In this piece, we will take a look at the ten best local bank stocks to invest in now.
As investors shift their focus from artificial intelligence to the labor market and its impact on potential interest rate cuts, the banking industry of 2024 is quite different from the one in 2021. Interest rates are at a 24 year high in America as of early September, which means that not only do the costs of borrowing money increase for consumers but banks also have to carefully monitor their loan portfolios to ensure liquidity and manage insolvency risks.
One consequence of this has been a growth in private capital, which covers loans made to firms by non banking entities. According to data from the International Monetary Fund (IMF), the private credit market crossed a whipping $2.1 trillion in 2023 through its assets and capital commitments. 75% of this was in the US as investors such as pension funds and others drove to funds that offered higher returns while corporate borrowers flocked to private lenders due to the relatively simpler process of acquiring capital and relaxed risk requirements when compared to banks.
In fact, private credit is one of the best performing investment vehicles when it comes to returns according to the IMF. The fund uses December 2000 as a base value of 100 to show that as of June 2023, private credit was up to almost 800 points. In comparison, the flagship S&P index, which was also assigned an index value of 100 for December 2000, was up to roughly 460 points by June 2023, while global stocks delivered the least returns as they sat at 400 points.
The IMF believes that while the risks from this shift from local banks to private capital are not immediate, they are still important particularly due to the opacity of private capital. Private borrowers are riskier than those who borrow from banks. For instance, while the debt to operating income ratio of private borrowers is roughly 4.75, the median firm size is roughly $500 million. On the other hand, firms that rely on investment grade bonds have a median value of $16 billion and a debt to operating income ratio ranging between 2.8 to 3.6.
Shifting gears, the growth in private capital isn’t the only disruption that banks are facing. While high interest rates create the opportunity for banks to earn more through interest income, they also increase interest expenses. In fact, according to research from S&P Global, the banking sector will see some benefits from the higher rates this year as the aggregate efficiency ratio (non interest expenses/revenue) can sit at 60.30 this year for a three point gain over 2023’s 57.25. However, this might be the only good news in store. This is because the sector’s net interest margin, return on average assets (ROAA), and return on average equity (ROAE) are all expected to drop in 2024. In 2023, the three respective metrics were 3.22, 1.09, and 11.52, while in 2024, they are expected to sit at 3.18, 0.97, and 11.52.
Additionally, two other ways in which the banking industry has evolved in today’s era of high interest rates are through growth in competition for deposits and the corresponding high deposit costs. Not only did the high rates start to fully make their mark in Q4 2023 as deposits grew by 1.4% after six consecutive quarterly declines, but the difference between the Fed funds rate and the rate paid to depositors also dropped in Q4. This was because banks enticed customers by increasing their deposit costs, and the difference between the two rates had sat at roughly 3.2% in Q2 2023 and dropped to roughly 2.9% in the fourth quarter. The S&P believes that by 2026, this should sit at roughly 1% as the Fed funds rate drops to a little above 2%.
The increasing competition for deposits in banks that spurred the smaller gap has also caused large drops in the banking industry’s non interest deposits. As of 2023 end, non interest deposits accounted for 21.8% of the US banking industry’s total deposits a sizeable drop over the 28.9% figure for 2021. This fall came when non interest bearing deposits dropped by 28% over the past two years while interest bearing deposits grew by 5%. Keep in mind that the growth figure for the interest bearing deposits is lower due to their larger volume. Looking at the future, the banking industry’s net interest margin is expected to grow to 3.26 and 3.35 in 2025 and 2026 when the deposit beta falls to at least 27%.
Finally, the boon in internet usage and the accompanying growth in consumer electronics and personal computing is also impacting the banking industry. As per McKinsey, 60% of US banking consumers under the age of 70 are using digital channels for their wealth management. At the same time, some of the richest banking consumers, i.e. those aged above 70 are also increasing their use of digital banking products. This usage has grown by 5% within this age group, with the broader trend allowing banks the ability to bring their cost to income ratios below 25% and cost to asset ratios below 50%. In short, digital banking is offering banks the ability to become quite light operationally.
With these details in mind, let’s take a look at the best local bank stocks to buy according to hedge funds.
