Analyst worries about threat to banks.

The bank rally is getting, long in the tooth, and it's time to start moving back to the higher quality names that have a "habit of achievement," said J. Richard Fredericks, an analyst with Montgomery Securities in San Francisco.

Mr. Fredericks, who has been a bank analyst for 23 years, has sizable concerns about the industry's prospects. He fears hanks are developing into "money mortuaries" as they lose ground to nonbank competitors that lend money and mutual funds 4hat have snapped up the best depositors.

Banks must compete toe to toe, but they are hamstrung by regulatory burdens and outdated approaches to business. Only a few banks have adopted a more customer-oriented and sales-oriented stance that's needed to get a bigger share of customers' funds, said Mr. Fredericks.

His six favorite banks fall into three categories. He wants banks that can generate revenue regardless of the economic environment. Mr. Fredericks said these banks have the "habit of achievement." His two top picks: Banc One and Sun Trust.

He likes banks with particularly predictable earnings, such as First Bank System and Barnett Banks. And there's still room for cyclical plays, such as Fleet Financial and BankAmerica.

Q.: The third-quarter numbers looked good, but have they alleviated any of your concerns about the industry?

FREDERICKS: Not at all. The game is changing for the industry. There is a possibility that banks will become money mortuaries. I worry whether banks are the brand names in finance when everyone wants everyday low prices. Many competitors can offer the same products as a bank at cheaper levels. If banks don't wake up and streamline themselves to compete nearly toe to toe, they will have problems.

The historic erosion of banks' share of market will continue. I'm particularly worried that the share of capturable businesses with attractive returns will be more difficult to come by, such as credit cards and mortgage servicing.

Q.: Explain "money mortuary."

FREDERICKS: You can name virtually any product and some nonbank operation is tooled to do it better. In commercial' loans, for example, there are many forms of banks. Brokerage firms such as Montgomery are banks, with funding for start-ups and secondary offerings.

Finance companies like GE Credit are doing business at record pace. Besides that, there's the Treasuries market, which sets the yield curve so that corporations can borrow cheaply and pay down bank debt.

Nonbank competitors have an advantage, because the banks suffer with 23 basis points of deposit insurance, CRA regulations, and excessive reporting requirements, which makes the cost structure burdensome.

Every bank CEO should understand he has been horribly disintermediated by the mutual funds. Customers find it easier to switch to a mutual fund and write checks off of it.

As rates come up, people may come back into banks, but I'm not sure that will be the case. Since 1985, deposits have been flat. Mutual funds have grown from $0.5 trillion to $2 trillion. The demographics of our society helped push that shift. Baby boomers are older.

In the 1990s, the group between the ages of 45 to 54 will be the fastest-growing part of the population. The 35-to-44 age group is the second fastest. These are savers, not borrowers. The 25-to-34 group is declining and the slowest-growing segment is the 15-to-24 group. Both those groups are borrowers, not savers.

So the savers are going up at a rapid rate. The borrowers are declining. That's one reason loan demand will be slow and why banks must have mutual funds as a product line in their quiver.

Q.: So loan demand won't bounce back?

FREDERICKS: One of the major trends is that we will have continued moderate pace of net interest income growth due to slower than historical norms in loan growth.

Part of that is because of the debt created in the 1980s. And there is an unwinding of larger credits in favor of smaller loans, such as consumer and mortgage loans. That creates sluggish net interest margins.

The only way you can offset that and compete in this world of the nonbanks is to be customer oriented, sales oriented, have cost-efficient delivery systems, with a disciplined line of business accounting approach.

Banks don't talk about sales per square foot. They aren't like retailers. Some do. First Bank. System thinks that way. So does Wachovia, Banc One, and BankAmerica.

Traditional bank lending and deposit products are only a quarter of the financial pie. Banks must get a bigger share of the customer's wallet.

Q: Are the high levels of capital a concern?

FREDERICKS: Ten years ago. I thought capital was king. It looks like the health of the industry has done such repair to the balance sheet that capital is not an issue. Banks will increase dividends at a fairly rapid rate and more often. The secondquarter dividends were up 14% for the top 50 banks.

We are accelerating that in the third quarter, up 16.5%. That's a particularly healthy growth rate relative to the S&P 400, and one that should attract investors. And the frequency of dividend increases is picking up.

Q.: Did you see any surprises in third-quarter earnings?

FREDERICKS: One of the surprises near term is that there appears to be loan growth. It isn't great. It isn't runaway. But it is better than people would suspect. Of the top 50 banks, 47 have reported as of today. The median for the regionals is 1.6%, which is over 6% annualized growth. Now we are heading into the fourth quarter, a seasonally strong time for loan growth.

The Federal Reserve numbers show that loans are up $35 billion from the spring. Consumer loans are up nearly $20 billion year to date.

I'm beginning to hear the rumbles of loan growth as the decline in commercial real estate wanes while consumer and mortgage loans are going up. I'm not hearing much on the commercial side, but there is some spotty demand there, too.

