Superregional bank stocks may have ruled the market in 1996, but small- cap financial stocks will dominate this year.

So says portfolio manager Remy W. Trafelet, who had a meteoric rise at Fidelity Investments by betting on the stocks of large banks.

Three months ago, Mr. Trafelet, a boyish-looking 26-year-old, left his high-flying position after four and a half years with the mutual fund giant to become a partner at Kramer Spellman LP, a small private equity fund.

His mission: to search out the gems in small-capitalization stocks.

"There is a lot of opportunity in small-cap financial stocks that aren't really followed that well on Wall Street," said Mr. Trafelet.

During Mr. Trafelet's three-year stint as portfolio manager, the Fidelity Select Regional Bank Fund performed slightly above the financial services average. But in 1996 alone, the Dartmouth-educated stock picker delivered outsized returns for his investors in part by taking large positions in Chase Manhattan Corp., BankAmerica Corp., and NationsBank Corp.

In the first three quarters of 1996, the Select Regional Bank Fund produced a cumulative return of 20.78%, while the average financial services fund generated a return of 14.69% during the same period.

"I put most of my money in the money-center banks in the beginning of 1996 because they were cheap relative to regional bank stocks," said Mr. Trafelet.

Mr. Trafelet expects to bring such above-market performance to Kramer Spellman, a money management firm that specializes in small financial institutions ranging from commercial banks and thrifts to finance companies.

The firm's private equity fund, which has more than $250 million under management, had a year-to-date return of 42.6% as of Dec. 31.

Some market observers point out that many portfolio managers tend to avoid smaller companies' stocks because they are less liquid than larger stocks.

However, Mr. Trafelet insists that the time is now for the stock of small financial companies.

The "story" with bank stocks is not a "revenue growth story and not a net income story," said Mr. Trafelet. "It is a capital efficiency story."

He said banks - regardless of size - that expand through excess capital or plow such capital back into shareholders' hands will move ahead in the market.

Mr. Trafelet said that some of his favorite stock picks include PonceBank in Puerto Rico and Bayview Savings Bank of San Francisco, which are overlooked by Wall Street because of their size.

The $3 billion-asset PonceBank is "one of the cheapest ones out there," said Mr. Trafelet.

He expects the stock - which now trades at $25 - to climb as high as $32 this year.

Another "fantastic" find has been Bayview, which kept itself busy last year acquiring auto finance companies.

The company, which has a solid management team according to Mr. Trafelet, has excess capital approaching 40% of its total market capitalization.

He said the company's share price, currently around $20, should climb into the high 30s.

Cityscape Financial Corp. in Elmsford, N.Y., is a "largely misunderstood" company, whose stock price does not reflect its inherent value, said Mr. Trafelet.

In November, the specialty lender's stock price hit a low after being besieged by short-sellers.

Yet Mr. Trafelet has awarded the company the highest earnings estimates on the street, because he is confident the stock will make a comeback.

The earnings-per-share estimate consensus for the company is $2.50 for this year, Mr. Trafelet said he expects the company to earn $3.50 this year and $5 in 1998.

"The market has yet to take into account the company's United Kingdom's operations," he explained. "They have a hold on the United Kingdom market and that alone means the company will make $2 " in 1997.

A recent push by Ugly Ducking Corp. to lend to used car dealerships will boost the Phoenix-based auto finance company's stock substantially, he said.

Although Mr. Trafelet is confident that small-cap financial stocks will hit pay dirt this year, he has not abandoned the large money-centers.

He continues to have considerable positions in BankAmerica, Bank of New York Co., and NationsBank because of their efforts to streamline operations and allocate capital efficiently.

Mr. Trafelet lauded BankAmerica for its major restructuring, announced in December, and its continued strategy to close and sell off branches and business. Bank of New York is a "favorite" because it generates strong revenue growth through its securities processing operations, he said.

"Loan growth is sluggish, and credit costs are increasing," said Mr. Trafelet. "But banks are restructuring, putting in fee businesses using their access capital efficiently and I think the market is starting to recognize that."

Mr. Trafelet said that while picking bank stocks is "fun," the market continues to be "treacherous and volatile."

"It's not like a couple years ago when everything was going up," said Mr. Trafelet. "You have to be able to recognize a buying opportunity and when a company is really in trouble."

That's why he spends two-thirds of his time meeting with company managements and poring over his own bank analysis.

"I spend a significant amount of time with the company and really try to understand what is driving the numbers," he said. "I can add a lot more value by understanding the company myself than relying on Street analysts."

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