Bigger isn't always better.
That's the outlook that two Generation X fund managers are using to turn profits with their new financial hedge fund.
The Acadia Fund, launched by Jeffrey A. Miller, 26, and Eric D. Jacobs, 28, invests predominantly in small banks, thrifts, and other financial institutions.
For the last six months, Mr. Miller and Mr. Jacobs have been riding the bull market on a wave of obscure, yet savvy stock picks.
Since its launching Feb. 3, their fund-which invests in 10 to 25 stocks at any one time-has posted a 65.5% return, according to Matthew J. Calistri, a limited partner in it. When most bank stocks fell in March, the fund achieved a 10.8% gain, he said.
Financial hedge funds garnered top returns among all types of hedge funds last year and are No. 3 overall this year, according to Hennesee Hedge Fund Advisory Group in New York.
So far, the Acadia Fund has attracted $7.5 million of capital, and Mr. Miller and Mr. Jacobs "hope to increase the fund by $10 million by yearend."
While most such fund managers currently favor money-center banks and superregional bank stocks, Mr. Miller and Mr. Jacobs-who have 10 years' experience in investing between them-have chosen to avoid the industry's biggest players in favor of much smaller ones.
"We are not trying to catch the wave in banking," said Mr. Jacobs, who previously did stints at PaineWebber Inc. and Lehman Brothers Inc. "We are not concerned about Chase Manhattan or Citicorp. We pick our companies on an absolute-value basis."
From an absolute-value perspective, larger banks tend to be overvalued and just too pricey, argued Mr. Miller, who spent three years as a banking industry analyst at Keefe, Bruyette & Woods Inc. before helping to launch the Acadia Fund.
"The average market multiple of many of the bigger banks is 15 times earnings, which means that you expect that company to grow at a 15% growth rate for a substantially long time," said Mr. Miller, who has invested in stocks since he was 12 years old.
"I don't think these banks are going to grow at that rate forever-yet that rate of growth for these companies is discounted into their price," he said.
The bottom line, according to the duo, is this: A few big banks deserve their market multiples, but most don't. Small banks, on the other hand, offer the most value in what these investment managers see as an increasingly inflated market.
It is much easier to find value in smaller companies because of the greater inefficiencies in their markets, Mr. Jacobs noted.
"For larger banks, the market is very efficient because the Morgans and Merrills are covering them," he said, referring to Wall Street's coterie of big investment firms. "But with smaller companies, market inefficiencies allow us to find more value."
Another important factor is that smaller banks, which tend to have relatively more capital than bigger banks, are becoming much more savvy about managing their excess capital than they used to be, pointed out Mr. Jacobs.
"They mimic the larger banks by doing buybacks and securitizations and by using technology that wasn't available before," he said.
Smaller banks are also more streamlined in terms of staffing, said Mr. Miller. "Bigger banks have all these layers of people, and that costs money," he said. "They tend to have pretty average efficiency ratios because of these layers."
Among Mr. Jacobs' and Mr. Miller's favorite banks and thrifts are Cascade Bancorp, a $224.5 million-asset bank in Bend, Ore.; Riverview Savings Bank, a $224 million-asset bank in Camas, Wash.; First Bank of Puerto Rico, a $3.1 billion bank in San Juan; Atlantic Bancorp, a $261.7 million bank in Boston; and Standard Financial Inc., a $2.6 billion bank in Chicago.
Other financial companies that they believe have intrinsic value include Resource America, a Philadelphia finance company specializing in leasing and real estate activities.
"Size is relatively unimportant to us," said Mr. Jacobs. "Obviously, it is how much we are paying for our earnings. If there were really large banks that were really cheap, we would buy them."
Mr. Miller and Mr. Jacobs both said that they evaluate banks on a discounted cash-flow basis as opposed to the traditional valuation method of relative price to earnings. "We don't feel we are overpaying," said Mr. Miller.
But he is quite certain that other investors are paying too much for future bank earnings-which he regards as the essential problem in the current market environment.
Mr. Miller said he thinks he knows the biggest reason this is happening, and it involves one of the guiding concepts on Wall Street-relative valuation.
Many market researchers appear to be valuing banks largely, and in some cases solely, on a relative basis. But simply because one bank's stock may be cheaper than another's stock "doesn't mean that it is cheap," asserted Mr. Miller.
He pointed out that some analysts this year have raised their investment ratings, earnings estimates, and stock price targets on some banking companies in the absence of any fundamental change in the company's outlook.
Mr. Miller and Mr. Jacobs readily acknowledge that one advantage of investing in smaller banks is that many will eventually be bought by bigger institutions. But they insist they are not relying on merger prospects to increase their returns.
"The nice thing is, we don't need it and don't expect it," said Mr. Jacobs. "If it happens, hey, it is a nice side benefit."
Mr. Miller and Mr. Jacobs also are quick to agree that investing in small-bank stocks is hardly a unique endeavor. But they believe that important aspects of their approach have not been fully used before.
"We don't believe in gambling or in guessing," said Mr. Miller. "We like to invest." u