Earnings will be up 15% already in the fourth quarter; loan demand could enhance that.

Q.: Bank stocks have been getting killed. Is the bull market over?

FREDERICKS: There is some itchiness to move on. The group is long in the tooth in terms of the age of the rally. I use Laszlo Birinyi as my source. The current group is approximately 155 weeks into this cycle. The longest cycle before this in the regionals was 124 weeks. For money centers, it was 177 weeks. The median is 66 weeks for regionals versus 41 weeks for money centers.

So far, regional banks have gone up 180% in this cycle. Money centers have gone up 173%. The previous record for regionals is 88% and 156% for money centers.

Some people sense that because the stocks have done so well, they can't continue. I understand the age of the rally. I understand the fatigue factor. The next move will be to a neutral position, but I think it's premature to do that.

The comparison to the S&P 400 is very strong. The volatility in earnings is better than the S&P alternative. You can count on the banks' earnings more than other S&P groups. The potential for maintaining the growth in the dividend is good.

Q.: So who do you pick?

FREDERICKS: Large portfolios should be moving toward a rebalance in ownership away from cyclical names. Half your portfolio should be names that have a habit of achievement, that perform well no matter what the environment, such as Banc One, Norwest, Wachovia, and SunTrust. I like Banc One and SunTrust the most of that group.

There has to be a link to revenues to be in this group. If they don't have loan growth, they better have another business in which they have scale and scope and some momentum. Like Banc One, which has a big processing business for credit cards and a budding brokerage effort. I think Banc One is arguably the best-managed bank in the country. The have operated in all economic time frames exceptionally well. We expect them to be above their long-term growth of 12.5% for the next few years.

And their valuations relative to their growth rate makes them one of the cheapest stocks I follow. I think this stock should trade in the low to mid $50s in 12 months. [Shares traded at $38.25 Wednesday afternoon, down 75 cents.]

SunTrust is producing above-average returns. If you exclude the ownership of Coca-Cola stock, which is worth just over $1 billion, they are selling at less than the median PE for regional banks. And they are not by any means a median bank. They have some earnings visibility, too.

SunTrust has 14 cents a share differential between their provision and their level of chargeoffs on a quarterly basis. That's 56 cents a share annualized, half of which will find its way into 1994 earnings and half into 1995 earnings. My price target is mids-$50s. [Shares traded Wednesday afternoon at $43.25, down 25 cents.)

Q.: Why is earnings visibility important?

FREDERICKS: Right now, one of the biggest concerns of investors is the visibility in late 1994 and 1995 for earnings per share. First Bank System has that visibility. So does Barnett.

First Bank System and Norwest are the Minnesota twins. They control the upper Midwest markets. First Bank System has a great franchise with very high returns. The return on assets was 1.43%. It will go over 1.5% in the fourth quarter.

They have a great management team, lead by Jack Grundhofer. They are stable, with rapid growth, a cash flow machine with a very strong sales culture. My target is low $40s. [Shares traded Wednesday afternoon at $31.125, down 25 cents.]

Barnett is by far the leading institution in Florida, a state which has recaptured its above-average growth. Within that, they are bringing down costs and their cost-related to losses. They have loan demand away from the commercial real estate arena.

They have a bright outlook on earnings through 1995, because of the cost reduction, even without loan demand. This stock should be in the high $50s or low $60s in 12 months. [Shares traded at $40.75 Wednesday afternoon, down 25 cents.]

Q.: What about your cyclical names?

FREDERICKS: There's been a tremendous fatigue factor with BankAmerica. We believe the current valuation has got virtually all the negatives incorporated. At 110% of book, with an above-average yield, and over 1% return on assets, the stock sells toward the bottom of the pack.

While earnings visibility is difficult, their dominant western franchise will ultimately lead to much stronger numbers and stock price over time. My target is $65 to $75. [Shares traded Wednesday afternoon at $42.25, down 12.5 cents.]

New England is trying to stabilize, which means there's a cyclical play. Within New England, Fleet has the best overall franchise. I think this is a high $40s to low $50s stock. [Shares traded Wednesday afternoon at $31.25, down 62.5 cents.] They are rebounding dramatically. If they hit their cost reduction target, that's another $1 a share, and if the provision goes where I think it can, it can another add 45 cents per share,

If the nonbanking operations, which historically have been a gem, can get back to what they were earning two or three years ago, that can lob on another 35 to 45 cents per share. It's earning close to $3 a share and you can add on nearly $2 more. If loan growth comes on top of that, terrific. Top PicksFrom J. Richard Fredericks"HABIT OF ACHIEVEMENT" Trading price(*) Price target Low toBanc One $38.25 mid-$50sSunTrust $43.25 Mid-$50s"PARTICULARLY PREDICTABLE EARNINGS"First Bank $31.125 Low $40sSystem High $50sBarnett $40.75 to low $60s"CYCLICAL PLAYS" High $40sFleet $31.25 to low $50sBank- $65America $42.25 to $75(*) As of 4p.m. Wednesday

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