Mr. Friedman, a banking expert with more than 20 years of capital markets experience, says investors who continue to wait for fundamentals to completely recover before investing in small and mid-cap banks could miss a sizable upswing in those banks’ valuations. He also notes that history illustrates prudent investing in the sector before the normalization of the credit cycle likely can lead to outsized returns.
The paper, Investing in Small & Mid-Cap Banks: Opportunity Driven by Credit Cycle, M&A and the Changing Regulatory Landscape, discusses the key catalysts and themes for community banks in 2010 and beyond, including the reemergence of consolidation led initially by FDIC- assisted transactions, and an increase in the number of mutual-to-thrift conversions in 2010 and 2011.
Despite the individual merits of many bank stocks, the market continues to take a broad, negative view on small- and- mid-cap bank stocks. However, current bank equity valuations aside, these institutions are not all created equal. In fact, the stronger banks view this environment as a generational opportunity to strengthen their franchises by taking market share from the weaker players through FDIC-assisted acquisitions and traditional standalone M&A activity.
Banks with excess capital and lower-than-average credit issues should be the long-term winners in this cycle. In the paper, Friedman estimates 100 to 300 banks could fail this year, with 300 to 500 total bank failures possible over the next 18 months. This scenario likely will create tremendous opportunities for the survivors to strengthen their franchises and prosper in the future.
Eventually, Friedman says the stronger banks will be distinguished from their weaker solvency- challenged peers, and the market values of the stronger banks’ equities should rise accordingly. The key is to find the stronger players whose valuations will rise.
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FJ Capital Management is an investment management firm based in Arlington, VA that offers fundamental investment strategies focused on under followed small and mid capitalization banks and thrifts.
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