First Boston sends out 'buy' signal on banks.

First Boston Corp. reiterated its "buy" recommendations on Friday, saying that the recent selloff in bank shares has not diminished the industry's fundamental strength.

The top picks: Chemical Banking Corp., NationsBank Corp., First Union Corp., and Keycorp.

If there is a common theme to those choices, it is the banks' successes in increasing earnings through mergers, First Boston said.

First Boston said bank stocks have rebounded from the recent selloff and will continue to rise as the prospect of strong second-quarter earnings lures investors. Earnings releases, due out in July, should generate more interest.

Summer Rally Seen

"We expect a pop in the stock prices this summer," said Merrill H. Ross, a First Boston analyst, speaking after a press conference last Friday.

The sector's shares have rebounded from their recent downturn, when prices tumbled by more than 10%. The fear that inflation and rising interest rates could damage earnings appears to have abated.

In the five trading days ended last Thursday, the American Banker index jumped 3.32%, versus a 0.86% gain for the Dow Jones industrial average.

Shares of First Union and J.P. Morgan & Co. had particularly strong showings. First Union rose 7.2%, to close last Thursday al $46.25. Morgan's shares gained 4.2%, to $67.50.

Earnings Anticipation

Some of the recent bounce has come from investors buying in before banks release their quarterly earnings next month.

Banks have been telling analysts that second-quarter earnings will be good and that net interest margins won't contract.

On Friday, for example, Fleet Financial Group confirmed that 1993 per-share estimates of $2.75 to $3 are on track.

First Boston has not given up on the bank rally, though the recent pullback in prices caught them unawares.

Back in January, Thomas Hanley, First Boston's lead analyst, forecast a rise in stock prices as investors award them a higher price-to-earnings multiple in line with the overall market.

Mr. Hanley continues to expect that in two years strong regionals will trade at 80% to 85% of the average trading multiple for the S&P 500. Currently, that's 17 times 1993 earnings estimates. Banks trade around 10 times 1993 estimates, or 60% of the broader market.

Fee Income Cited

The next two years, First Boston said, will be very good for bank earnings, even if loan demand does not return. Fee income is growing, and it is not being put into loan-loss coverage. And banks are slowly lowering their overhead.

First Boston estimated that if the 35 banks it follows allowed their loan-loss provisions to rise over the next two years from the current 60% of loans to only 80% - rather than 94% First Boston expects - they would generate $9.9 billion in pretax revenues. The good times won't roll forever, First Boston warned. By 1995, the significant benefits from cost cutting will taper off. If commercial loan demand doesn't resurface, earning will be imperiled.

Merger Benefit

A resurgence in merger activity, which First Boston believes will start within three months, should help draw investors to bank shares. Big mergers reinforce the idea that the industry is eliminating competition. Besides, acquisitions get the attention of money managers, who like to bet on takeover stocks.

Bank executives have told First Boston that they have mandates from their boards for acquisitions.

Within the next 12 months, First Boston believes that BayBanks Inc., UJB Financial Corp., and Crestar Financial Corp., among others, will be taken over.

Each of these banks, First Boston said, has a good franchise and a market price equal to 1.5 times book value or lower.

The recent selloff in BayBanks shares has reduced that ratio to 1.2, one of the lowest in the industry. High-quality regional banks trade at 1.6 or 1.7 times book.

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