Can You Bank on Regional Banks?

J.P. Morgan’s (JPM - Analyst Report) recent $2 billion-and-counting trading loss should justifiably make you wary of the big banks. The black-box nature of these very large banks makes their business model inherently risky and unpredictable. But you don’t need to shun this entire space simply because of these large banks. There are plenty of other operators in the banking space -- mostly the small local/regional players -- that remain in very good shape.

As the economy continues to improve and the bad loans made during the downturn roll off, the condition of the banks’ balance sheets has improved. Consumer delinquencies have been falling as the slowly improving jobs market has been helping heal household finances. Some of the reserves that banks had set aside for bad loans now seem excessive, and those reserves are being released, and less new money has been put aside.

Free raw materials (deposit rates near zero) have made the loans that the banks have been making recently very profitable. As a result, many small banks, which don’t face many of the problems of the big guys, have been showing surprisingly positive earnings. As a result they are performing very positively on the Zacks Industry Rank.

Zacks Industry Classifications

Our expanded industry classifications provide a fairly granular view of the industries by tracking more than 250 different groups. The Zacks Industry Rank, which derives its predictive power from the time-tested Zacks Rank, helps us identify the industries that are expected outperform others. The top 1/3^rd of the Zacks Industry Rank qualify as industries with ‘Good’ prospects, the bottom 1/3^rd have ‘Bad’ prospects, and middle 1/3^rd as ‘Neutral.’

But many of these ‘industries’ have just a few companies in them. So it’s not particularly noteworthy if a single small industry shows up doing well; a single firm with good news can propel a one- or two-firm industry to the top (or bottom) of the list.

It is interesting when you see a cluster of similar industries close to the top of the list. The same holds true for the bottom of the list. The definition of size that matters here is not the total sales or market capitalization, but the number of companies in the ‘industry.’

Breaking Down the Groups

We break up the overall banking sector into five regional groupings, plus a “multi-regional” group that is mostly the very large banks like J.P. Morgan, Citigroup (C - Analyst Report) and Bank of America (BAC - Analyst Report). We also have a separate “industry” for the foreign banks.

Four of the five regional groupings are all showing up in the top 1/3^rd of all industries, meaning having a ‘Good’ outlook. The remaining one, banks in the Northeast, falls in the middle 1/3^rd -- a ‘Neutral’ outlook. The ‘multi-regional’ group of large banks is also in the top third.

The Southwest region ‘industry,’ with 12 firms in it, is the strongest of the bank groups, coming in 11th place. Texas Capital Bancshares (TCBI - Analyst Report) is a Zacks Rank #1 stock in this group. The Southwest group is the smallest of the regional groups and probably the reason it is the best regional grouping. Normally industries in the top 15 have fewer than ten firms in them.

Banks in the Midwest are the next best, in 15th place. The Midwest ‘industry’ has 35 stocks in it. Rosemont, Illinois-based Taylor Capital Group (TAYC - Snapshot Report), the $400 million market cap parent of Cole Taylor Bank, is one of the Zacks Rank #1 stocks in this group.

Banks in the West are at the 54^th place, while the Southeast region is close to the cut-off for the top 1/3^rd mark at 78^th place. Banks in the Northeast are firmly in the ‘Neutral’ category at 126^th place.

Lesser Known, but Not Lesser Investments

You probably have never heard of most of these banks. Some of them you might recognize if they happen to operate in your town, but it is a fair bet that the names of most of them are new to you.

None of the banks on either of the lists are large caps, and even the mid-caps are on the small side of the range. One could actually take a ‘package approach’ to investing in these banks. You can create a ‘synthetic’ national bank -- one that avoids the regional risk that these banks pose -- by having a portfolio made up of small positions in many of these names, rather than just taking one normal-sized position. Given the thin trading volumes in these names, even an individual investor could impact the price if they tried to take a big portion in just one of these names.

The valuations are for the most part reasonable; not rock bottom, but by no means excessive. And unlike the big boys of the banking world, most of these firms are free to pay whatever dividends their boards deem appropriate. As you can see, many of these small banks provide very attractive dividend yields. Dividends from some like Ohio’s FirstMerit Corp (FMER - Snapshot Report), Virginia’s First Community Bancshares (FCBC - Snapshot Report), Kentucky’s Community Trust Bancorp (CTBI - Snapshot Report) are really juicy.

However, just as a word of warning, they tend to be thinly covered, so an individual analyst raising his or her numbers for the firm has a much bigger impact on the mean estimate than is the case with the big, well-covered banks. Still, higher earnings will allow these banks to pay higher dividends in the future, so if you do buy them and tuck them away, there is a very good chance that your yield on cost will be much higher a few years down the road than is indicated in the tables below.

Zacks # 1 Rank (Strong Buy) Local Banks

Zacks # 1 Rank (Strong Buy) Local Banks

In evaluating the Zacks Industry Ranks, you want to see two things: a good overall score (low, meaning more Zacks #1 and #2 Rank stocks than #4 or #5 Rank stocks) and some improvement the relative position from the prior week. It is also helpful to understand exactly what the Zacks Industry Rank is.

The Zacks Industry Rank is the un-weighted average of the individual Zacks Ranks of the firms in that industry. It does not matter if the stock is the 800-pound gorilla that dominates the industry or some very small niche player in the space -- they have the same influence on the Industry Rank.

Also, that means that the bigger the industry in terms of number of firms, the less influence any given company has on the industry rank. It also implies that small industries, with just two or three firms, should be the ones found at either the top or the bottom of the list. Thus, I do not always focus on the very highest-rated industries, but on the highest-rated ones in which there are a large number of firms.