Investors Should Ask: 'Why Am I Not in Community Banks?'

I spend most weekend days in my office with some sort of sports program on in the background and doing my heavy reading. It is nice and quiet, the market is closed, there are no deadlines or details to keep track of and I can really dig into articles, filings and reports.

My biggest takeaways this weekend are that the NFL has become almost unwatchable, thanks to salary caps and the quest for parity, and that the Trade of the Decade is gathering serious momentum. I make it a habit to use Twitter (TWTR) as a personal filing system by tweeting all the articles I find interesting. My weekend feed is full of articles on the accelerating pace of small bank merger and acquisitions in 2016.

The Boston Globe quoted lawyer Kenneth Ehrlich, who runs the banking practice for Nutter McClennen & Fish, as saying "new Dodd-Frank requirements for local banks are a driving force behind the uptick in mergers, as an increasing number of community banks, particularly those where the CEOs are retiring, look for the safety of a bigger partner."

Ehrich also said "there are pressures on them that are forcing the smaller ones to really think about making an exit."

Fitch, the ratings agency, released Fitch Ratings' 2016 U.S. Banks Outlook Report and suggested that mergers and acquisitions will pick up in 2016. In the report, Christopher Wolfe, managing director, financial institutions, said that even with steady capitalization levels, U.S. bank earnings will be challenged next year due to economic headwinds and the strengthening dollar.

"As banks grapple with the cost of regulation and soldier on in the lower-for-longer interest rate environment, banks' net interest margins and profitability will be pressured, which we expect to lead to mergers and acquisitions in 2016," Wolfe said.

The report also added: "The pace of industry consolidation will increase in 2016 due to the need for greater scale efficiencies from costly compliance with financial regulation, technology investments..." It said the prolonged low interest rate environment would not be "sufficient enough to improve profitability. Achieving scale is even more important, as banks will have fewer reserve releases to flatter the earnings picture in 2016"

Jimmy Dunne, co-founder at Sandler O'Neill & Partners, went on Bloomberg late last week and replied "absolutely" when asked if regional banks' M&A would continue. Dunne said that conditions were ripe for continued activity and that it was not a case of "I think it is going to happen. It is going to happen".

A good friend passed along the Keefe Bruyette & Woods outlook for community banks in 2016. The financial services specialist brokerage firm said that owning growth, differentiation, and select asset sensitivity remains its call on the small- and mid-cap banks.

"We recommend investors also consider allocating capital to M&A as the building momentum is also likely to be a profitable investment strategy. In the face of somewhat elevated multiples and relatively-stagnant profitability metrics, stock selection, both fundamentally and M&A-based, should provide the backbone of investor returns in 2016," the firm also said.

Even my good friend and fellow contributor Roger Arnold got in on the action. In his article on RealMoney last Thursday, Roger pointed out that "essentially and actually, the Fed's decision greatly enhances the profitability of the largest banks while simultaneously putting enormous pressure on the profitability of the rest of the banks.

"This in turn provides an immediate catalyst for an increase in mergers and acquisitions by all the smaller banks."

I talk about the community banks and why you should own them all the time. The objections I get are laughable to me. When people tell me that community banks are too illiquid or boring, I know I am talking to someone who is more addicted to the action than they are interested in making money over the long run.

Liquidity is your worst enemy as a serious long-term investor and exciting is really bad for your account balance. The bank consolidation trend is going to go on for a long time. Sound small banks with high-quality loan portfolios, with sufficient capital purchased at a discount to book value, will make you money as a long-term investor. If you can identify those that qualify and have an activist or bank-stock specialist as a significant shareholder, your odds of success are off the charts.

It is not just Tim Melvin who sees the opportunity here. It's the lawyers, the bankers themselves, the brokerage firms and ratings agencies that are telling you where the opportunity lies. In addition to those I have cited,search "Community Bank M&A" online and just skim the first 20 pages of results.

The Trade of the Decade is real, it is happening and it is continuing to happen. The question you have to ask yourself as an individual investor is "Why am I not in?"

At the time of publication Melvin had no positions in stocks mentioned but holdings are subject to change.