These small-bank stocks are good values now

Tiny financial services companies could see big benefits from new regulations

SAN FRANCISCO (MarketWatch) -- Every Friday afternoon for the past year, it's been the small-bank death watch: Which U.S. bank would federal regulators seize next?

In 2009, it was 140 banks stretching from Florida to Washington state. The number is 85 and counting so far this year, including two failures announced late Friday.

Yet with federal banking reform moving ahead this week, shares of the smallest community banks are a good bet on any recovery in the credit cycle, say money-managers and industry analysts, who are becoming more bullish about a turnaround for banks with assets of $1 billion or less. See how financial stocks fared on Friday.

"We're in value territory for the right banks," said Michael Natzic, senior vice president of Stone & Youngberg's Community Bank Group, which tracks 60 California banks. "The strong will continue to get stronger and the weak will get weaker."

Branching out

Like their larger peers, tiny community banks have been struggling under the weight of the massive credit crunch. Since the end of 2007, when the U.S. recession took hold, the SNL Small Bank Index is down 36% as of June 24, compared to a 14% decline for the S&P Small Cap 600 Index and a 23% drop for the Russell Microcap Index.

Yet lately small bank stocks have been gaining traction. So far this year, the SNL Bank Index is up 14%, outpacing the 2% gain for the S&P Small Cap Index and a 3% gain for the Russell Microcap Index.

Investors and analysts who specialize in microcap banks say the ones that will emerge from the economic downturn in stronger shape are the banks that didn't make too many loans on speculative construction of commercial buildings, strip malls, or housing developments.

Debt pressure

For others, the picture is more ominous. Sinking commercial real estate projects have hammered bank profits, forcing companies to write-off bad loans and to allocate capital to shore up loan-loss reserves. For some banks, bad loans have become overbearing and regulators have moved in.

Moreover, many small banks are trying to pay back TARP monies, while commercial real estate vacancies and loan defaults are both still high.