James K. Schmidt remembers fondly when tennis partners would pick his brain for small-bank stocks that might be ripe for takeover.
But as small-bank shares languish, Mr. Schmidt, a portfolio manager with the $5.8 billion-asset John Hancock Regional Bank Fund, says he's now more likely to be pressed by his court buddies for his knowledge of Internet stocks.
"And that's after I make it clear to them that this is not what I follow," the Boston-based fund manager said.
What a difference a year makes in the life of a professional small-bank investor. Last summer the stocks of small banks and thrifts fell dramatically with the rest of the market. And, while larger banks recovered with other large-cap investments, the smaller banks haven't been so fortunate.
The Nasdaq bank index-a key measure of small-bank stock activity-is down 5.8% for the year, while the Standard & Poor's 500 was up 7.9%. The American Banker index, based on the shares of 50 large banks, was up 8.1%, suggesting that investors are still intrigued by large, household-name banks.
The slump, investors say, stems in part from a cooling of merger activity. In last year's record merger market, many stocks of small banks rose on takeover speculation.
At the same time, the shares have suffered from a general shift by investors away from small-capitalization stocks-not just in banking but in a number of industries. Large institutional investors have grown increasingly concerned about the lesser liquidity of small stocks, which can make it hard to move in or out of a stock quickly. And investors large and small have been flocking to skyrocketing Internet stocks.
Institutional investors interviewed for this story-four whose holdings are tilted toward community banks-are reporting losses for this year or gains of a few percentage points.
Jeffrey Miller, who manages the Acadia Fund for Miller & Jacobs Capital of Villanova, Pa., has been more fortunate than many of his peers. His portfolio is up 5% for the year. But that gives him little solace, given the strength of the broad stock market.
"A partner at my firm said, 'That's great-you're up 5%, but my American Online tripled,'" Mr. Miller said. "You go home at night thinking, 'Am I really that dumb?'"
He and others are trying to make the best of a bad situation. Indeed, all the investors interviewed said the current downturn has made it easier to buy up undervalued banks and thrifts.
Some of these companies, they say, have earnings growth potential that far outstrip price-to-earnings multiples, which have dipped as low as seven or eight times estimated 1999 earnings.
"There's more value in the sector than there has been in the past four or five years," Mr. Miller said.
As Mr. Schmidt and others see it, small banks and thrifts have a story worth telling. Currently riding a wave of strong profits, many of these institutions are picking up market share at the expense of larger banks that have alienated customers after mergers.
And the future, they contend, should bring steady gains in cost savings plus new revenues, as smaller banks step up their presence in businesses such as insurance and mutual fund sales.
Marc A. Davis, the manager of the Columbus, Ohio-based Bank Stock Group Fund, a $15 million asset fund that invests in more than 100 community and regional banks and thrifts, cites statistics showing that banks have outperformed the S&P 500 in annual earnings growth over the past five years. Western banks generated earnings growth that doubled the market during the period, he said.
And on the basis of analysts' estimates, this trend is expected to continue over the next five years, Mr. Davis added.
In the face of such strong fundamentals, investors are approaching the current downturn with patience. Here's a rundown on stock picks of each of the four interviewed.
Marc A. Davis
Bank Stock Group Fund
Like the others, Mr. Davis is focusing on value. He wants banks with price-to-earnings multiples that are 20% lower than their peers.
At the same time, he's looking for companies with strong profitability ratios-return on equity in the mid-teens or higher-and double-digit earnings growth. He calls them "growth stocks at value prices."
He's also bent on confining his search to banks that are in particularly prosperous areas of the country, such as Las Vegas and Southern California.
Among his favorites: ITLA Capital Corp., a $1 billion-asset bank company based in La Jolla, Calif. The company trades at just above book value, yet registers 20% earnings growth.
He also likes Atlantic Bank and Trust, a $450 million-asset bank based in Boston, and Quaker City Bancorp, the $920 million-asset holding company for Quaker City Federal Savings and Loan in Whittier, Calif.
Atlantic is an unusual bank because of its "hidden assets," Mr. Davis said. The bank makes some of its money by purchasing performing loans at a discount from larger banks. "They had $425 million in performing loans, for which they paid $372 million. As those loans mature, that additional $53 million falls to their bottom line," he said.
The bank recently announced it was developing a sophisticated, transaction Web site-news that prompted a run-up in the stock.
Quaker City is a thrift that has dramatically lowered its cost of funds as it converts more of its deposits to retail checking accounts, he said. In the past year the bank generated earnings growth of over 30%, he said.
James K. Schmidt
Hancock Regional Bank Fund
Unlike Mr. Davis, Mr. Schmidt isn't that concerned about stellar growth. What he really wants are companies that are "understandable and predictable."
Among his favorites: Cascade Bancorp of Bend, Ore.; Bank of the Ozarks Inc. in Little Rock; and Oak Hill Financial of Jackson, Ohio.
Cascade, a $301 million-asset company, has gained market share in Oregon from U.S. Bancorp following that company's merger with First Bank System of Minneapolis. Bank of the Ozarks, a $612 million-asset bank that has branches mostly in northwestern Arkansas, has also benefited from big-bank mergers in the region.
Oak Hill, a $430 million-asset bank, benefits from serving an underserved market, the largely rural portions of southeastern Ohio.
Mr. Hovde, the president of the Washington-based hedge fund firm, has a fondness for bank stocks that he believes have been unfairly punished. A case in point is BYL Bancorp, a $280 million-asset company in Yorba Linda, Calif. Though the bank has some exposure to the troubled subprime mortgage lending field, it benefits from being located in one of the fastest growing markets in the country-Orange County.
He also likes Greater Bay Bancorp., a $1.6 billion-asset bank in Palo Alto, Calif., because of its success in making seamless acquisitions of other banks. The bank has an above-average return on equity and double- digit earnings growth.
Looking forward, Mr. Hovde believes that a steady stream of mergers are an inevitable feature of this industry, given the need of banks to achieve operating efficiencies and additional distribution channels.
Mr. Miller has a yen for western banks, which have generated earnings in recent years far exceeding those of banks in the rest of the nation.
Among his favorites: Western Bancorp of Los Angeles; First Mutual Savings Bank of Bellevue, Wash.; and FirstBank Corp. of Lewiston, Idaho.
FirstBank Corp., which has $200 million of assets, is generating 20% earnings growth, yet has been trading at about 10 times projected 199 earnings. And Western Bancorp is a $2.5 billion-asset holding company that has followed the super community bank model to a T.
"Their goal is to acquire companies cheaply, integrate them, and then eventually offer up the whole company to a larger company," he says.
While managers of small-bank investment portfolios argue that they can sleep easily at night because of the cheap valuations of their picks, they recognize that it may be a while before their investments come back into market favor.
"What will make things turn is when earnings deteriorate among the larger-cap stocks," Mr. Davis said. "Once that starts to happen, people start to look at mid- and small-cap for earnings growth, and the smaller banks will gain attention."