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2 Small-Cap Bank Stocks to Watch in 2020

Always look for small banks in good local economies.

Small-cap bank stocks can be great investments. They can grow fast. They are very safe these days (there were very few bank failures in 2018 and 2019). And many small-cap bank stocks come with dividends. An important factor to look at in a small-cap bank stock is its location, because many of these banks only do business in a local or regional market.

One market that is doing well is the heavily banked Boston and greater New England region. With all of the construction and high-growth sectors, value plays in this market and sector are a rare but great find. That's why I'm particularly interested in Berkshire Hills Bancorp(NYSE:BHLB) and Century Bancorp(NASDAQ:CNBKA), which are both worth a look for your portfolios.

2 Small-Cap Bank Stocks to Watch in 2020
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Finding value in New England small banks

Bank investors like to compare the book value of a stock, or the net value of a company's assets and liabilities, to the price that the stock is currently trading at to determine whether the stock is undervalued or overvalued. While many investors like to use the price-to-earnings metric to look at valuation, book value is a better metric for banks because it more accurately measures the value of a bank's assets than the P/E ratio.

Right now, it is uncommon to see a bank trading below book value in this region because of the thriving economy and low rate environment. That's usually a boon for the type of small business lending that smaller banks tend to excel in.

Out of the 12 bank stocks in and around Boston with a market cap above $200 million, the average price-to-book value multiple is about 1.5. But Berkshire and Century are trading slightly below book value.

The other Berkshire

At $13.5 billion in assets, Berkshire Bank is the second-largest state-chartered bank in Massachusetts. It has made a number of acquisitions in recent years and positioned itself as the first regional bank to enter Boston in more than a decade, with a funky geographic footprint that includes branches in Massachusetts, Rhode Island, Connecticut, New Jersey, New York, Vermont, and Pennsylvania.

Part of the reason the bank's stock trades at current valuations is that it spent much of 2019 in transition mode. The bank's acquisition-hungry former CEO Michael Daly abruptly resigned at the end of 2018 due to what one analyst referred to as a "toxic" workplace culture. That, coupled with a few unusual loan writedowns, depressed earnings and hurt investor sentiment.

New CEO Richard Marotta has made it clear that the company is shifting out of growth mode and planning to focus on profitability going forward. The bank has made several large acquisitions for its size resulting in merger and acquisition (M&A) expenses in almost every quarter over the past few years. The good news is that the bank could finally see zero M&A expenses on its book sometime this year.

However, Berkshire's main challenge is that it currently has more than $1 billion in borrowings. Typically, banks prefer to attract deposits rather than borrowing money, but Berkshire has had difficulty bringing in deposits. However, the bank has made some progress in this arena, already having brought down its total borrowings by roughly $500 million through the first nine months of 2019.

The question going forward is whether Berkshire can find a way to attract more deposits to fund its loan growth. Yet with a new headquarters in Boston and top deposit share in Worcester, Massachusetts' second largest city, Berkshire has some good prospects for growth.

North of the Charles

Century Bank has been a family-run bank since it began in 1969, and operates the bulk of its franchise right next to Boston in prospering cities like Cambridge, Somerville, and Medford. The bank has been profitable quarter after quarter, with record earnings in its most recent period and an extremely clean balance sheet.

The main reason why Century is trading at a low valuation is its small loan-to-deposit (LTD) ratio. Essentially, Century has the opposite problem as Berkshire: It has more deposits than it can loan out to customers. At just 55%, Century's LTD ratio pales in comparison to a lot of competitor banks in the area that currently have an LTD close to or exceeding 100%. This means the bank is having a tough time originating loans at a time when it should be easy because of low rates.

However, there are signs of improvement in this key metric. The bank has increased its LTD from 51% at the end of 2018 and also announced that it is planning to open its first ever out-of-state branch in New Hampshire, suggesting growth is on its mind. Another thing to consider is that Century Bank's largest lending segment is commercial and industrial lending, or equipment financing. This segment across the country struggled in 2019, partly due to trade friction with China. Confidence in C&I lending is much higher going into 2020, which could bode well for the bank.

Take a closer look at the small bank sector

Small-cap bank stocks can be hidden opportunities. One important consideration for a small bank with a diversified lending portfolio is the geographic footprint that a bank operates in, as overall economic conditions will influence how that bank performs. Berkshire Bank and Century Bank are rare value plays in a strong market because, even with their struggles, they have built up a solid base over many years with the infrastructure needed to execute upon strategic initiatives.

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