Bear, Stearns & Co. has initiated coverage of three midsize banks' stocks with "buy" ratings-and a challenge to the accepted wisdom that bigger is better.
Crestar Financial, Mercantile Bancorp. of St. Louis, and Summit Bancorp received kudos Tuesday for being "the trophy franchises in their markets."
Analyst Sean Ryan, issuing his first report at the New York firm, pegged seven other banks as "attractive" or "neutral." Mr. Ryan joined Bear Stearns in May to cover banks with $1.3 billion to $14 billion in market capitalization. He had spent time in bank equity research at Lehman Brothers and UBS Securities.
Mr. Ryan said smaller banks' stocks are being unfairly penalized by the perception that larger banks run more efficiently.
Economies of scale are largely exhausted at the relatively low asset threshold of $10 billion, Mr. Ryan said. After that, certain "diseconomies kick in and offset the cost advantages of size.
"The conventional wisdom about scale is essentially wrong," Mr. Ryan said in an interview. "The mid-cap regionals are just as capable as their large counterparts" of sustaining strong profit growth for the next several years.
That line of thinking was once rare, but is now becoming more mainstream. More analysts have begun saying that increased leverage and improved asset mixes-not lower unit costs-supply most profit gains in large bank mergers.
Mr. Ryan, whose coverage list includes banks with $5 billion to $50 billion of assets, said financial institutions in general are likely to enjoy continued growth in their price/earnings multiples.
"The mid-cap regionals should go along for the ride, if not outperform their larger counterparts," he said, given comparable or superior superior growth in per-share earnings "as well as the ongoing consolidation activity in the industry."
He looks for "skill, not size" when making his picks.
"The quality of management and its ability to successfully identify and execute its business strategy" can reduce costs by 20%, he said. "There are few obstacles a strong bank management cannot overcome."
He favors institutions that are expanding into fast-growing fee-based businesses. First Tennessee, First American, and SunTrust are in this category, Mr. Ryan said.
He also likes banking companies that are expanding into fast-growing markets, including Colonial BancGroup and Regions Financial.
He said the midsize institutions are trading at an average 25% discount to the Standard & Poor's 500, "significantly below valuations attained during similarly favorable economic periods.
"Although the current economic backdrop and the health of the bank industry are stronger than at any point since the 1950s," he said, "bank stock valuations remain below even the levels of the 1970s."