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  Lackluster and loving it

BENJ GALLANDER and BEN STADELMANN

Friday, October 10, 2014

One pattern we have noticed with many stocks in our portfolios is they progress through three distinct phases. In the initial stage, companies in deep contrarian territory recover sharply off their lows. As the prospects of bankruptcy and ruin recede, selling abates, shares rebound and the fundamentals move from a critical to a more stable condition.

This is often followed by a second period, where the price meanders back and forth, making little advancement and trailing the overall market. Yet a look under the hood reveals significant upgrades in operations and prospects. Revenues grow, net income expands, margins rise, the balance sheet strengthens, management initiates share buybacks or dividends, and analysts start to cover the company again.

During the final chapter, stocks often ramp up smartly, the earnings multiple expands, institutional investors jump back in, rosy analyst outlooks reappear and media coverage shines. As often happens, the company hits the target price and we take our winnings and move on to the next needy and unloved candidate.

Currently, our U.S. regional banks are in phase two. The post-crisis recovery from 2010–2013 provided a powerful assist to our portfolio returns. But so far this year, these financials have been treading water or have stumbled, even though, by our way of thinking, they have shown significant improvements.

Bank of Commerce Holdings, for example, is down 7.2 percent on the year. Despite this negative performance, the company's balance sheet has improved, revenue and earnings have picked up, the capital ratios have strengthened and deposit growth has been solid. Insiders have been buying and valuation metrics are more attractive.

This trend has also occurred at Suffolk Bancorp, Fidelity Southern, Macatawa and First Busey. All of these banks have slipped in 2014, but financial results continue to impress and their capital ratios have strengthened.

Suffolk, Fidelity and Macatawa all reinstated a dividend. Though the yields are nothing to write home about, the payout ratios are also modest, and we reckon that future dividend increases will propel them higher. First Busey maintained a dividend through the dark days and bumped it up by 25 percent earlier this year.

Our conclusion is simple: though fundamentals win out in the long run, it is investor psychology and changing shareholder ownership that are the primary forces driving stock prices in the shorter term.

In the depths of the financial debacle, buyers were hardcore contrarians with strong stomachs and a high tolerance for risk. Then the speculative trading crowd got excited, playing the rebound. As the opportunity for "easy money" dwindled, those folks moved on, but the mainstream isn't quite ready to take over. Without a solid constituency of buyers, a period of listlessness and tedium follows.

With fundamentals improving and risks diminishing, one could argue that these enterprises are now a better buy, even though they are no longer cheap. Although the sector is no longer strictly contrarian, we have continued to augment our holdings in the sector. In our view, there is still plenty of upside once stage three gets underway.

When might that be? We don't know, but we suspect that consolidation has a ways to run yet. In the meantime, we are happy to hold and harvest the dividends as they grow and roll in.


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