Small Banks Dodge Woes of Their Big Competitors
Analyst John Kline loves UCBH Holdings Inc., a San Francisco bank that caters to Chinese immigrants, but he felt compelled to downgrade the stock last week. The problem: UCBH has so many admirers that its shares are up 400% in three years.
“The business fundamentals are impeccable,” said Kline, who follows banks and thrifts for Sandler O’Neill & Partners in New York. “But you have to wonder if they have gotten ahead of themselves” in terms of their stock price.
The price of success is an issue today for smaller banks, which, protected by their specialty niches, generally have weathered recent economic storms far better than big national and regional banks.
An index of small-cap banking stocks climbed 30% during the last year, compared with a loss of about 1.6% for an index of large banks, in part reflecting a general shift by investors weary of tech flameouts and accounting scandals.
“Small-cap value stocks are where the action has been all this year and part of last year,” said Floyd Coleman, portfolio manager for the AXA Rosenberg small-cap funds, whose holdings include East West Bancorp Inc. of San Marino, a rival to UCBH for the ethnic Chinese market.
Smaller financial institutions dominated a recent U.S. Banker ranking of U.S. banks and thrifts that considered return on equity, capital, and changes in profits and stock prices.
J.P. Morgan Chase & Co., the nation’s second-largest bank, came in last; No. 1 was Doral Financial Corp., a Puerto Rico bank that is expanding rapidly in Florida and New York.
These small banks tend to focus on specialty markets--in Doral’s case, mortgage lending to Latinos. And they generally avoid buying into the huge syndicated loans the industry makes to giant corporations--a specialty that got Morgan in trouble when companies such as Enron Corp. hit the rocks.
Few have been involved in investment banking, high-risk lending to tech firms or venture capital deals, enterprises that soured last year at many larger institutions. Some big firms, notably Citigroup Inc. and FleetBoston Financial Corp., also lost heavily when Argentine loans and bonds went into default.
Providing More Personalized Service
The result is what Kline calls “a reverse image in the mirror” from 1998 and 1999, when larger banks were the stars, expanding into new markets amid financial deregulation and excitement over the “new economy.”
“Despite the strengths and many services large banks provide, there’s a huge demand for institutions that are close to local customers and more flexible,” Irvine banking consultant Norman Katz said.
Big banks may be tempted to regard the smaller fry “the way you think of a gnat or a mosquito--as an irritant,” Katz said. But the highly touted attention that Wells Fargo & Co., Bank of America Corp. and others now are paying to the huge Latino market indicates “in some cases they see these niche players as viable competitors.”
To be sure, retail giants such as Wells and BofA provide a huge range of services to customers. The smaller banks must contract with outside vendors to provide many of these services, and they can’t match some, such as extensive ATM networks.
Yet small banks have been able to keep profits growing by charging higher fees for more personalized service in niches such as small-business lending, industry specialization or affluent individuals, or by catering to specific ethnic groups.
One standout niche these days is the Asian American market. Shares in UCBH, the parent of United Commercial Bank, and East West Bancorp have risen more than 40% over the last year. Cathay Bancorp Inc., the oldest bank in L.A.’s Chinatown, is up nearly 50%.
During two decades of quiet expansion off the radar screens of most investors, Cathay and East West have opened Northern California branches and UCBH has expanded into Southern California. More recently, the Asian banks have been opening offices and buying banks in other states and countries.
Expansion outside home markets is “definitely the trend to watch,” said Martin Friedman, director of research at Friedman, Billings, Ramsey & Co., an investment banking and money-management firm in Arlington, Va.
“We’ll have to monitor it to see if they can reproduce the quality outside their natural markets. But it’s a good business concept in general--to take what they’ve learned from serving their niche and transfer it to other areas.”
Cathay Bancorp, for example, has offices in Taiwan, Hong Kong, Texas and New York, as well as 12 Southern California and seven Northern California offices. In January, it won Chinese government approval to open a representative office in Shanghai.
Twenty years ago, the needs of Cathay’s customers were concentrated in the immediate area, said company Chairman Dunson Cheng.
“Now 90% of our commercial customers are doing business nationwide,” Cheng said. “It’s not unusual for them have branches in Houston or New York City, so we have to follow them.”
Cathay, whose specialties include foreign trade financing, has seen its profit grow at an average annual rate of more than 26% since the last recession ended in 1995, including a 10% gain last year as the economy slowed and terrorists struck.
