities purchased when interest rates were low.

This was a toxic mix. When their depositors fled, the banks had to admit paper losses on their debt securities that had fallen in value because interest rates went up so sharply.

This kind of depositor exodus is not repeated at most regional banks. “I have done channel checks with banks and analysts covering banks, and we are not seeing a massive departure,” Schutz said. The main reason, he added: “When you are a smaller regional bank, your senior management is accessible to customers and there is a trust factor.”

Here’s what Lapey and Schutz say are five key qualities to look for in banks.

1.Strong balance sheet: This is key when you buy bank stocks, Lapey says, especially now given that the group is under pressure.

“During the Covid stock bubble, financial strength was irrelevant to the eyes of many investors,” Lapey says. “This year with banks it is crucially important.” Lapey credits his focus on financial strength as one reason why his fund has outperformed the sector so far this year.

As an example, Lapey singles out New York-based TrustCo Bank TRST,
The company reports 18.4% Tier 1 common equity, a financial strength measure used by regulators. “Generally, banks like to be around 10% [Tier 1 equity]so TrustCo is significantly overcapitalized,” Lapey says.

TrustCo’s conservative style meant it held cash for much of 2022. The company was criticized for its caution at that time. But now that interest rates are higher, the bank has cash to invest for better returns. Says Lapey: “This will help their net interest income at a time when deposit costs are going up. It will serve to keep earnings relatively stable.”

In contrast, many banks are seeing profit margins squeezed because they are locked in lower yields.

Another example of financial strength is New York-based global investment bank Moelis MC,
says Lapey. The company has $300 million in cash and no debt. “It can focus on their core business of advising companies,” Lapey says.

2. Solid management: Most of us do not have personal access to managers. So management’s ability can be tough to judge. Here’s a shortcut: Look for big insider ownership. That’s a sign of quality management. “I want management to be managing the capital as if it were their own,” Lapey says. This tells him management is less likely to be reckless. (Lapey has a lot of his net worth in the financial services fund he manages.)

Lapey pointed to North Carolina-based First Citizens BancShares FCNCA,
as an example. CEO Frank Holding Jr. and other insiders own a combined 13% of the stock. “That is significant skin in the game,” Lapey says.

How much insider ownership is enough? Generally, at big banks (over $50 billion in market cap) you want to see insider ownership of tens of millions of dollars worth of stock. At smaller banks (under $1 billion in market cap) a few million dollars could be enough.

Another sign of quality management is a long record of earnings growth. At First Citizens, earnings have grown an average of 13% a year over the past 18 years. Lapey also likes to see long-tenured management. Holding has been CEO at First Citizens BancShares since 2008, and leadership of the bank has been in his family for decades.

Schutz, who also looks for substantial insider ownership, cites Texas-based Veritex Holdings VBTX,
where chairman and CEO Malcolm Holland owns a lot of stock.

3. Acquisition potential: “Mergers and acquisitions will still be part of this industry,” Schutz says. “Maybe not over the next couple of months, but it will become a major theme again. The easiest way to get into the next market and cut costs is to buy your neighbors.”

One possible takeover target from among his fund’s holdings is USCB Financial Holdings USCB,
based in Miami-Dade County, Fla. The bank has scarcity value, because it is one of the few that would give a buyer instant exposure to Southern Florida. Large share ownership by private equity firms is another hint. Private equity often looks to exit positions via buyouts. The bank also has high insider ownership.

4. Cheap valuation: Lapey is a value manager who learned from one of the best — Marty Whitman of Third Avenue Value Fund. Lapey has built a portfolio of stocks with an average price-to-book ratio of 0.65 vs. 1.73 for the Morningstar bank index. This focus on value also factors into the fund’s strong return.

To find cheap banks, consider those trading at a low tangible book value. (You can usually find this in filings or earnings press releases.) Lapey cites Citigroup C,
which has a tangible book value of $70 per share. Its stock recently traded at about $46. This means it trades at just over 0.6 times the tangible book value. For context, large US banks normally trade in a range of 1.5 to 2.5 times tangible book value. For small banks, the figure is 1.0 to 1.5 times. Owning cheap banks can also put you into potential takeover targets.

5.Deposit strength: Local banks fit the bill because they have long-standing relationships with customers, Schutz points out. “Deposits are very sticky at regional and community lenders,” he says. “They are not having a run, and they are not going to have a run.” He favors banks that can keep deposits without raising rates a lot — a sign of customer loyalty.

Schutz cites First Bancshares FBMS,
a small regional bank based in Mississippi. “Depositors are not panicking at First Bancshares,” he says. “They have a lot of core operating accounts with small businesses. They are not competing with JPMorgan Chase.”

The bank’s deposit base also benefits from southward population migration in the US It has customers in Georgia, Florida and Mississippi. This bank has significant insider ownership. Two other examples Schutz offers are Equity BancShares EQBK,
in Wichita, Kan., and Tennessee-based FB Financial FBK,

Finally, here’s a good tip from Lapey that will help your portfolio results: Admit when you’re wrong.

For example, Lapey sold his fund’s Credit Suisse Group CS,
stake at a loss last year, in part because a series of corporate restructurings did not help the bank. The fund took a hit, but the decision avoided further losses. “I resisted the temptation from earlier in my career to average down. At some point you have to look yourself in the mirror and say, ‘This is a mistake.’”

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested C and JPM in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks

more: 10 bank stocks that look cheap based on this valuation method — First Republic heads the list

Also read: Bank insider action tells us the battered financial sector is a buy: These 4 regional bank stocks are tempting those in the know.