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How Our 'Five Fetching Bank Picks' Fared

Two smaller-bank picks perform well, three large ones slide.

In September, we looked at the bank and savings-and-loan stock components of the Standard & Poor's 500-stock index, the S&P 400 Mid-Cap and the S&P 600 Small-Cap indices, and narrowed the group down to five that were attractive to investors based on these criteria:

  • Dividend yield of at least 5%.
  • Price-to-book ratio below 2.
  • Dividend payout ratio below 100%.
  • Nonperforming assets comprising less than 1% of total assets.

In the chart below are the total returns of the five stocks we selected, along with the returns of their respective S&P Financial indices:

If an investor purchased the three members of the S&P 500 index we selected, of course, he or she would have suffered over the past several months, along with most of the banks.

As you can see, the smaller players on the list,

FirstMerit Corporation

(FMER)

and

Susquehanna Bancshares

(SUSQ)

actually achieved stellar returns during this relatively short period, and beat the performance of their respective indices by a mile.

The large banks on the list,

Huntington Bancshares

(HBAN) - Get Huntington Bancshares Incorporated (HBAN) Report

,

Wachovia

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and

Bank of America

(BAC) - Get Bank of America Corp Report

all suffered as the problem mortgages and related CDO writedowns manifested in the third- and fourth-quarter earnings announcements.

Let's take a closer look at Susquehanna and FirstMerit.

Susquehanna Bancshares still looks like quite a bargain, with a price-to-book ratio of 1.08 as of the market close on Feb. 27. According to

Bloomberg's

weekly data, Susquehanna's price-to-book ratio has averaged 1.49% over the past five years. The company's price-to-earnings ratio was 15.90 as of Feb. 27, a high level compared to its five-year average of 15.15. However, this reflects lower earnings for 2007, resulting from the acquisition of Community Banks Inc. in November.

FirstMerit had a much higher price-to-book ratio of 1.83, which was still lower than its five-year average of 2.11. The price-to-earnings ratio was 13.25 as of Feb. 27, much lower than the five-year average of 17.55.

Fourth-Quarter Financial Reports

Both companies have maintained strong asset quality in a difficult overall environment. Both have high levels of capital and more-than-adequate loan loss reserves.

Susquehanna's earnings slipped in 2007, in part because of a $13.1 million charge related to its acquisition of Community Banks Inc. in November. Also affecting earnings was an additional $11.1 million provision for loan losses in the fourth quarter, to cover credit risk associated with the former Community Banks loan portfolio.

This was a major acquisition, which increased the company's size by about 50%, to $13.1 billion. Susquehanna now has more than 230 branches in Pennsylvania, New Jersey, Maryland and West Virginia.

Susquehanna's capital position is solid, with a leverage ratio of 10.24%, and loan loss reserves covering 130% of nonperforming loans.

FirstMerit's earnings performance for 2007 showed a significant improvement over 2006, running counter to the industry trend. Net income for 2007 was $123 million, up from $95 million in 2006.

While the company managed to improve its net interest margins during the year (no mean feat), the main reason for the earnings improvement was provisions for loan losses totaling $30.8 million, down from $76.1 million in 2006. FirstMerit didn't need to reserve as much in 2007, because it maintained strong loan quality and reduced its exposure by selling $74 million in commercial loans.

Even after adding so much less to reserves in 2007, FirstMerit's loan loss reserves covered 219% of nonperformers as of year-end. It is very well capitalized with a leverage ratio of 8.24%.

Both FirstMerit and Susquehanna Remain Attractive in This Environment

While FirstMerit has higher price-to-book multiple, it has maintained stellar asset quality and taken steps to reduce risks in a difficult market. Its dividend yield of 5.57% is quite high, and looks reasonably safe considering the holding company's strong asset quality and decent earnings.

Susquehanna has aggressively grown its franchise with a large acquisition. While there is always the risk of surprises when an acquirer works through the loan portfolio of its prey, the holding company hopefully took care of any surprises by making the extra provision for reserves in the fourth quarter.

Susquehanna's price-to-book multiple remains quite low and it can reasonably be expected to post better earnings numbers in 2008. It also has an attractive dividend yield of 4.77%.

Philip W. van Doorn is senior bank analyst for TheStreet.com Ratings.