Richard Moroney, editor of Upside — which focuses on small to mid cap stocks — sees upside opportunities in the regional banking sector. Here, he looks at three well-situated regionals that earn his qualitative-based buy ratings.

Steve Halpern: Our special guest today is Richard Maroni, editor of Upside.  How are you doing today Rich?

Richard Moroney: Good, thanks for having me.

Steve Halpern: Now, most of our listeners are familiar of your role as editor of Dow Theory Forecast, the top ranked advisory newsletter that focuses on high quality, larger cap stocks.  For those not familiar with your more specialized service, Upside, could you give an overview of the newsletter and it's objectives?

Richard Moroney: Sure, Upside is designed to take advantage of some of the same things we use in Dow Theory Forecast, mainly our quantitative ranking system called Quadrix and we apply that to small and mid-cap.

What we'd learned back around the year 2000 was that Quadrix works quite well with small company stocks and in fact in some ways it works better with small company stocks because they're not as closely followed and you can get just bigger gains.  

You do get more volatility as well but the basic idea is to use all the strengths that we've developed at Dow Theory Forecast and applied them to small and mid-cap stocks and since we've started it in the year 2000 it's been quite successful.

Steve Halpern: Now, in your latest issue you did a special report on regional banks.  Now, before we look at the opportunities we see in this sector could you first highlight some of the headwinds that have been impacting regional banks.

Richard Moroney: Sure, the biggest headwind is really the compression in their net interest margins as the Fed has kept rates basically near zero percent.  

More and more of bank's loans that were at higher rates have rolled off their books as well as their investments that were at higher rates have rolled off their books.

So you've seen a steady kind of compression in the interest margin, that is the amount they're earning on their loans and investments has gone down at the same time the cost that they're paying for deposits is basically flat lining at zero so you're seeing this compression that has slowed somewhat but it hasn't stopped.  

Most of the banks are still facing -- in the most recent quarter -- were still facing lower interest margins.  You have had some regulatory costs in the wake of the financial crisis and that has been an issue for some of the regionals but it's a bigger deal for the big money center, diversified banks.

The regional banks, none of them are systemic risks.  They don't face all of the same headaches and regulatory costs that the big banks face and then earlier this year there was a fairly meaningful headwind with all the banks that had oil and gas exposure in their loan portfolio.

SSo you saw ones that were more exposed to oil and gas, investors were worried about how big a deal that was going to be.  Some did take write-offs.  With oil and gas stabilizing that's kind of; I wouldn't say it was a non-issue but the worst appears to have past.

Steve Halpern: So despite the challenges the sector has faced you also see upside potential in regional banks, particularly looking out over the long term.  What's the bullish space of this sector?

Richard Moroney: The bullish space -- in the short and intermediate term -- I would say is loan growth.  It was a strong demand for commercial and industrial loans and that's really the bullish, near term driver of profit.  

Loan demand has come back strong over the last year and many of these regional are well positioned to grow their loan portfolio by 10% to 15% recently and I see that continuing in the near term.  

Longer term, I think the biggest long term bullish play would be just that the net interest margins have really only one way to go and that's up and as the feds raises rates you're going to see net interest margins widen and that's going to be in the regular, up and down, well maybe not up and down but a regular type of march higher but I do think net interest margins are headed higher over the long term.

Steve Halpern: So turning to some specifics recommendations among the regionals.  One stock you like is Ameris Bank Corp. (ABCB).  What's the attraction here?

Richard Moroney: I would say the biggest attraction really is strong loan growth.  Loans rose 17% organically in the first half of the year so they're enjoying strong loan demand and they have about 100 branches across the south east with a pretty big exposure to commercial and contrition real estate which has been a good source of demand for them.  

I would say the other positive for Ameris is they've done a good job of making acquisitions and making those acquisitions pay and I would that you can never really predict those things but I would say they're going to remain opportunist in buying smaller banks.

Steve Halpern: Now, looking at Texas-based bank you like Independence Bank (IBTX).  Could you explain the positive case there?

Richard Moroney: This would be, I would say, a more conservative bank than Ameris Bank Corp but also the main appeal is loan growth and a reasonable evaluation.  

The bank generated 13% organic loan growth in the first half of 2016, the strongest growth coming from commercial real estate.

This is more of a broadly diversified bank with no more than 10% of it's loan portfolio in any single industry.  Not much oil and gas exposure right now although it expects to rebuild that.  

I mean, it's traded at about 5% to 10% discount to the other regional banks but it's growing much more quickly.  You do get a small yield with Independent Bank and we rank that one as a buy.

Steve Halpern: Now, among California banks you have a best buy rating on Preferred Bank (PFBC).  What's the story here?

Richard Moroney: This was kind of a neat story.  It originally was focused on serving a Chinese American community.  It's a Los Angeles censored bank though they have expanded beyond Los Angeles.  

The first half of 2016 they had 13% per share profit growth with 30% loan growth and 34% growth in deposits so just a real strong organic story there.

They've done some acquisitions too.  They recently bought a home mortgage portfolio and they've made some niche acquisitions in the past so I would expect them to be an opportunist.

It trades at about 15 times earning so, again, it's at a discount to the group and it is one of the better yielders that we have, with a yield of about 1.7%.

Steve Halpern: Again our guest is Rich Moroney of Upside.  Thank you so much for your time today.  It's always fascinating to hear your thoughts.

Richard Moroney: Sure, thanks for having me.

By Richard Moroney, Editor of Upside