Backwoods Straight Arrows

11/09/2009 1:00 pm EST

Focus: STOCKS

Roger Conrad

Founder and Chief Editor, Capitalist Times

Roger Conrad, editor of the Utility Forecaster and associate editor of Personal Finance, recommends two smaller banks unscathed by the industry's excesses.

From June 2007 peak to March 2009 nadir the S&P 500 Financials Index plunged 82.5%. Despite nearly tripling since the bottom the typical big bank is still off 58% from the halcyon days.

With nearly 100 failures thus far in 2009 and the federal government still a large shareholder, the industry is hardly out of the woods now. Last year’s bailout plan remains deeply unpopular. Additional shocks to the system are possible, from rising unemployment, surging mortgage and credit card defaults and the sliding value of US commercial property.

The good news is odds of a late-2008-style systemic collapse are increasingly remote. After more than a year of unprecedented intervention, monetary authorities know where remaining weakness lies. And they stand ready to commit whatever taxpayer funds are needed to seize insolvent institutions and keep weaker ones afloat.

More important, the lending environment has thawed dramatically since the dark days after Lehman Brothers fell. Investment-grade corporations and better-capitalized investors are borrowing at the lowest
rates in a generation. That’s the result of low Treasury yields combined with the lowest risk spreads since early 2007.

Businesses’ access to capital markets has in turn taken pressure off banks. And despite the weak economy, the industry is rapidly recapitalizing. Giant JPMorgan Chase (NYSE: JPM), for example, reported an improvement in its third quarter 2009 Tier 1 capital ratio—a primary measure of banks’ strength—to 10.2% from 8.9% a year ago.

Smaller regional and community banks have once again proven their ability to ride out industry crises. Upstate New York-based regional bank Arrow Financial (Nasdaq: AROW ) is growing deposits and its low-risk loan portfolio while holding nonperforming loans to just 0.32% of total loans.

Arrow’s key competitive advantage is its ability to build relationships with individual customers. Under-the-hood knowledge helps it pinpoint risks that larger banks are too big to identify. That, plus notoriously conservative management, which largely avoided subprime and other lending frenzies, promises to keep the bank on the right track in coming years.

Management boosted the cash dividend 4.2% over the past year and paid a 3% stock dividend. Buy Arrow Financial up to 28 if you don’t already own it. {Shares closed at $25.49 Friday—Editor.]

Penns Woods Bancorp (Nasdaq: PWOD) is a smaller, higher-yielding version of Arrow, operating in rural Pennsylvania. The bank grew deposits 13% and its loan portfolio 5.3% during the 12 months ended June 30, 2009.

Nonperforming loans to total loans remained at a low 0.68% thanks to laser-like focus on customer relationships and risk management. Interest expense was cut 15.1%. Not counting a loss on the value of securities held, earnings per share covered distributions by a comfortable 1.26-to-1 margin. Penns Woods Bancorp is a buy up to 35. [Shares closed at $31.51 Friday—Editor.]

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