As small-caps continue to rally, we still see many corners of the asset class where valuations remain attractive to us. Small-cap banks, an area that we have been investing in for many years, are one of those areas. We typically focus on smaller regional and community banks—those that play important roles in serving small and middle market companies throughout the U.S.—and look for what we think are well-managed banks with established histories of strong and/or steady profitability and capital allocation practices. We also like banks that are conservative about credit risk, that operate in growing markets, and that make regular dividend payments.

There are six conditions that we think are especially favorable for small-cap banks now:

• First is the steeper yield curve. Most regional banks draw the bulk of their income from spread income. The steepening yield curve has led to growth in spread income which in turn is leading to improved profits for a number of small-cap banks.
• Deregulation is another important factor. Smaller banks usually lack the scale to absorb new regulations that larger banks do, so as regulations are being relaxed, smaller banks receive a bigger benefit.
• The current M&A environment is also helping. We are seeing this dynamic play out in two ways: some smaller banks are being acquired at attractive selling prices while others are making what we think are smart acquisitions.
• Valuations remain attractive to us across much of the landscape on both an absolute and relative basis. JP Morgan, for example, currently trades for roughly 3x its tangible book value from just prior to the 2008-09 Financial Crisis, while valuations for many small-cap players are markedly lower than they were a decade ago—during the first Trump administration, valuations for most small banks were 30-40% higher than they are today.
• Promising earnings, which are a significant positive in their own right and relate favorably to currently attractive valuations. On average, small-cap banks are trading for less than 10x projected earnings per share (EPS) for 2027 versus 20x EPS for the broader market next year.
• AI. One of the reasons we like our small-cap bank holdings is that they are established in the geographies they serve. These banks are still very much person-to-person businesses where the bankers know their customers well, and they differentiate themselves by emphasizing relationships and personal service. In this context, we see AI as eventually helping these companies as administrative processes and regulatory work become increasingly automated.

Of course, there are risks. As we noted back in November, the private credit industry has experienced rapid growth in the last decade, largely spurred by growth in the riskiest loans. When the market once again begins to price in credit risk, a downdraft is likely that will hurt nearly all banks, even though the smaller regional and community banks have far less exposure to loans to NDFIs—non-depository financial institutions. Prolonged inflation, like what we experienced in 2022-23, would also hurt small-cap banks. Lastly, should doomsday fears about AI materialize, many businesses would be adversely impacted, which in turn would likely affect credit quality at banks. However, we believe the AI picture is far more nuanced than what is being seen in certain parts of the market.

There are two holdings that exemplify the attributes we look for. Home BancShares (NYSE: HOMB) has some of the best fundamental financial metrics in the industry, specifically, return on assets (ROA) and return on tangible common equity (ROTCE), which measures profitability by calculating net income as a percentage of tangible common equity (total equity minus intangible assets and goodwill) and is crucial in evaluating how effectively banks manage their capital. Home BancShares has a fortress-like balance sheet, is a conservative underwriter, and is likely to do more M&A, where the bank has historically limited itself to only do deals that are accretive. It also serves attractive markets. Its biggest is Florida, and Home BancShares also serves Arkansas (a surprisingly vibrant market), Texas, and soon, in Tennessee. It trades at approximately 11x earnings, which we think is a slight premium for a best-in-class bank. Finally, it pays a safe 3% dividend that is growing by roughly 8% per year.

Towne Bank (Nasdaq: TOWN) is headquartered in the Portsmouth, Chesapeake, and Virginia Beach area. The bank has a dominant market share that is rare for a small bank. Like HOMB, Towne boasts a strong financial profile, and we like that it serves an attractively stable market in Virginia and a fast-growing market in North Carolina. It’s also unique in that it has some highly valuable non-bank assets, including an insurance brokerage. In fact, Towne is the largest bank owned insurance broker in the country and top 50 overall. We think that its insurance brokerage alone could be worth close to $1 billion versus Towne’s total market value of $3.3 billion. It’s been trading at roughly 9x earnings and pays a growing, 3% dividend.

Beyond banks are two other companies in which we have long-term conviction. The first is Academy Sports & Outdoors (Nasdaq: ASO), which is the second largest sporting goods retailer in the U.S., behind Dick’s Sporting Goods. Its footprint is primarily in the Southeast. This concentrated footprint today means we see strong unit growth potential as Academy expands beyond the Southeast. The company endured weak same store sales for a few years due to the “covid hangover” (when many products such as treadmills saw high demand during the pandemic) and, more recently, the K-shaped economy. We think its business is at an inflection point, however, as same store sales have trended positively even without the tailwind of increased spending by lower-income consumers. The company has used multiple self-help levers, including expanding its partnership with Nike and adding the sneaker giant’s Jordan brand to 145 stores as well as online, offering buyers rewards, and improving its app. Academy also boasts a very strong balance sheet. Its shares are still cheap, trading at 9x earnings, and management has acted opportunistically with share buybacks, having repurchased around 12% of the outstanding shares over the last seven quarters.

J&J Snack Foods (Nasdaq: JJSF) makes iconic brands, such as ICEE, Dippin Dots, SuperPretzel. Its shares were caught up in the burgeoning popularity of weight loss drugs such as GLP-1 and the “MAHA” movement, which have created legitimate concerns around packaged food volumes. However, we like the fact that most of JJSF’s products are experiential; they’re sold at movie theaters, amusement parks, pro sports games, etc. It’s also a rarity for a company in the packaged food space to be able to grow its topline and generate meaningful margin improvement. Over the last few years, J&J has transitioned from a founder-led company that lacked sophisticated technology and tools, had too many plants, and struggled with inefficient distribution to a business that appears poised for significant margin improvement over the next couple of years. We think its valuation is attractive. It is supported by a net cash balance sheet (another industry rarity) and a nearly 4% dividend yield.

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