Bluestone Financial: Small-Cap Bank Bets

07/29/2015 10:00 am EST


Jason O’Donnell, CIO of Bluestone Financial Institutions Fund, discusses this hedge fund that invests in micro-, small-, and mid-cap community banks, the strategy's fundamental bottoms-up analysis approach, and several banks that meet the fund's criteria.

Steven Halpern:  Joining us today is Jason O’Donnell, CIO of Bluestone Financial Institutions Fund, a hedge fund that specializes in small- and mid-cap community banks.  How are you doing today, Jason?

Jason O’Donnell :  I’m doing great.  How are you?  

Steven Halpern:  Very good.  Thanks for taking the time.  First, could you give our listeners some background on Bluestone Financial?  

Jason O’Donnell:  Absolutely. Bluestone Financial is a hedge fund.  The strategy was launched about three years ago—about two-and-a-half years ago—and was opened to outside investors about six months ago. What we do is we invest in micro-, small-, and mid-cap banking institutions throughout the United States.  

The fund is very much a fundamental bottoms-up analysis approach to investing.  We maintain a relatively small number of positions, around 15 to 20 companies, so you can know them very well.  It’s a very plain, vanilla strategy in the bank space.  

Steven Halpern: Now, looking at the overall sector, you see a number of factors such as M&A activity, low credit costs, and strong asset quality that you feel will drive the community bank sector higher in 2015 and beyond.  Could you expand on this?  

Jason O’Donnell:  Sure, happy to.  There are a number of factors that are driving the bank space to outperform and we expect those factors to continue to drive the space to outperform.  If you look at what’s happened just over the last three months, we’ve seen a big gap between the way the bank market is performing and the way the Russell 2000 and other small-cap banks are performing, you know, a big diversion in a good way for the bank space.  

Those factors you mentioned are critical.  On the bank-on-bank acquisitions front, there’s a lot of activity happening now.  The pace of acquisitions is up around two-fold just over the last couple of years.  

What that means is it’s good for investors.  It’s good for investors that own banks that are selling, obviously, for big premiums, but it’s also good for investors that own banks that aren’t sellers.

Many of these banks are experiencing a higher valuation multiple as a consequence of stronger bank-on-bank acquisition activity.  On the credit side, on the credit quality front, asset quality and credit quality has been very, very strong.  

What’s really interesting here is we’ve got...we're at a real place in terms of fundamentals where capital relative to credit costs, that ratio has never been higher historically in the bank space.  

We’ve got very high levels of capital relative to the amount of credit costs that are being experienced, and so, this is an industry that’s well-positioned and well-capitalized to grow going forward.  

I think the third piece, which you didn’t mention, which is critical, is interest rates. Interest rates by all accounts at this point seem to be heading higher; we’ll see what happens with the advanced GDP number that’s released at the end of this month, which will be critical.  

If everything continues to go in the right direction here over the next couple of months, our expectation is that interest rates will be raised for the first time in several years in September and that’s going to mean very good things for valuations for these banks.  

These banks are very levered to interest rates, and as the yield curve shifts up in a parallel fashion, we expect earnings growth rates for banks to go from somewhere around 9% or 10% to somewhere closer to 12% or 13% just for your average banking institution.  


Steven Halpern:  Now, interestingly, you emphasize the importance of direct contact between management and the investment community and others such as yourself. In fact, you suggest that you won’t invest in a bank if you don’t have access directly to the CEO.  Could you explain why this is such an important factor?  

Jason O’Donnell:  Well, lines of communication and having to maintain lines of communication with executives and with the banks that we manage in—that we invest in rather, excuse me—that’s critical.  We read the 10-Qs, and the 10-Ks, and the regulatory filings, and we do all the things that other investors do.  

We also go out to conferences and meet with these management teams, but it’s really important for us to have communication—lines of communication—open outside of those conferences and things, because as a bank puts out an A-K, often times what we find is the devil is in the details.  

Often times those details aren’t necessarily disclosed, or if they are, it’s not clear what they mean.  It’s critical for us in order to generate alpha in the market, and to be able to really outperform the market, to have superior information.  

Now we only own 15 to 20 companies at a time, so that gives us the luxury of being able to really hone in on our relatively small number of companies and know them better than the Street.  

