Financial Funds Come Bouncing Back

NEW YORK ( TheStreet) -- After Congress averted the fiscal cliff, financial stocks surged. Investors figured that the deal should enable the economy to continue growing -- boosting the bottom lines of banks.

Shares that jumped more than 2% the first day included Bank of America ( BAC), Morgan Stanley ( MS) and Wells Fargo ( WFC).

Can financials continue rallying? Probably. The valuations remain modest and the ongoing economic recovery should boost profits. To participate, consider a financial fund. Top choices include Hennessy Large Cap Financial ( HLFNX), Hennessy Small Cap Financial ( HSFNX) and T. Rowe Price Financial Services ( PRISX). To hold a diversified fund with a big financial stake, consider Akre Focus ( AKRIX).

Since they were clobbered during the turmoil of 2008, financial stocks have been recovering. During the past year, the average financial mutual fund returned 24.7%, surpassing the S&P 500 by 8 percentage points, according to Morningstar. The shares have rebounded as companies have improved their balance sheets, cutting costs and reducing their debt.

As lending standards have tightened, default rates have declined. Much of the credit for the revival must go to the rebound in housing. With house prices rising, banks are suffering from fewer bad loans.

"As the housing numbers have improved, the multiples on the bank stocks have increased," says Hennessy portfolio manager David Ellison.

Ellison likes the big Wall Street banks, including Goldman Sachs ( GS) and Morgan Stanley. He says the banks stand to benefit from the Federal Reserve's quantitative easing program. Under the program, the Fed is buying $40 billion of mortgages a month. The big banks earn hefty fees by selling mortgages to the Fed.

Despite the improving picture, the market has not yet appreciated how strong earnings growth will be, says Ellison. The big banks trade at 10 times next year's earnings. That is a modest price at a time when the S&P 500 trades at 14 time earnings.

"The stocks look very cheap based on their book values," says Ellison.

To hold a cross section of blue chips, consider T. Rowe Price Financial Services. Holdings include US Bancorp ( USB) and Wells Fargo. During the past five years, the fund returned 0.6% annually and outdid 74% of competitors. During the financial crisis, the fund sank hard. But because of its emphasis on blue chips, T. Rowe Price outdid most peers in the turmoil of 2008.

A relatively steady choice is Hennessy Small Cap Financial. Portfolio manager David Ellison can hold cash when markets collapse. A big cash stake helped him limit losses in the financial crisis. During the past 15 years, the fund returned 7.8% annually, ranking as the top performer in the category.

A Hennessy holding is Flagstar Bancorp ( FBC), a Michigan institution that was saddled with nonperforming loans during the financial crisis. Ellison says the balance sheet is improving as housing markets recover. The stock sells for around $19, a cheap price for a company that should earn $4 a share in the next year, Ellison says.

Another holding is Encore Capital ( ECPG), a debt collector. Ellison says the company buys unpaid debts from credit card operators, often paying 3 cents on the dollar.

Encore aims to earn healthy profits by contacting debtors and collecting 5 cents on the dollar or more. Ellison says that he has owned the stock a number of times over the years. He likes to buy when the shares are depressed because the economy is weak and borrowers are struggling to pay debts. He aims to hold as unemployment falls, and collection rates improve.

Akre Focus can hold stocks of all sectors, but the fund currently has 46% of assets in financials. Portfolio manager Chuck Akre looks for companies that can deliver high returns on equity for years. He aims to buy when the shares sell at modest prices. His high-quality strategy has been working lately. During the past three years, the fund returned 16.6% annually, outdoing 95% of competitors in the mid-cap growth category.

A holding is MasterCard ( MA), which has rich profit margins of more than 30%. The company charges banks fees for facilitating transactions at millions of locations around the world. Because of its dominant position, MasterCard can continue increasing profits, says Akre.

"The economic characteristics of the business are almost without peer," he says.

Another holding is Moody's ( MCO), the credit rater. The company's reputation suffered in the financial crisis when many top-rated mortgage securities collapsed. But Moody's maintains its dominant position, supplying ratings for issuers who want to sell bonds.

Akre says that many investors will not buy bonds without ratings. He says that Moody's should continue enjoying solid growth.

"The world will need to raise an increasing amount of debt," he says.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.