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Tim Melvin

Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, advisor and portfolio manager. He has also...

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Small Banks Can Lead To Big Dividends

The bank stress test results are in; later this week, the review of capital plans will be released by the Fed as well. This will tell which of the big banks will be able to go ahead with their planned dividend increases and share buybacks.

With 20 of the 30 biggest banks passing the rather tough test, it is expected to see strong increases in both. Given the recovery in the banking system, this should continue into the foreseeable future. Bank Analyst Dick Bove at Rafferty Capital thinks that the banks stock are poised to double in value over the next few years as a result of the improvements in the condition of the banks.

As exciting as this story is, it is even more so for the smaller banks.

Related: Down On The Corner Of Main Street And Wall Street

During the financial crisis, many banks reduced or eliminated their dividend payout and halted buyback programs to preserve capital. The banks are now starting to resume and raise dividends, and buy back stock in the open market. Many of them are doing so at a discount-to-book value and the buybacks will significantly improve shareholder value.

The smaller banks are much cheaper than their larger competitors, as measured by price-to-book value and tend to be far less volatile. While big banks can trade on every headline and tidbit of news, the smaller banks are hard for the fast money crowd to trade.

The small bank stocks could be the best dividend growth and buyback story of the next decade.

Westfield Financial (NASDAQ: WFD) is a great example of a little bank that is working to improve shareholder value. The bank is located in Westfield, Massachusetts, and has 13 branches with about $1.2 billion in assets. The have an equity-to-asset ratio of 11.53 and nonperforming assets are a minuscule .20 percent of total assets.

The bank has been buying back stock at a steady rate and since 2009, the share count has gone from more than 29 million outstanding to just 19.4 million today. During the same time frame, the dividend has gone from $.20 a share to $.24 -- that's a growth rate of about 4.6 percent annually. The stock currently yields 3.6 percent and trades right at its tangible book value.

ESSA Bancorp (NASDAQ: ESSA) is a 27-branch bank in Stroudsburg, Pennsylvania, with $1.35 billion in assets. The bank is in fantastic financial shape, with equity-to-assets ratio and nonperforming assets that are just 1.9 percent of total assets.

The bank just announced a 40 percent increase in the quarterly dividend payout and another five percent stock buyback. This will be the sixth such buyback plan for the bank since its IPO in 2007. The dividend has gone from $.08 a share to the current level of $.28 in the past five years, while the share count has dropped from 16 million shares to just 12 million today. The stock trades at just 87 percent of tangible book value and yields two percent at the current price.

Related: Do Small Banks Have A 'Buy Or Die' Ultimatum?

It took a push from activist investor Joseph Stilwell to set things in motion, but HopFed Bancorp (NASDAQ: HFBC) doubled its dividend payment last year and also announced a five percent buyback program. HopFed is the holding company for Heritage Bank in Hopkinsville, Kentucky.

Heritage has 18 offices in western Kentucky and middle Tennessee and about $967 million in assets. The equity-to-asset ratio is 10.97 and nonperforming assets are just 1.22 percent of total assets, so they are in good financial shape. The stock trades at less than 90 percent of book value and the stock is yielding one percent at the current level.

In addition to the prospects of future buybacks and dividend increases, there is a strong chance that Mr. Stilwell successfully pushes management into selling the bank at a higher price.

The big banks passing the stress test and the possibility of increased dividends and buybacks in the near future has captured the headlines. However, the real dividend growth and stock buyback story would appear to be in the smaller regional and community bank stocks.

Posted in: Education Long Ideas News Dividends Buybacks M&A Federal Reserve Trading Ideas