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Small-cap stocks tend to be riskier and more volatile than large stocks. Do your research or consult an adviser before deciding if they’re right for you.

4 good reasons this small-cap, dividend-paying stock sector could reward contrarian investors

Jay Kaplan of Royce Funds says the timing is right for investing in shares of community banks.

  • By Philip Van Doorn,
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Jay Kaplan of Royce Funds is looking toward Main Street as an investment target: community banks.

Kaplan has co-managed the $1.7 billion Royce Total Return Fund (RYTRX) for 13 years with Chuck Royce, who has been the lead manager for the fund for more than 25 years. The managers focus on selecting stable small-cap companies that pay dividends as part of a long-term low-volatility strategy.

Royce Funds is based in New York, has about $12.8 billion in assets under management and is majority-owned by Legg Mason (LM).

A contrarian play

One reason Kaplan likes community banks for investment right now is that the subsector has underperformed. The S&P Small-Cap 600 Small Cap Index (.SML) returned 8.3% for the 12 months through March 1 (with dividends reinvested), while its banking industry group returned 4.4%. One reason banks have underperformed is that while short-term interest rates have been increasing, long-term rates haven't moved much higher. This flattening of the yield curve has squeezed banks’ profits.

During an interview on March 4, Kaplan gave several other reasons for favoring small-cap banks:

  • “The economy is still really good, so credit quality is good. That gives us some margin of safety,” he said.
  • There is an opportunity for net interest margins (the spread between what banks earn on loans and investments and what they pay for deposits) to widen. The Federal Open Market Committee changed the tone of its policy statement on Jan. 30, indicating it was less likely to continue raising short-term interest rates. This means the increase of banks’ deposit gathering expenses will slow or stop. Meanwhile, “if the economy is going to be good and to grow ... long-term rates should go up,” which means greater profit for community banks, Kaplan said.
  • “There is an out-of-consensus argument that inflation is coming,” he added. Higher inflation generally means higher interest rates. This may also “take care of that yield-curve problem,” Kaplan said.

When asked about long-term concerns from investors burned during the 2008 credit crisis that if the U.S. economy eventually slips into a recession, any bank stock would be especially risky, Kaplan said: “It is even worse now in an ETF world. [Investors] can fast-finger one ETF,” sending bank-stock prices plunging.

“My argument is there are companies with internal self-help things that may buffer some of that, or they have a track record or geography, or something interesting. But even if they are sold off by the fast-finger crowd, it can create a buying opportunity,” he said. In other words, these stocks are for investors who can not only be patient, but can also hold on for many years.

Kaplan named these three bank stocks as especially attractive:

In this table, ROCE stands for return on common equity, while RBC stands for risk-based capital.

Here’s how all three stocks have performed over the past year:

Here are comments from Kaplan about each of the banks:

Financial Institutions Inc.

Financial Institutions Inc. (FISI) is based in Warsaw, N.Y., which is near Buffalo. It is conventional wisdom to consider upstate New York to be an economic dead zone, but Kaplan said “Buffalo is growing, believe it or not.” Kaplan called the bank “very interesting, at 1.2 times book, 11 times earnings with a dividend north of 3%, so I get paid while I wait.”

Financial Institutions has been growing “by double digits,” he said. During 2018, when the company didn’t acquire any other banks, its loan portfolio increased by 12.9%.

Kaplan sees an opportunity for a significant improvement in the bank’s profitability as it shifts its balance sheet away from securities and more toward loans. “There is an opportunity in a couple of years for them to look better,” because the shift will improve the net interest margin, he said.

National Bankshares

National Bankshares (NKSH) is based in Blacksburg Va., which is also the location of Virgina Tech. “College towns are usually good places to do business,” Kaplan said.

He’s comforted by the bank’s “very strong, very low-cost deposit franchise,” as well as “a very long record of outstanding asset quality.”

If you look at the table above that lists the three banks, it shows that National Bankshares has had the lowest returns on common equity over the past year. However, this doesn’t tell the entire story. You can see that National Bankshares has, by far, the highest level of regulatory capital among the three banks, all of which are considered “well-capitalized” by regulators. This is why it has had the lowest returns on common equity.

If we were to compare returns on average assets (ROAA) for the three bank holding companies for the most recent available quarter, we would see Northrim Bancorp (NRIM) in the lead with an ROAA of 1.32%, followed by National Bankshares at 1.29% and Financial institutions at 0.94%.

National Bankshares “has way too much capital and they should be giving money back” through share buybacks or higher dividends, Kaplan said. The stock’s dividend yield is 3.18%.

“They have announced a buyback. Will they execute on that? Who knows. But if they give money back, they will be even more profitable. It is a really good bank,” he said.

Northrim BanCorp

Northrim BanCorp of Anchorage, Alaska, had the third-largest deposit market share in the state as of June 30, according to the FDIC. With low competition for deposits, the bank has “really high margins,” according to Kaplan. For the third quarter (the most recent one available for all three), the bank’s net interest margin was 4.71%, compared to 3.21% for Financial Institutions Inc. and 3.33% for National Bankshares. According to the FDIC, the aggregate net interest margin for all U.S. banks in the fourth quarter was 3.48%.

The bank is “about 10% directly exposed to energy,” Kaplan said. Weak oil prices have kept loan growth in the “low single digits,” he said, but he added: “That is OK. Credit quality is good in spite of oil prices not being good.”

Even if energy prices don’t rise significantly, Kaplan expects that Northrim “will be fine.” Meanwhile, he is pleased with a valuation of 1.3 times book and 13.4 times the consensus forward earnings estimate, along with a dividend yield of 3.17%.

Fund performance

The Royce Total Return Fund (RYTRX) has various share classes, with different expense ratios and investment minimums, depending on the relationship between your broker or investment adviser and Royce Funds. The fund’s Investment class of shares is available directly with the company or through advisers or brokers with a $2,000 account minimum and annual expenses of 1.21% of assets, which Morningstar considers “average” for its “small blend” fund category.

Here’s how the Royce Total Return Fund’s Investment shares (RYTRX) have performed against the Russell 2000 Index (.RUT) over various periods:

So the fund has underperformed the index (which, of course, has no fund-manager expenses) for all periods except for 20 years. But the outperformance for 20 years is more significant than it may appear when looking at the average performance figures. Here’s a chart showing the 20-year total return for the fund’s Investment shares against the index:

According to Kaplan, the 20-year outperformance validates the fund managers’ strategy of holding a large number of stocks of quality companies with low price volatility. This means that in a very strong period for stocks, the fund may underperform the market, but you can see it has worked out over the very long term.

Kaplan said the sharp decline in stock prices during the fourth quarter sprang from investors’ fear of a recession. “There’s no evidence of a recession,” he said, but he believes the market is still anticipating one.

If you believe we’re in for more of what we saw during the fourth quarter, take a look at this chart:

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