Rummaging for hidden investment treasures among the small banks and thrifts of the Northeast is the specialty of McConnell, Budd & Downes Inc., Morristown. N.J.

The firm was launched two years ago by a quartet of seasoned veterans from New York's keefe, Bruyette & Woods Inc.: C. Edward 'Ched" McConnell, David A. Budd, William J. Downes, and Thomas J. Romano.

They see their role as generating information about these often obscure institutions for potential shareholders, making a market in their rarely traded stocks and acting as a nonthreatening financial adviser for them.

many such banks and thrifts will probably be bought over the next several years by larger institutions at prices offering good returns for shareholders. But there are some other good reasons for buying into these companies, they believe.

Smaller institutions are enjoying faster loan growth right now than the larger banks - which should translate into good earnings for conservatively managed companies. And because they lack market liquidity, shares of smaller banks and thrifts are sometimes undervalued in relation to earnings.

Moreover, even shares of small companies that do not get acquired tend to benefit from an "indirect acquisition play" because others around them are being taken out. Often that provides the smaller remaining companies with at least a temporary competitive advantage.

New Jersey is by far the hottest acquisition market in the Northeast, they say. Large acquirers are seeking to enter the state from all sides, with banks in New York and Pennsylvania particularly interested in staking a claim or enlarging their presence. Massachusetts is also a center of strong activity.

But small banks are not necessarily being managed with takeovers in mind, Mr. McConnell and Mr. Budd said.

While many would probably sell out if they could get a price of twice book value, they are content to focus on running a profitable bank in the meantime.

Recently, Mr. McConnell and Mr. Budd discussed their activities in the small-capitalization end of the banking industry.

Q.: Why did you choose small banks and thrifts as the focus of your company?

McConnell: Because we saw a real void in terms of investment-type knowledge about these institutions. Many of them have been undervalued through being misunderstood - if the market even knows they're out there in the first place. We felt we could add something in this area that we couldn't have done in the realm of larger banks. Issuing another opinion on Citicorp wouldn't add much value for investors.

Q.: How many institutions are we talking about?

BUDD: There is a surprisingly large number of these banking companies in the small piece of the U.S. market we've chosen to focus on. We've identified 350 banks and thrifts within Maryland, Pennsylvania, New Jersey, New York, and New England that are trading on pink sheets and have assets between $150 million and $400 million.

They're all potential diamonds in the rough -- and some of them will actually turn out to be diamonds.

Q.: How do you get to know these companies?

BUDD: It can be quite difficult to get information on them. They have to be guided through financial disclosure and they're a little wary of the outside world. We spend a lot of time talking with not only with management but with boards of directors, trying to make them more comfortable with the whole idea of being in the marketplace and of having shareholders from outside their own territory.

Q.: Many of these institutions are closely held, and in some cases almost privately held. How do you make a market in their stocks?

McConnell: Timing and patience. Some companies trade in blocks when they trade at all. You can go from nothing at all being traded to 25,000 shares from an estate or other source.

In such cases you have brokers looking for a marketmaker, someone to evaluate and handle the stock. If we have some good information and we're comfortable with the situation, we're in an advantageous situation. A stake can can be built up over time.

For instance, Raritan Bancorp., a $200 million-asset New Jersey thrift institution had a dissident shareholder who wanted to sell a 9.9% stake. We examined the company, liked it, and felt comfortable with the level of the stock. We bid for the whole block and parceled it out to clients over a period of time.

Q.: In how many such companies do you make a market?

BUDD: We generate statistical information on several hundred institutions, actively follow 65 to 70 of them on a regular basis - that is, at least quarterly. We make markets in the shares of 28 or 29 of them. In many cases, the activity level of trading in the stocks would not be economical for the larger New York firm.

For instance, we did about 50,000 to 60,000 shares last year of Growth Financial Corp., Basking Ridge, N.J. It's a good company with a four-branch network in an affluent market. It could probably be acquired, but management is not inclined to sell. Still, it's a good stock to buy and hold.

Q.: What do you offer these companies from a financial advisory standpoint that can't be gotten from the big Wall Street Firms.

