Q4 2018

Equity markets, and bank stocks in particular, were down substantially in the fourth quarter and for the year. As a reference, the KBW Bank Index (representing large cap banks) was down -17.7%, the NASDAQ Bank Index (which consists of domestic and foreign bank stocks traded on NASDAQ) was down -16.2%, and Community Bank Stocks were down -16.5% (as measured by the First Trust NASDAQ ABA Community Bank ETF) during 2018.

Geopolitical events as well as economic concerns rattled the markets in the fourth quarter leading to the equity market declines. In December, the US Federal Reserve Bank increased its short-term interest rate (The Fed Funds Rate) for the fourth time in 2018 and the ninth time this tightening cycle. This increase, combined with the decline in the yield of the ten year US treasury rate (from 3.2% in October to 2.7% currently) has resulted in a “flat” yield curve. Concerns over compressing Net Interest Margins have caused a decline in bank stock valuations and presented us with an opportunity to make new investments at low premiums to book value. With the increased volatility in the markets, expectations for additional increases in The Fed Funds Rate for 2019 have declined.

We have focused on the ability of our banks to maintain profit margins and grow earnings and dividends.
Of the top ten banks we held at year-end, nine raised their dividends during 2018, by an average of 13%. In spite of the volatility in the market, we expect this trend to continue in 2019.

Portfolio Strategy

We continue to find attractively priced Community Banks that we expect to grow earnings and dividends. The recent decline in bank stock prices has resulted in new investment opportunities and we have added new names to our portfolio, including:

First National Bank of Long Island (FLIC): FLIC is a $4.2 billion asset bank that has been serving businesses, professionals, consumers, and public bodies in Long Island and the New York City boroughs since 1927. We recently met with management and discussed their growth plans, which include expanding their branch network in Queens and Brooklyn. We like the Bank’s strong deposit franchise, with 30% of its deposits in noninterest bearing accounts, which we expect will help keep its funding costs low. The Bank is in a high growing economic area, with good demographics, and has the ability to make additional commercial loans.

Management is focused on earnings growth, and the maintenance of a strong balance sheet. FLIC has consistently increased its dividend and recently announced a $20 million stock repurchase program. We think the risk / reward profile is attractive as FLIC offers a 3.3% dividend yield and trades at only 12 times expected 2019 earnings.

Q3 2018

Domestic equity markets persisted upward through quarter end, and broader markets had been mixed as follows:

Financial sector performance was also mixed:

We are monitoring the interest rate environment closely as it impacts the yield banks will earn on their loans and the rate they offer on deposits. During the quarter, long-term interest rates continued to rise: The ten year US Treasury yield has risen to almost 3.2%, a level not seen since 2011. The US Federal Reserve continued to increase its benchmark, short-term interest rate (Fed Funds Rate) for third time in 2018. This brings it up to a range of 2.00% to 2.25%. Market expectations are for one additional increase in December of this year, and three more in 2019.

Portfolio Strategy

We continue to look for well managed Community Banks that pay attractive dividends and offer upside potential. We highlight the following investments:

Citizens Community Bancorp, Inc. (CZWI). Citizens is the holding company of Citizens Community Federal N.A., a federally chartered bank based in Wisconsin, with 22 branches in the area. In June, we purchased mandatorily convertible preferred stock in Citizens, which was converted into common stock in late September (now tradeable on NASDAQ). Citizens used the proceeds from the convertible private placement to acquire United Bank (a community bank also located in Wisconsin), which will make Citizens the largest community bank by total assets headquartered in its market.

MainStreet Bancshares, Inc. (MNSB) operates six branches and is headquartered in Fairfax, Virginia, offering a fully integrated online and mobile banking solution. MainStreet is positioned in one of the most favorable demographic areas in the U.S. (northern Virginia) in terms of per capita income and has a track record of performance after previous capital raises. In August, we participated in a capital raise and expect the proceeds to be used to bolster regulatory capital ratios, for organic growth, and potential acquisitions.

Q2 2018

Portfolio Strategy

We are monitoring the interest rate environment and its impact on bank income statements. In June, the US Federal Reserve increased the Fed Funds rate again to a range of 1.75% to 2.0%. Expectations are for two further increases in 2018, with the next hike coming at its September meeting. As short term interest rates rise, we are evaluating our banks ability to increase the rates they receive on loans to offset increased interest payments on deposits.