Its assets have grown to more than $2.5 billion--five times more than what the government considers to be a community bank, though still dwarfed by mainstream giants such as San Francisco-based Wells Fargo ($300 billion in assets), or even business and private banking specialist City National Corp. in Beverly Hills ($10 billion in assets).
Last month Cathay announced a 2-for-1 stock split, effective Friday, and a 12% dividend increase--actions that should help attract new buyers to a company whose stock has been thinly traded, with little analyst coverage.
Cathay May Be
a Takeover Target
The stock has proved volatile of late, rising from a split-adjusted price of $36 on April 9 to more than $45 during trading Monday, before dropping back to close Friday at $42.70, down 43 cents, on Nasdaq.
Joe Gladue, an analyst who follows companies run by minorities and women for Chapman Co. investment bank in Baltimore, said the latest dip probably was triggered by investors collecting profits after all the positive news.
Gladue, who rated Cathay a “buy” in October when it was trading at about 40% below its current price, recently downgraded it to “hold” as the stock price jumped. “I think the company will continue to perform well,” he said. “I just thought it had gotten too high.”
Kline, the analyst who downgraded UCBH from “buy” to “outperform” for similar reasons, offers another possible explanation for Cathay’s volatility.
He believes some investors are speculating that Cathay, which acquired First Public Savings Bank of Los Angeles in 1996 and Golden City Community Bank in New York in 1999, may have become a takeover target itself.
If so, it would be the second longtime minority-owned bank up for grabs recently in Los Angeles. Black-owned Family Savings Bank in South Los Angeles began entertaining offers recently after the group that controls it ran into financial trouble.
The bidders include Los Angeles-based Founders Bank of Commerce, which last year merged with Boston Bank of Commerce to form the nation’s first bicoastal African-American bank
Kline said that in Cathay’s case, the logical acquirers would include East West and UCBH, each of which has slightly more assets than Cathay but more than twice the market capitalization--an indication of investors’ high regard for them.
A key statistic on loan quality shows why. One quick way to judge a bank’s strength is to check the percentage of its loans that are in default: anything under 1% of all loans and other investments is generally considered strong.
Cathay’s percentage of these so-called nonperforming assets was an enviably low 0.36% at year end, but East West beat that handily with a 0.21% ratio.
And at UCBH, the figure was 0.03%, a testament to careful lending and to the willingness of borrowers to ensure repayment by living “a step below their means instead of a step above,” as UCBH chief financial officer Jonathan Downing puts it.
Banks such as East West and UCBH have been generating more than 25% annual earnings growth in recent years, compared with 13% to 15% at well-performing big banks, said Campbell Chaney, a bank analyst for Sanders Morris Harris in San Francisco.
Word is Out About Small Banks’ Stock
East West and UCBH enjoyed growth spurts after going public in 1998, but Chaney thinks they can continue to increase earnings at a 15% to 20% rate.
The small banks understand every nuance of Chinese culture, he said, and the Asian segment of the population will continue to be the fastest growing in California.
The downside for investors is that the word is out, so “it’s getting tougher and tougher to find” attractive small stocks, Chaney said.
He recently upgraded East West, saying the bank was controlling costs better and hadn’t moved quite so far as UCBH, which he downgraded as too expensive.
But Chaney and others think investors looking for value may have to consider bigger banks, such as UnionBancal Corp. and Zions Bancorporation.
One tough choice as these banks expand is whether to keep playing to their current strengths or to try to keep their core clientele while going mainstream.
Affluent Counties Remain ‘Underbanked’
The latter strategy has become familiar in recent decades to customers of many Japanese-owned banks, but the classic model was set by A.P. Giannini, whose San Francisco bank started by catering to blue-collar Italian immigrants and became Bank of America.
The Great Depression created opportunity for Giannini by reducing the number of U.S. banks from 64,000 to 31,000.
Ed Carpenter, head of a boutique Irvine investment bank catering to small financial institutions, sees a similar opportunity for small banks today.
Carpenter notes that 53% of the institutions operating a decade ago in California have been submerged in waves of consolidation.
Many of the state’s most affluent counties, among them San Diego, Orange, Santa Clara and Santa Cruz, are among the most “underbanked,” he said.
“This disappearance of banks ... allows anyone offering high-level services and deployed in a local branch system to have very much the same opportunity as Giannini after the Depression,” Carpenter said.