Part of our process focuses in on really getting to know—on a personal level to some degree—the CEOs, the CFOs, the COOs—that are the chief operating officers, the chief financial officers of these companies—so that we can best position the portfolio for outperformance.  

Steven Halpern:  Let’s look at a few investment ideas that make the grade, so to speak, in terms of the community banks you like. One is Bank of the Ozarks (OZRK). What’s the attraction here?  

Jason O’Donnell:  Well, Steve, we invest in three different types of stories.  We like growth stories, we like turnaround stories, and we like takeout stories, banks that are positioned to sell themselves, potentially.  Bank of the Ozarks is in that growth category.  

This bank has about $9 billion in assets.  They are about $3.5 billion in market cap, roughly, so they’re solidly a mid-cap bank, although they’re really more of a community bank in many respects.  

They have a footprint throughout the Southeast.  They do have a little bit of a presence in New York.  What we like about them is they’re growing earnings at around 20% organically, which is obviously a very high level of growth, certainly in the bank space at least.  

They’re doing it through, primarily, commercial real estate and business loan lending. They’re doing these very complete commercial real estate and business loan deals that a lot of the other larger banks aren’t going to do because it doesn’t check all their boxes neatly.  

They’re really taking share from the larger banking institutions in the country and growing earnings organically at a very fast rate.  They are also participating in the whole bank M&A market and that bank-on-bank acquisition activity that I referenced.  


They are a participant in that on the buyer side.  We expect them to announce in transformative acquisitions sometime in the next 12 months, it’s going to take their franchise somewhere around $8.5 billion to $9 billion in assets up to somewhere, probably, in the neighborhood of at least $12 billion or $13 billion or more in assets, which we think is going to be very rewarding for shareholders.  

Steven Halpern:  Now, a less well-known name that you like is Peapack-Gladstone (PGC).  What’s the story here?  

Jason O’Donnell:  Sure, so PGC is a much smaller name.  The market capital is somewhere around $350 million, assets of around $3 billion.  It is not as well-known as Bank of the Ozarks.  It is a turnaround story.  It fits into that turnaround bucket I mentioned.  

This is a franchise that really didn’t do much from a shareholder value creation standpoint, certainly not during the financial crisis, nor since.  Over the last couple of years, though, there’s been a change underway.  Doug Kennedy is the CEO who has been hired.  He was brought in a couple of years ago.  

What these guys are doing is generating significant EPS growth and they’re growing kind of around that 20% EPS growth level.  They’re hiring lots of lenders and new talent.  Doug has grown his group from private bankers—is what they call them—from three just a couple of years ago up to around 35, or so, today.  

This is a franchise that’s growing at a very high rate.  It’s not as expensively priced as the Bank of the Ozarks.  It’s much cheaper. Trades at 135% of the annual book value, which is relatively inexpensive for a growth story, and around 15 times earnings for next year, and it’s very compelling, just given how undervalued it is.  

Steven Halpern:  Now, finally, you highlight Sun Bancorp (SNBC).  Could you share your thoughts on Sun?  

Jason O’Donnell:  Sure; Sun Bancorp fits into that third and final category I mentioned as a seller or potential takeout candidate in our view.  Sun Bancorp is located actually in the southern half of New Jersey.  Peapack-Gladstone, by the way, if I didn’t mention it, is actually in the northern half of the state.  

Sun has historically underperformed the bank space and its peers by a wide margin for a long time, as long as I can remember.  This is the scenario where shareholder value has been lost in a big way over the last several years or more.  
Management was changed, Tom O’Brien from State Bank Corp.—which he sold to a bank called Valley National just a couple of years ago, or so—he was brought in last year in July to turn this institution around, to get it back to profitability.  

He was successful in doing that.  They turned the breakeven corner in the first quarter of this year.  My expectation is that these guys are going to re-recognize their deferred tax assets at some point next year.  

I expect them to turn around and sell the bank at some point next year for a meaningful premium, and so, this is one that I expect to be a seller here in the next 12 to 18 months.  

Steven Halpern:  Again, our guest is Jason O’Donnell of Bluestone Financial Institution Fund.  Thank you so much for your time today.

Jason O’Donnell:  You’re welcome.  Thank you, Steven.  

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