McConnell: Well, first, it helps to be in Morristown, New Jersey. A lot of the smaller banks are immediately suspicius if somebody arrives saying, "I'm from Wall Street and I'm here to help you.

BUDD: We're 35 miles from New York -- virtually in Indian country. I can tell people that my office is located in the old school building where I attended kindergarden and first, second, and third grade. I played Little League right across wearing suspenders on my business calls a long time ago.

Actually and seriously, we look a lot less threatening to a lot of our clients by not being part of a monolithic firm on Wall Street.

Among other things, we void the syndrome of barraging our clients with [corporate finance] products of the week with the idea that if you saturate the market you'll get a few hits.

We take the time to learn what our clients' real business objectives are, help them mold their game plan if necessary, and then help them try to implement it.

We're not saying we have to have $300,000 in revenue based on our relationship with you for the first six months of 1994. All that is attractive to a lot of small banks.

The institutional market also, sometimes understandably, tends to look at is investment in a banking company as if to say: "I've owned your stock for days now, so why haven't you sold your bank today at twice book?" This is not the first thing on the agenda in the morning for a lot of these bankers.

Q.: But isn't consolidation going to take out most, or at least a lot, of these banks?

McConnell: Yes, a lot will be gone, but the timing of that is something very hard to pin down. These banks are not all "in play" at all times. Some are doing some buying of their own, building their own franchises and focusing on being as competitive and profitably as they can.

Q.: Have you worked on any such deals?

McConnell: Yes. Most recently, First State Financial Services' acquisition of Ocean Independent Bank in New Jersey. We also handled four other deals last year.

Q.: Do smaller banks have a long-term future?

McConnell: A lot of people are concerned that profit levels at community banks will decline over time because of their relative size and competitive factors. I'm not sure that's true.

There is a niche for community banks.

Q.: What is the attitude of small bankers about consolidation?

BUDD: A lot of them are not running their banks to sell them. But some banks do have older management and a succession problem, or they may be concerned about their profitability going forward. The feeling of many of them is that they will sell if they can get two times book, but in the meantime they will keep on doing the best job they can.

Q.: Why oen these stocks if not for their takeover potential?

McConnell: Even the stocks of community banks that are not involved in the acquisition game benefit from an indirect acquisition play, since a lot of others are being taken out around them. Often that helps them competitively for at least the short run.

In the meantime, may smaller community banks right now are experiencing a lager loan volume pickup than the bigger banks and have a healthy earnings outlook. Many have excellent fundamentals. But they aren't well known and trade at discounts because the stock doesn't move much.

Q.: Where do you think bank stocks - large and small -- are headed in the future?

McConnell: Buying bank stocks is no longer like shooting fish in a barrel, as it was for about three years after 1990. Then, all banks were cheap because of their earnings problems and all the stock subsequently did very well on the earnings recovery play.

There are a few turnaround situations left, but most of those stories are behind us. I think we're in much more of a trading market for the bigger bank stocks.

I think banks of all sizes are going to keep doing reasonably well. But I do doubt we'll see the spectacular returns of the past few years for either large or small banks. That was the perfect environment.

Q.: What is the hottest takeover market in the region you cover?

McConnell: New Jersey. It has a concentrated population mass and a recovery economy. There is pressure for consolidation from all sides. Its banking industry is going to look very different in a few years.

The Pennsylvania banks want to come in, the New York banks want to come in. Chemical would like to add to its presence in the state. Keycorp and Fleet would like to do something here. Midlantic may surprise and do a few acquisitions of its own before it goes itself.

Massachusetts is also a strong acquisition market with a lot of interest in the market around Boston.

For small banks -- especially inthe $700 million to $1 billion category, but even smaller -- their franchises have real value if only because a lot of people are looking at them.

Q.: How do you select the small banks you decide to follow?

McConnell: We do the statistical work, look at the perceived value and attractiveness of the franchise, and talk to the management about how profitable they think the can be over the next three to five years. We also evaluate risk factors, look at where the stock is trading versus its book value, and assess whether the market has been pricing it efficiently. In many cases with small banks the market is not doing so.

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