A Case for Bank Stocks

NEW YORK ( TheStreet) -- Financial stocks have rallied lately. During the past year, financial funds returned 33.3%, compared with 24.8% for the S&P 500, according to Morningstar. Can the gains continue? Some fund managers think so. They argue that banks have remained undervalued since the financial crisis unnerved investors.

Banks typically sell for 80% to 180% of their book value -- the assets minus liabilities. At the depths of the financial crisis, prices dipped to near 50% of book values. Since then, the shares have recovered to 110%. That price appears to be cheap at a time when the S&P 500 commands 220% of book.

Make no mistake, many banks remain troubled. With the economy still sluggish, earnings growth is weak. But fund managers argue that the outlook is improving.

"As the economy strengthens, bank earnings will rise, and you will get up to the higher stock valuations," says Peter Kovalski, portfolio manager of Alpine Financial Services ( ADAFX).

David Ellison, portfolio manager of Hennessy Large Cap Financial ( HLFNX), says that the current market reminds him of the banking cycle that occurred from 1987 through 1991. At the time, banks weakened their standards, making loans to shaky borrowers. What followed was a wave of defaults that caused dozens of institutions to collapse. Then pressured by regulators, banks began making sound loans. "After the down cycle, the banks all got religion," Ellison recalled.

The tougher standards enabled institutions to resume reporting profits. As a result, bank stocks rallied from 1991 through 1997. Ellison says that the same process is now unfolding. Instead of giving mortgages to unqualified borrowers, banks are being stingy. "They are making good loans," Ellison says. "They will be living off this good crop of loans for a long time."

To bet on the revival of banks, consider Alpine Financial Services. During the past five years, the fund returned 5.7% annually, compared with 3% for its average peer.

Portfolio manager Peter Kovalski favors small community banks. He looks for undervalued stocks that seem poised to rise because of catalysts, such as new management teams or acquisitions. Many of his favorite targets are not followed by any Wall Street analysts. "We like to get in before Wall Street starts paying attention," he says.

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