Banking

Finding Opportunities In Small Cap Banks

PM Jay Kaplan makes the case for his interest in small-cap banks.

Q4 hedge fund letters, conference, scoops etc

Banking

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Why are small-cap banks usually overlooked?

Small-cap banks I think are often overlooked. The world thinks about the big banks. They know the Citibank, the JPMorgan Chase or the investment banks, the Goldman Sachs of the world, and the banks that I invest in are small, neighborhood-y, community banks, the bank you find on Main Street in your own small town, the bank that is making mortgages, the bank that is lending to the small business owner, the bank that is financing the small construction project in town. Those banks are very different from the major money center banks. They don’t have investment banking. They don’t have capital markets activity. They’re bread and butter businesses, taking deposits, making loans and earning a spread.

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How are big banks and the small community banks run differently?

The small community banks run a more conservative business as long as they know how to lend and do their credit work, and they’re not really susceptible to the vagaries of the capital markets. So in today’s world where the economy is good, credit has been very, very good, so banks are making loans and they’re getting paid back, and that’s really, really good. Loan growth is positive. It’s not terrifically buoyant, but loans are growing, and that’s a very good thing.

Why are small-cap banks interesting now?

Here’s why I think investing in small-cap banks is interesting now. The yield curve is kind of flat, almost inverting. When that happens, it costs the banks more to raise money, and they can get less for the money that they lend, so their spread contracts and their margins contract, so there’s been some pressure on profitability growth. Loans are still growing, so that’s good. Credit quality is phenomenal, and there’s no reason why that should change anytime soon. So that’s really good. Once the marketplace comes to believe that the economy is not in a recession and is growing again, the yield curve should steepen. That will help the bank spreads go up, and their profits will start to grow faster. When that happens, the valuations should go up, and that’s why community banking is interesting today.

What’s the appeal for small-cap banks to an active management strategy?

I think small-cap banks are a really interesting place for active managers to be. They’re relatively illiquid. They’re really small. They’re not well covered, and they are easily overlooked. So if you’re willing to put in the time, roll up your sleeves and do the work, you really can uncover some supreme opportunities.

Article by The Royce Funds


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