Stocks of smaller banks likely to come up big

With megabanks besieged by regulators and facing a public backlash over the 2008 credit crisis, portfolio managers increasingly are looking at smaller banks as a value play in the financial services sector. By and large, the stocks of many smaller banks lagged behind their bigger brethren last year, but managers and analysts expect that to change in the months ahead. Keefe Bruyette & Woods Inc.'s KBW Bank Index (BKX), which tracks the largest banks, returned 22.2% in 2010, compared with the KBW Regional Banking Index (KRX), which gained 18.2%. Indeed, many large banks are likely to find their ambitions hampered by regulatory reform. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 imposes strict limits on the types of activities that many big banks pursue. Basel III, meanwhile, raised the amount of capital that big banks are required to keep on their books.

'LEVEL PLAYING FIELD'

“Historically, larger banks have been able to use greater leverage than community banks,” said Fred Cannon, co-director of research at KBW. “That won't be the case anymore, and it puts community banks on a level playing field.” Some portfolio managers think that as Congress looks at ways to stimulate the economy, it may pass legislation that will make it easier for regional and community banks to lend to small businesses. “The big banks don't want to lend to small businesses, because it's labor-intensive and they can do one big financing that will eclipse their entire loan book for small companies,” said Richard Bernstein, chief executive of Richard Bernstein Advisors LLC, manager of the Eaton Vance Richard Bernstein Multi-Market Equity Strategy Fund Ticker:(ERBAX), which was launched in October. “I think regulators are going to realize that community banks are more vital to the economy.” There were 7,095 community banks — those with less than $1 billion in assets — and 665 banks with more than $1 billion as of Sept 30, according to the Federal Deposit Insurance Corp. The trick is finding the gems among smaller banks, analysts said. One such stock that analysts point to as a good buy is Plano, Texas-based Viewpoint Financial Group Inc. Ticker:(VPFG). “The company does a good job of managing its capital, and we think there is growth in Texas,” said Kevin O'Brien, co-manager of Prospector Funds Inc.'s Opportunity Fund Ticker:(POPFX). Another bank that had a good amount of capital going into the downturn is Bank of the Ozarks Inc. Ticker:(OZRK), said Ralph Bassett, an investment manager at Aberdeen Asset Management Inc. That regional-bank stock is good because the Little Rock, Ark.-based company has conducted three FDIC-assisted deals in seven months, said Tim Holland, principal and co-portfolio manager of Tamro Capital Partners LLC, which manages the Aston/Tamro Diversified Equity Fund Ticker:(ATLVX) and the Aston/Tamro Small-Cap Fund Ticker:(ATASX). He also likes another regional, Glacier Bancorp Inc. Ticker:(GCBI) of Kalispell, Mont. “It is very well-capitalized and it didn't take any [Trouble Asset Relief Program] money,” Mr. Holland said. Wintrust Financial Corp. Ticker:(WFTC) is another regional bank that handled the downturn and the months after it very well, said Jason Kotik, a senior investment manager at Aberdeen. Still, smaller banks do come with their fair share of risks. “I think it's an extremely interesting time to be looking at the community banks, but it's one that is fraught with danger,” said Ben Hesse, financial sector leader at Fidelity Investments and the portfolio manager of the Fidelity Select Financial Services Fund Ticker:(FIDSX). One of the main dangers that such banks pose is that they often have high holdings in commercial real estate loans — much higher than bigger banks, he said. “By and large, community banks hold 30% to 35% of assets in commercial real estate, while large banks have 10% to 15%,” Mr. Cannon said. Although many of the problems associated with individual real estate loans have surfaced, those associated with commercial real estate are just beginning to emerge, observers said. “Just over the past several months, you saw a number of smaller banks report credit problems with commercial real estate loans,” Mr. Cannon said. Investors need to take a hard look at the balance sheets of smaller banks before investing to see how much they have in commercial real estate loans, said Jim Sinegal, an analyst with Morningstar Inc. “You want to be wary of any bank with a high concentration in commercial real estate,” he said. One factor that bodes well for community bank stocks is that there are too many of these banks in existence, observers said. “There is going to be consolidation, and that's going to be good for valuations of the community banks,” Mr. Holland said. Some of that consolidation may come as large banks look to grow selectively, Mr. O'Brien said. “The big banks are having trouble growing, and if they buy one of the big national players, they get a lot of risk in parts of the country they might not want, like California,” he said. “But buying community banks allows them to own markets they want.”

VALUATIONS FAVORABLE

And valuations today for thrifts in particular are favorable due to the regulatory environment, Mr. O'Brien said. Under Dodd-Frank, these banks are going to be regulated by the Office of the Comptroller of the Currency instead of the Office of Thrift Supervision. Many smaller thrifts are mutual holding companies, but it is still unclear if under the new rules, this structure will be favorable to them, Mr. O'Brien said. As a result, many of these thrifts are going public, and today there is an overabundance of publicly traded thrifts, he said. “These offerings are coming at clearly depressed valuations,” Mr. O'Brien said. Overall, portfolio managers recommend that advisers look at community banks but proceed with caution. “I just had the CEO of one of the biggest world banks in recently, and he said that if he could do anything, he would start a community bank,” Mr. Hesse said. “There is a lot of opportunity there.” E-mail Jessica Toonkel at jtoonkel@investmentnews.com.