We continue to find value in community banks. As we progress in the economic cycle, our opportunity set includes funding strong management teams to pursue acquisitions. We recently took part in a capital raise for a Wisconsin bank, used in part to fund an acquisition and in part to build capital for future acquisitions. We anticipate more of these investment opportunities as the wave of bank mergers and acquisitions continues.

Q1 2018

In March, the US Federal Reserve increased the Fed Funds rate by another quarter of a percent. This brings its benchmark rate up to a range of 1.50% to 1.75% and market expectations are for two or three additional increases in 2018. With interest rates rising, we are looking for Community Banks paying an attractive dividend with the potential for increases. During the quarter, eighteen banks in our portfolio announced dividend increases, with a median increase of 9.3%. While it will take some time for the boards and management teams of our Banks to see the full benefit from the recent tax reform, we think lower taxes and higher earnings will provide an additional tailwind to dividend payments this year.

Portfolio Strategy

We continue to find attractive Community Bank Investments and highlight the following:

VSB Bancorp, Inc. (VSBN):VSBN is the holding company for Victory State Bank, a Staten Island,New York-based Community Bank. Founded in 1997, Victory operates five full service bank branches, with plans to open another in 2018. Victory is also adding new business development officers, which will help to increase total assets from the current $350 million level. Victory has paid 42 consecutive dividends and recently increased the quarterly dividend payment by 25%. We increased the size of our position during the quarter.

Q4 2017

With an improving economy, improving consumer confidence, and a persistently buoyant stock market, the Financials Sector performed well. The KBW Bank Index increased 18.6% and the NASDAQ Bank Index increased 5.5% for the year. The tax reform bill, passed in the final two weeks of the year, drove equity prices and Financials in particular higher into year end. We expect the tax reform to be positive for the Financials Sector and Community Bank stocks in particular as they have domestic earnings subject to the statutory tax rate. The Community Banks we invest in will benefit from a sharp reduction in taxes paid and a corresponding increase in earnings. We believe this will allow for further dividend growth and equity price appreciation. In the short term, we expect to see some of our portfolio companies with Deferred Tax Assets announce write-downs, as it will take them longer to recoup the value of this asset. However, this will be minor compared to the benefits from lower cash taxes.

We’d like to highlight the following new addition to the portfolio in the fourth quarter:

Pacific City Financial Corp (PFCF): Pacific City is a California State-chartered bank with $1.4 billion of assets. It operates 13 branches and focuses on individuals and small-to-mid sized businesses. It is headquartered in Los Angeles, California, and has expanded to the east coast over the past three years, targeting New York and New Jersey. Pacific City initiated a cash dividend in 2015, and has increased it in both 2016 and 2017. Since initiating the cash dividend, it has also issued two 10% stock dividends, which compound the increase in cash dividend received by shareholders. We expect additional dividend increases and think there is upside to the equity valuation.

Portfolio Strategy

We continue to follow developments at the Federal Reserve. Jerome Powell was nominated as Fed Chair and has given indications that he favors a gradual rise in short-term interest rates. The Fed did hike the Federal Funds Rate by a quarter of one percent at its December meeting and we expect further increases in 2018. Powell also appears to support rolling back
banking regulations. While it is difficult to quantify the benefit to our Community Banks of
regulatory easing, what we are hearing is that the pace of hiring to satisfy new regulations has been reduced dramatically. Whether this turns into actual decreases in regulatory related expenditure is yet to be seen.

We continue to find attractively priced Community Banks, with dividends that we expect to grow. The multi-year economic expansion has left banks with strong capital ratios and a low level of troubled loans. Further, as bank stocks have risen in price, acquirers will be more willing to make acquisitions paid for with stock. We expect this to fuel the boom in Mergers and Acquisitions.

We’d like to highlight a Community Bank in which we may increase our position:

Parke Bancorp, Inc. (PKBK): Parke Bancorp is a New Jersey based bank with over $1 billion of assets. It operates 7 branches, providing personal and business financial services primarily in the Philadelphia and Southern New Jersey areas. We added to our position in the fourth quarter. Parke currently pays a 2.3% dividend yield. This cash dividend was initiated in 2014 and it has been increased 6 times since. It has also issued two 10% stock dividends, compounding the increase in the cash dividend received by shareholders. We expect additional increases in the future.