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A Big Fan of Small Banks

Tim Melvin

Yesterday, my email and Twitter feed were full of what I call "down day chatter." After a decent selloff the past five days, everyone thinks the world, or at least the market rally, is ending. I confess that I don't really pay attention until we are at least 10% below the highs, and we are not yet close to that level. At 20% below the recent highs, I will start getting a little excited as bargains are created. Until then, I consider the day-to-day market gyrations to be noise. Alcoa's (AA) earnings surprise has brought hosannas and higher prices, and I am not going to pay much attention to that either. I want to own good businesses at great prices for a long time, and the day-to-day news-driven fluctuations are not that big a factor in my investing strategy.

One of my favorite businesses to own is small banks. They have seen their stock prices suffer in recent years as the industry faced both economic and regulatory pressures. In better times, local banks are a license to print money, and some of my most successful investments have been little banks that grew and eventually were taken over by a larger competitor after years of earnings and stock-price growth. As we emerge from the credit crisis, small banks will see another wave of strong growth and merger activity that should again be a source of large profits.

I peeked at one of my local bank holdings on Tuesday. I rarely talk about my little banks, as they are smaller issues and can be thinly traded at times. In honor of opening week in baseball and the Orioles' chances to be a winning team, I have declared this "long-shot week." As a result, I have opened up and talked about a few of my microcap holdings that are off the radar screens of most investors. Be aware, these are small stocks and can be difficult to trade. The smaller banks face issues related to local economics and regulatory pressures, so also be aware that there are extra risks with these little stocks.

One of my favorite little banks is located in Annapolis, Maryland. Annapolis Bancorp ANNB is the holding company for BankAnnapolis. It has a strong regional presence with seven branches in the area. Current assets total about $441 million. It's what I call a typical small-town bank. I banked there for many years and would still had I not married a banker from a competing institution. The lobby always had coffee and donuts, as well as newspapers and CNBC on the lobby TV in case I had to wait to conclude a transaction. I knew everyone in the lobby at every branch that I used over the years.

BankAnnapolis' loan portfolio is heavily tilted towards commercial loans. Sixteen percent of the loan portfolio is commercial loans secured by receivables and other borrower assets. Underwriting standards usually call for a personal guarantee of the principles of the borrowing company as an extra measure of security. A little of more than 39% of the portfolio is commercial real estate loans at an 80% to 85% loan-to-value ratio. While heavy commercial exposure hurt the bank a little in 2009, non-performing assets peaked at 4.35% of total assets and have fallen back to the current level of just 1.88%.

It is a great little bank, but it is not without risk. It has not yet repaid the government TARP money it received in 2009, and the warrants issued to the federal government could be a source of dilution in the years ahead. The annual dividend payments on the TARP preferred shares will reduce profits. The costs of dealing with new regulations are a bigger burden for smaller banks, and these costs will hit the bank's bottom line.

In spite of the risks, this is a well-run bank and its stock is cheap. At about $6, the shares currently trade at just 75% of tangible book value. The tangible equity-to-assets ratio is 8.46, and the balance sheet is very strong. The bank's officers and directors have deep ties to the local community. Some of them have been buying stock in the open market over the past few months and insider's own roughly 60% of the bank, so they seem to be confident in its future.

At this price, Annapolis Bancorp strikes me as an outstanding buy. It is a chance to own a solid banking business for many years and earn returns of many multiples of your initial investment. As a bonus, if you conduct on-site research, they serve donuts.

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