Two Bargains in Banking Stocks

We may be approaching the bottom of the market for financials, as mortgage players such as IndyMac Bank (IMB Quote) expect problem loans to peak in late 2008.

While it may be a bit early, this is a good time to start looking for bargain bank stocks that could produce stellar returns for patient investors once the recovery begins.

Back in September, TheStreet.com Ratings looked at the bank and S&L stock components of the S&P 500, 400 MidCap and 600 SmallCap indices, and narrowed the group down to five that were attractive based on several criteria, including a price-to-book ratio below two.

On Friday we gave an update on the performance of the group, with three of our picks tumbling and two bringing in stellar results.

Filtering Out Candidates

The Treasury Department and the largest players in domestic mortgage servicing have been addressing the problems of subprime borrowers facing unaffordable rate resets, through the Hope Now Alliance and Project LifeLine. With the "R" word being bandied about, the Federal Reserve has made aggressive rate cuts and is likely to do more.

Starting again with the three S&P Financial Indexes, here are criteria for filtering out potential candidates for bank and S&L holding company stocks in this market:

• Price-to-book ratio below one.

• Nonperforming assets comprising less than 1% of total assets.

• Loan loss reserves covering at least 100% of nonperforming loans.

• A ratio of nonperforming loans to core capital and reserves of less than 10%.

• Positive net income for 2007.

• 2007 Dividend payout ratio below 100%.

We skipped the dividend yield criteria this time, but continued to exclude holding companies paying out dividends exceeding their earnings. With the real estate crisis continuing to unfold, it seems imprudent for holding companies to reduce capital at this time, in this manner.

Here are the bank and S&L holding companies that meet the new criteria:

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Here's the group again, with the rest of our selection ratios and definitions:

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Finally, let's take a look at capital ratios and compare 2007 earnings performance with the previous two years:

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All eight institutions have weathered the housing storm well, and have plenty of reserves to cover bad loans.

We discussed Susquehanna Bancshares (SUSQ Quote) in detail last Friday.

Here are two more standouts that the market threw out with the bath water. Both maintained strong asset quality during 2007 and kept their earnings from falling significantly. It's interesting to note that while the media pays attention to the prospects of giant banks like Citigroup(C Quote), Bank of America(BAC Quote), Wells Fargo(WFC Quote) and Wachovia(WB Quote), none of those names qualify under this criteria.

First Community Bancorp (FCBP Quote) achieved the best returns on assets for the group over the past three years, and has excellent loan quality. Nonperforming assets comprised just 0.37% of total assets as of Dec. 31, up only slightly from a year earlier. The holding company's return on average assets (ROAA) for 2007 was 1.71%, holding up very nicely in a year when most banks and thrifts saw their earnings tumble.

Returns on average equity (ROAE) have been less impressive, since the company has traditionally maintained a high level of capital. Of course, in the current environment, that's a good thing.

First Community's price-to-book ratio was 0.70 as of the market close on Feb. 29. According to Bloomberg, this ratio has averaged 1.65 over the past five years, with a high of 2.26 on Feb. 3, 2006. The company's price-to-earnings ratio (P/E) was 8.96 as of Feb. 29. This compares with an average P/E of 17.62 over the past five years.

The company's quarterly dividend of 32 cents a share translates to a current yield of 4.5%. That seems safe, considering the steady earnings and strong capital level.

First Community has maintained stellar net interest margins by focusing on commercial real estate and construction lending in the Los Angeles and San Diego areas. These loans generally have higher rates than residential loans, and also tend to adjust monthly. This makes it easier for the bank to manage interest rate risk. First Community's focus on commercial real estate and construction lending in the current environment makes their continued strength in loan quality remarkable.