Financial Funds to Extend Gains, Managers Say

NEW YORK (TheStreet) -- After collapsing during the stock-market crash, financial mutual funds have soared 69% in the past year, according to Morningstar.

Big gains in shares of banks and money managers propelled the gains. Can the stocks extend their advance? Yes, say managers of some top-performing financial funds. "The industry should take important steps forward in the next year," says Lisa Welch, manager of the John Hancock Regional Bank Fund ( FRBAX).

Since the credit crisis began, banks have been reporting a growing amount of troubled loans, Welch says. But the rate of increase has been slowing in recent months, an indication that the problem is peaking. By the second half of the year, nonperforming loans should start declining. That will boost profits. Soon banks that had been gushing red ink will move into the black.

While the banks are making progress to solve their problems, the stocks remain undervalued, Welsh figures. She says many banks sell for less than their book values. In the next several years, good banks will return to their normal earnings levels, and the stocks should sell for two times book values, the typical historical level. Investors who buy now may be able to double their money.

David Ellison, manager of FBR Small Cap Financial ( FBRSX), says the current downturn resembles the cycle that began in the late 1980s. At the time, many savings and loans collapsed under the weight of bad loans. But by the early 1990s, surviving institutions had taken their losses and began making profitable loans. "The industry changed, and from 1991 to 1996, financial services was one of the best places to be in the market," says Ellison.

In the current cycle, banks are now working through their problems and being very cautious about making loans. "The loans they are making today are a lot safer than the loans they were making two years ago," says Ellison. "Five years from now, I guarantee you that nonperformers will be a lot lower. And when you can show a spectacular decline in nonperformers, the stocks will go up."

To bet on a revival of banks, try Burnham Financial Services ( BURKX), which returned 16% annually during the past decade, ranking as the top-performing fund in its category. Manager Anton Shutz avoided big losses during the downturn by steering away from troubled institutions and selling some stocks short.

These days he is buying relatively healthy banks in Florida and other troubled markets. While his favorites have problems with nonperforming loans, they have enough capital to survive and grow by acquiring weakened competitors. Florida holdings include 1st United Bancorp ( FUBC) and CenterState Banks ( CSFL). "After they complete a few acquisitions, they will show amazing earnings growth," says Schutz.

Ellison's FBR Small Cap Financial returned 14% annually during the past decade. He holds a mix of strong banks and weaker institutions. He figures that both kinds of stocks have good upside potential. The healthier companies seem poised to gain market share, while the troubled businesses can rebound from depressed levels.

A weaker holding is Huntington Bancshares ( HBAN). The bank has been losing money, but its nonperforming loans are declining. The stock sells for less than book value. "They are getting their arms around the nonperformers, and they have ample reserves to survive," says Ellison.

A healthy holding is Hudson City Bancorp ( HCBK). By reining in costs and focusing on plain-vanilla mortgage lending, the bank reported record profits last year. The shares sell for 1.2 times book value.

Holding a broad collection of banks and thrifts, John Hancock Regional Bank Fund has returned 5.6% annually during the past decade, outdoing 55% of competitors. Welch, the manager, owns a mixed group of strong and weak companies. A profitable holding is JPMorgan Chase ( JPM), which sells for book value and earned $2.26 per share in the past year. With conditions improving, Welch figures the company can increase annual earnings to $4 a share by the end of next year. If the shares trade at a modest 10 times earnings, the stock would rise 50% from $40 today.

A shakier holding is Zions Bancorp ( ZION). The bank has been losing money, but Welch says the stock is cheap, trading for less than book value.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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