A banker closely examining a document while seated at his desk.
Our Methodology
To make our list of the best local bank stocks to buy according to hedge funds, we ranked the 40 most valuable regional US banks in America in terms of market capitalization by the number of hedge funds that had bought their shares in Q2 2024 and picked out the top stocks.
For these stocks, we have also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points. (see more details here).
10. Bank OZK (NASDAQ:OZK)
Number of Hedge Fund Holders In Q2 2024: 34
Bank OZK (NASDAQ:OZK) is one of the oldest regional banks in the US and is headquartered in Little Rock, Arkansas. While it has a sizeable balance sheet with $34.4 billion in total assets, Bank OZK (NASDAQ:OZK)’s stock is down by 19% year to date. While this might appear to be surprising on the surface as bank stocks have held off against losses (the KBW banking index is flat year to date), Bank OZK (NASDAQ:OZK) is heavily exposed to one of the most tumultuous markets in the US. This is the real estate market, and as of June 2024, $21.6 billion of the bank’s $28.6 billion loan portfolio was for real estate loans. This accounts for 75.5% of the overall portfolio, and its overall asset base is further complicated by the fact that non-interest bearing deposits account for a small 13% of Bank OZK (NASDAQ:OZK)’s total asset base. This means that in a high interest era, the bank’s interest rate costs remain high as well. However, if the Federal Reserve cuts interest rates and the real estate sector starts to pick up steam, then Bank OZK (NASDAQ:OZK) could see its high exposure to real estate pay out well.
Diamond Hill Capital mentioned Bank OZK (NASDAQ:OZK) in its Q2 2024 investor letter. Here is what the fund said:
“Shares of regional banks Live Oak Bancshares and Bank OZK consolidated some of late 2023’s gains tied to investors’ expectations the Fed would begin cutting rates in 2024 — which would relieve deposit pricing pressure and commercial real estate stress. As investors have adjusted expectations for fewer rate cuts in 2024, shares of both companies have declined in sympathy.”
9. Comerica Incorporated (NYSE:CMA)
Number of Hedge Fund Holders In Q2 2024: 38
Comerica Incorporated (NYSE:CMA) is a Texas based bank that operates in its home state, California, Florida, and other American states. Like Bank OZK, the bank’s shares are also down year to date and they have lost roughly 2% so far. This is partly due to the fact that $26 billion of its $51 billion in total loans are to commercial customers, which has led to a drop in its net interest income. Additionally, Comerica Incorporated (NYSE:CMA) also holds significant money market and interest bearing checking deposits, which have seen their interest payouts grow during 2024 to further stress its income statement. While the bank could have helped buffer this through non interest bearing deposits, these dropped by $1 billion sequentially to $25.3 billion in Q2 2024. Comerica Incorporated (NYSE:CMA) hasn’t been helped by the fact that it lost the Treasury Department’s Direct Express Mastercard program in Q2, which removed a key non interest income stream from its income statement right at the time when its overall costs were rising and potentially lower interest rates are expected to stress its interest income.
Comerica Incorporated (NYSE:CMA)’s management commented on the loss of the Direct Express business during the Q2 2024 earnings call:
“Before moving to the outlook, as indicated on Slide 14, we recently received preliminary notification from the Fiscal Service that Comerica Bank was not selected to continue serving as the financial agent for the Direct Express prepaid debit card program following the expiration of our contract early next year. This process remains fluid as contract negotiations are not yet final, but at this time, we do not expect that Comerica Bank will retain the business long-term. As detailed on the slide, we’ve recognized noninterest income in card fees, but that is generally offset by expenses associated with managing the program.
The financial value has been in the noninterest-bearing deposit balances related to monthly benefits funded on the cards, which have grown over time and averaged $3.3 billion in the second quarter. As we have discussed in the past, there are various potential scenarios with regards to the timing and mechanics of the deposit transition and we expect more detail in the coming quarters as terms become final. However, our experience with this program leads us to believe this transition maybe longer than shorter and we do not currently anticipate an impact to 2024 deposit balances, noninterest income or expenses. While we have been honored to manage this important program, we see this as an opportunity to refocus and reprioritize resources towards targeted deposit strategies more in line with our core relationship operating model.”