Ernst manager spies bargains in banks.

The recent selloff in bank shares, combined with banks' excellent third-quarter earnings, have created buying opportunities for investors, according to Robert A. Bonelli, who runs the Ernst Bank Equity Fund for Ernst & Co.

Unlike some other fund managers, Mr. Bonelli is not ready to turn bearish on bank stocks. Even Morgan Guaranty Trust's recent cut in its prime lending rate, which sent bank stocks falling, hasn't dissuaded him.

"The earnings reports have only reinforced my bullishness," said Mr. Bonelli, who knows the industry well.

He began his career as a banker, first at Citicorp, then UJB Financial Corp., and finally Howard Savings. He made the switch to fund manager three years ago.

The $6 million fund is up 18% this year, more than double the performance of the average bank stock. Mr. Bonelli invests in shares of money-centers, superregionals, and regionals.

His top picks: Chemical Banking Corp., Society Corp., Comerica, and Magna Group.

Q.: How do third-quarter earnings look so far?

BONELLI: For the most part, the earnings are coming is as expected. Some are record earnings, some are flat to last year's third quarter, which was a record quarter. There is a bias toward the upside, particularly with the money-centers and regionals, which have come in well above the composite estimates.

I think the industry will have $10.25 billion to $10.5 billion in earnings for the third quarter. In the second quarter, it was about $10.4 billion. So we will be at that or better for the third quarter.

The thing that people aren't focusing enough attention on is the strength of the banks. The asset quality is splendid. The whole question of asset quality is now behind the industry. Now companies can look forward rather than cleaning up the mess they left behind.

To me, that's extremely positive.

Q.: Any downside in the earnings?

BONELLI: We've seen some margin compression, which is explainable in terms of acquisitions. A lot of the banks that were acquired were less-than-stellar performers. First Union has margin compression because of the acquisition of a of thrifts. I believe the market misread that compression when it sold off the stock.

You shouldn't lose sight of the absolute value of the net interest margins. When a margin comes down to $.7% from 4.9%, I'm not concerned. The margin is a question of loan volume, and you have to look at what is happening there.

Some regionals are reporting loan growth. That's the second straight quarter of loan growth. Banks in the Southeast and Midwest are leading the show. That means banks are leading the general economic recovery, however meager that recovery is.

With the combination of loan growth and stronger asset quality, banks are throwing earnings growth forward, which means sustainable earnings growth over quarters to come.

Q.: Any disappointments? You mention some banks have reported no earnings growth.

BONELLI: Of the banks we follow, I haven't see anything that's disappointing. What you have to keep in mind is that the earnings estimates have gotten ahead of the banks.

Not meeting or exceeding those estimates is going to result in a pencil-and-paper disappointment. I'm looking at what is behind the announcements: the composition of the earnings and the sustainability of the earnings.

What I'm not seeing in the earnings announcements are one-time gains. Where I see flat earnings, you go into last year's earnings and you see one-time gains. You subtract that, and you see earnings increases. So I'm encouraged by the growth in core businesses.

Q.: What about Morgan's cut in the prime rate and the possible effect on bank profits?

BONELLI: Morgan doesn't make loans and it dropped its prime. Harris has a huge private banking group and most of its loans are priced off Libor. No one else followed them.

Walter Shipley at Chemical said he saw no reason to raise his prime, because it wouldn't generate loan growth. The chairman of Wells Fargo & Co. said, "Why should we?"

I think the "why should we?" is permeating the industry. It's been 48 hours now since Morgan's announcement. There's no indication of a drop in the prime at other banks. If the Federal Reserve drops the discount rate, they might.

I'm not concerned about a prime-rate movement, especially because you aren't seeing banks follow. When Chemical, Citibank, and Chase change their prime, that serious. If Citibank dropped its rate, 15 banks would follow in an hour.

But it's a couple of days later, and nothing has happened. Morgan has stepped out of the limelight as a lender and become more of an investment bank. So there's less significance to Morgan lowering the prime. The net effect of it is no effect at all in the performance of the companies.

The question of the prime-rate drop has been totally over-blown. If there weren't opportunities in the telecommunications sector, we would have seen less of a selloff in the banks.

Bank stocks are doing well today. Prudential put a buy on Citicorp, and the stock is up more than $1 and is taking other money-centers with it.

Keep in mind that at the end of the second quarter, bank stocks sold off because there was fear of rising rates and people where afraid banks couldn't make money in a rising-rate environment.

Now people are worried that banks can't make money in a falling-rate environment. There are a lot of people who don't understand the banking industry.

