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Home > The Sophisticated Investor - Articles & Interviews > Interview with Doug Hughes of The Small Bank Newsletter

Take it to the bank.

Interview with Doug Hughes of The Small Bank Newsletter
We sat down with Mr. Douglas Hughes, the Senior Editor of the Small Bank Newsletter, one of the all-time top performing investment newsletters published. Still picking winners while conservatively managing risk Mr. Hughes discusses his investment strategy, trends and even gives us a recommendation.

How did you get into the business?
We started the newsletter about 15 years ago. We just saw a niche for the banking sector. It was extremely undervalued and there were deals happening for the last fifteen years, and we felt there would be deals for another 15, and then another 15. It was basically just tremendous opportunities in the sector where stuff was selling at half price, liquidation value. Thatís how we started out. Itís a pretty simple business to understand, not too complicated, and well regulated. Most of the banks pay stock in cash dividends so all that attracted us to the sector as well.

You picked small banks because those were the undervalued ones?
Correct, and theyíre easier to understand. You can talk directly to the management. You can find out if the guy is a smart guy or not in five minutes versus trying to get a hold of the President of Citibank, you canít actually go meet the guy with one dayís notice, like you can in most small banks.

Is there a continuous supply of small banks to invest in?
It is like a never ending cycle. 200 banks will get taken over this year and then another 100 or 200 will start up. We probably lost half the banks in the last 20 years, and the next 20 weíll probably lose another half. Weíre not going to go to ten banks or five banks like in Canada. We are probably going to go from 8000 banks to 3000.

Where would you see the market going over the next 5 years?
Same consolidation trends but basically most of the new banks are starting in the high growth markets, Georgia, Florida, Vegas and we would say that is where the money is to be made and thatís where the earnings growth is and thatís where the banks are getting bigger multiples times book and earnings. It seems that is where the better bankers are going because they know they can build a franchise that can be worth a lot more in certain parts of Florida than it can be in upstate New York where the economy continues to slowly die. Thatís the opportunity. You got to have the smart management but you got to be in the good markets. And itís certainly not as easy today as it was three or four years ago. So there are a lot more banks opening in the hot markets, everybody thinks they can make money. Getting good people to help you run it is definitely the problem.

Your letter covers domestic banks. Do you cover any banks overseas?
Once in a while weíll go to Canada, we did that once two years ago. But we just tend to stay with the small banks in the US.

Do you have any bank recommendations right now?
The newest one Iím putting in is CLBK, itís a Commercial Bankshare of Florida. I am recommending to accumulate it below 33.

So this is your typical well managed small bank in a great growth area? Pretty much. Itís been around a lot. Itís not three years old. Itís very well seasoned. Itís just over a billion dollars. Itís got a perfect asset quality which is obviously very important in todayís world because who knows where real estate is going to go. The management is very strong, no bad loans, very conservative bank, and in some of the fastest growing markets, Miami, Dade County, Florida, these are upsides where they can really scale cost into their earnings power here and earnings are going to continue to come through. If itís taken over, it has at least a 30% upside in a takeover value. And a couple of the guys there, the top two guys are getting up in age, both almost 70. You see thatís an age where they look at selling. Insiders do own over 15% of the stock which is another good sign. You see thatís a good amount that is not too much where they donít sell ever, where it passes down from generation to generation. Just enough that they have a sizeable interest that they will sell or hold out for a very good price and there are obviously not many banks of that size in that market and the much smaller ones have been selling for 2.5 to 3 times book. Thereís no reason why this one shouldnít get the same price since itís a better bank.

Do you have any opinion or any concerns about the Federal Reserve chairman, Bernanke? Most of the banks [we recommend] are in the commercial banks, we are not into thrifts. They continue to make more money as rates rise. So a steady rise of rates that the Fed is telepathing for them, cause these banks to make more and more money. And the Fed has never made it more clearer or more fairer in the past 20 years as exactly what theyíre going to do and in the past few years, theyíve done exactly that. Now if they change their path and go drop rates a half or raise them three quarters or a point at once or something, obviously that could hurt some of the banks. But if they stick to what they said they were going to do, which so far they have, the banks will generally make more and more money. Obviously when the rates get to a certain point, growth is going to get hurt. But right now the banks are in the best shape theyíve ever been. But many banks are extremely overvalued. You definitely have to look very hard and be very careful and make sure that you buy at the right price.

Do you think the fast rises in Real Estate prices pose any risk to the banking industry?
Thereís definitely some risk, especially in the thrifts, the ones that lend the residential real estate, and like I said, they are the ones that are getting squeezed on their margins more. Weíre not really in those except for a couple on a case-by-case basis. But, sure we think real estate could collapse in a handful of the markets anywhere from 10% to 50% over the next one, two, three, four, five years. I mean who knows when itís going to end. But, I called the top in real estate you know, three years ago, so I would say I was wrong in some of these hot markets. Itís definitely slowing down, inventories are definitely building, and prices are coming down in some markets, and with the inventory building, in many, many markets, thatís usually always a sign that the prices are going to drop; itís just a matter of time. And the higher the rates go and the more the inventory builds the faster the prices will drop. Everybody remembers October of Ď87 the market crashed, real estate prices also dropped 20% to 30% that day in hot markets, and yields just felt apart by the window. So that could easily happen again after stock market crashed or oil prices went to $100 a barrel or we went to some other kind of war or terrorist attack, I mean thereís a handful of reasons that could cause a collapse of the banks and the market.

About The Small Bank Newsletter.
Every month you'll receive new buy/sell and hold recommendations. Mostly these are small banks which are not followed, resulting in big gains -- usually paying 1-4% dividends with limited downside risk. Our average hold time is 3-5 years. Lately it has been much shorter due to the strong market. Each month we personally speak to the management in over 100 banks and find the best values for the greatest returns. Some of our current members include Fidelity Investments, Second National Bank, numerous bank board members and brokers from all major firms. Doug Hughes was educated at Pace University in New York, studying both Finance and Economics and is currently residing in New York. Mr. Hughes' highly successful approach is based on the search for undervalued securities to invest in, while managing risk to produce superior gains over the market averages. He simply looks for businesses whose financials can be easily understood and which he can buy at bargain prices. In the current market there are many attractive situations.

Mr. Hughes also manages money for individual investors and companies specializing in smaller and mid-size regional bank stocks. Mr. Hughes currently has over $50 million in assets under management, and has been investing in the small bank sector for over 20 years.

About Small Banks.
Banks earned more in the last 6 years than they did between 1960 and 1990. Not many investors can turn away from this. Many small, under-followed banks have only 1-8 million shares outstanding -- which should produce strong returns. These small banks also tend to be prime candidates for stock splits and buyouts. The spread is usually Ĺ point to 2 points, so these stocks are not for traders.

You have two kinds of bank stock investors today: people who like the bank business and those just discovering them because of their performance e. Banks today are buying back stock, increasing cash dividends and paying stock dividends. This really adds up over the long run in creating value to shareholders. They continue to provide moderate growth and low valuations relative to the broader market. To date, banks have over 250 different fees. This has increased from around 90 fees in 1990 and now account generally for 30% or more of most banks' earnings.

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