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.

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