The truth of the matter is, individual bank managements pay close attention to their assets and liabilities. Banks can react as long as the rate movements aren't precipitous - not more than a 50-basis-point move in six months.

So even if there was an interest rate move, there's wouldn't be much of a rush for banks to do anything on the liability side. Balance sheets are extremely liquid. Banks have a lot of latitude. They have the liquidity to meet any loan demand right now by using the securities portfolio.

If you have a lower yield on your loans because of lower rates, that's still yielding more than investment securities. So the net interest margin will benefit, because your average earning-asset yield will go up.

Q.: Whose third-quarter earnings look particularly good?

BONELLI: Chemical's earnings look brilliant. They blew away the estimates. They announced that Shipley is stepping up as CEO, which is a positive for the bank. He is an excellent banker with a close affinity to the middle-market business, which will be their bread and butter going forward.

I think this is the best money-center bank that can be purchased today. I took gains on it earlier this year, and I'm eager to buy back in. They have a broad cross section of business and a great balance sheet. My target is $45 to $50 in 12 months and closer to the high end of that range. [Shares traded at $41.375, up 25 cents Wednesday afternoon.]

Society's earnings came in quite strong, and they announced that the merger with Keycorp will boost 1995 net income 7% to 8%. They had strong loan growth. This stock is an incredible buy. It won't sell at eight times earnings for long. The price-earnings ratio is historically 11% to 12%.

My price target is $35 or $36 in 12 months. [Shares traded at $28.25, unchanged, Wednesday afternoon.]

The same is true for Comerica. Comerica's earnings were 70 cents per share. They had a 15.73% return on equity and a 1.25% return on assets, which is incredible for a bank that size. They still haven't taken full advantage of the merger with Manufacturers National. Loans increased by 6.2%, and C&I loans were up 12%.

Their margin decreased by 12 basis points. If you look into it, it was caused by a large amount of restructuring a runoff of mortgages, and restructuring of the investment portfolio.

At $27, this is one of the best buys on the market. It is selling at 8.8 times earnings. It won't be this price for long. I think it will be selling at $34 to $35 in 12 months. [Shares traded at $26.875, up 12.5 cents. Wednesday afternoon.]

Comerica is supporting a 4.15% dividend yield. Society's yield is 3.9%. There's no risk in these companies.

I also like Bank of Boston, which hasn't reported yet. I think they can be a $30 stock in 12 months. [Shares traded at $23.50, off 12.5 cents Wednesday afternoon.]

Q.: How about among the smaller banks?

BONELLI: There's Magna Group. I think their earnings announcement was good, even though they had a relatively flat quarter and gave back something in net interest margin. The key with Magna, and the reason that their stock trailed other midwestern stocks, in concern about asset quality after the Landmark merger, which kicked in at the end of 1991.

The nonperforming loans dropped to $36 million. That's compared with $64 million a years ago. They are over 100% reserved for nonperforming loans.

Asset quality is no longer a question. They can keep doing what they've been doing-bringing on talented people and working with the brokerage company they recently bought. They have depth in their management.

Magna has 100 branches in Illinois and Missouri. As the Missouri banking laws loosen, it is a likely takeover candidate. I expect them to trade around $21 a share this year. They're now trading now at about $18.375.

Q.: So even with the selloff and the cut in the prime, all the third quarter did was reinforce your bullishness?

BONELLI: Yes. Overall, I'm a long-term investor and the long haul looks excellent. These companies have sustainable performance over the next 12 to 18 months.

I'm seeing continued balance sheet strength and a platform for sustainable earnings growth because loan volume will be increasing. I'm encouraged by the continuing improvements in efficiency. The industry's culture has changed. They've become extremely cost-conscious.

There's no place I'd rather be invested than in bank stocks. This selloff has created buying opportunities. This morning I started reinvesting, after taking gains last week.

Q.: Do you still see room for these stock prices to move up?

BONELLI: In 1986, banks stocks sold at 14 times earnings, with weaker balance sheets and less efficient companies. In fact, in every decade, banks stocks have sold between 12 and 14 times earnings. I think we will see it again in the 1990s. In the past it was driven by consolidation and speculation. This year, it is solid fundamentals.

It is clear to me that reading into the strength of these companies, they should be achieving record price-to-earnings multiples over the next 12 to 18 months.Top PicksFrom Robert Bonelli ofErnst & Co. Trading Price price targetChemical $41.375 $45-$50Society 28.25 35.36Comerica 26.875 34.35Magna 18.375 21GroupBank of 23.50 30

Boston

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER