PORTFOLIO STRATEGY - Banking on Better Days

Diversified revenue streams are the key to survival.

These are tough times

for bank-stock investors. Rising short-term interest rates, combined with an inverted yield curve and the alarm bell of subprime loans going bust, have conspired to depress shares in the sector. These difficulties are evident in the performance of bank-stock mutual funds, which in the 12 months ended March 31 delivered an average total return of just 1.91 percent, almost 10 percentage points behind the Standard & Poor’s 500 index. The funds’ three-year annualized returns of 6.47 percent were better but still trailed the broader market by 3.59 percentage points.

As investors have fled the sector, declining assets have added to bank-fund managers’ woes. Boston-based John Hancock Regional Bank Fund, with $2 billion in assets, has seen net outflows of more than 20 percent since the end of 2004, despite a decent 12-month total return through March of 6.99 percent. Similarly, the Arlington, Virginiabased FBR Small Cap Financial fund has seen its assets plunge by nearly 60 percent over the same period, from $660.6 million to $264 million, despite delivering five-year annualized returns that topped the S&P 500 by more than 6 percentage points.

In the short term some bank shares can be cyclical, their fate hitched to the U.S. Federal Reserve Board and the bond markets. But over the long haul, many bank stocks are value plays that have significantly outperformed the market and offered steady growth.

With interest rates potentially at or near a peak, now may be an opportune time to build positions. Lehman Brothers bank-stock analyst Jason Goldberg recently studied the sector’s price performance before and after the Fed’s initial interest rate cuts following the four previous cycles of rising rates. He found that the average bank stock tended to beat the market in the six-month stretches both before and after those initial rate cuts.

The bank-fund managers who know the industry best are favoring regional banks whose fortunes aren’t entirely dependent on net interest margins, which have been squeezed by the Fed’s recent round of rate hikes.

“Investors can hedge their bets by identifying tightly run banks with diversified revenue streams,” says Raymond Stewart, founder of Rasara Strategies, a suburban New York money management firm that specializes in bank stocks and oversees $220 million for institutional accounts. Rasara has generated five-year annualized returns in excess of 10.5 percent, outpacing the S&P 500 by 3.8 percentage points.

One of Stewart’s key holdings is Columbus, Georgiabased Synovus Financial Corp., a regional bank that serves the southeastern U.S. Thanks to a high-quality loan book, its nonperforming assets and net charge-offs are about half the industry average. And its 81 percent stake in Total Systems Services, a bank transaction processor, makes it more resilient in an unfavorable interest rate climate. Noninterest revenue accounts for about 65 percent of Synovus’ total revenue, versus an average of 20 to 25 percent for most banks. About half of its noninterest revenue comes from TSS.

Stewart began building his position in Synovus in January 2004; it now accounts for 3.5 percent of his portfolio. The bank has been a stellar performer: Last year it had a return on assets of 2.07 percent, twice the industry average, and a return on equity of 18 percent, 50 percent higher than the industry as a whole.

At a recent $32.75, Synovus’ stock has also delivered. It was up 10 percent annually from 2004 through 2006, topping the S&P 500 by 90 basis points. This year through early April, shares returned more than 6 percent.

John Hancock Regional Bank Fund manager Lisa Welch also likes diversified revenue streams. Her fund is a longtime holder of Marshall & Ilsley Corp., a Milwaukee-based company whose shares make up 3 percent of her portfolio. The bank is expanding into fast-growing regions like Arizona and Florida. Last year noninterest revenue was 56 percent of its total revenue. About one fifth of profits came from Metavante Corp., a wholly owned data-processing subsidiary that M&I plans to spin off to shareholders by the end of the year.

Welch has been buying M&I’s stock since 1991 at an average cost of $10.72; the stock recently traded at $48.75. She has a year-end price target of $56 based on an estimate of 10 percent earnings growth and a low trailing price-earnings ratio of 14.7.

“Compared to peer banks, it’s selling slightly cheap,” says Welch, whose fund has topped the S&P 500 by 3 percentage points annually since its inception in 1985.

Despite his fund’s suffering huge outflows, manager David Ellison of the FBR Small Cap Financial fund has racked up five-year annualized returns of 13.70 percent by focusing on healthy regional banks that are trading at even greater discounts than M&I. He favors those with price-to-book values that are less than 2 and P/E multiples of less than 12.

One all-weather holding is Spokane, Washingtonbased Sterling Financial Corp., which Ellison began buying a decade ago and now accounts for more than 6 percent of his portfolio. Since January 1997 the regional bank has generated annual growth in earnings per share of more than 16 percent; its shares have climbed 20 percent a year on average.

The bank sector is out of favor with investors. But in this part of the market, as in others, the crowd’s wisdom may be suspect.