Why Bank Stocks Could Vault Even Higher

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"Investors should be looking at buying and owning investment and money center banks. As you move down from there, it becomes much harder—more of a stock picker's game and less a macro call," Harte says.

How Smaller Banks Are Vulnerable

Investors believe the next stage of pain from commercial real estate losses will be felt more by the smaller banks, says Harralson at KBW. So far, banks have recognized only one-tenth of the cumulative losses from commercial real estate loans that the market expected to see in the 2008-2010 period. Now the market is trying to figure out whether the losses were overestimated or are just coming more slowly than anticipated, he says.

Not everyone is wary of smaller bank stocks. The $200 million Polaris Global Value Fund (PGVFX) currently has a 20% weight in financials, and most of its domestic financial holdings are midcap or small-cap names. Fund manager Bernard Horn thinks smaller banks' share prices were pulled down by the drone of negative speculation about regulatory reform throughout 2009 more than by any concerns about specific company risks. Horn cites a huge performance gap between the stocks of large banks that recovered quite a lot in 2009 and small and midsize banks that in some cases fell 30% to 40%. That, he says, has created an opportunity.

"When you normalize earnings over time, that leaves small or midsize banks with much more upside to their stock prices than most of the large banks," he says. "We think the midsize banks may be one of most undervalued investments in the world."

Garbage Cleanup

Some of the best bets are strong banks capable of acquiring some of the failed banks in areas with the highest concentrations of problem banks, he says. Two examples are Southwest Bancorp (OKSB) in Oklahoma, a bank holding company that includes Stillwater National Bank & Trust and the Bank of Kansas, and Ameris Bancorp (ABCB) in Georgia, which recently acquired two failed banks. For this year through Mar. 16, Southwest shares were up 22.5%, while Ameris shares had risen 34%, with both stocks still trading under $10.

Horn predicts changes in four factors that have hurt bank earnings will eventually help stock prices rebound: a decline in net charge-offs and loan loss provisions, which for the midsize banks never reached the level they did for most of the large banks; a return of FDIC insurance premiums to lower levels; elimination of millions of dollars in preferred dividends banks are paying the government once TARP loans have been repaid; and a sharp reduction in the number of warrants the government received in exchange for TARP money as banks buy them back.

Elevated FDIC insurance premiums, in particular, have siphoned off large portions of commercial banks' earnings. (The agency began hiking premiums in October 2008 to help replenish its deposit insurance fund.) Premiums that once were a few hundred thousand dollars a year have jumped to the multimillion-dollar range and now consume nearly 20% to 25% of a banks' annual profit, says Horn. The failure of 165 banks in 2008 and 2009 pushed the balance in the FDIC's insurance fund to less than zero by September 2009. That prompted the agency to require that banks prepay premiums for the next three years at the end of 2009, taking an even larger bite out of profits. The time it takes premiums to come back down depends on how many more failures the FDIC has to absorb, but Polaris' models show that many banks are still greatly undervalued even if premiums never retreat, says Horn.

Receptive to Capital Raisings

KBW's Harralson agrees that TARP recipients will be better off once they have repaid the funds and no longer have to pay preferred dividends. But the number of new shares that banks will have to issue in order to raise the money needed to repay the TARP and how quickly they raise those funds could put more pressure on stock prices, he warns.

On the horizon is an abundance of capital-raising deals by banks eager to repay TARP money. The good news is that the market, still encouraged by positive fourth-quarter earnings, remains receptive to new share issuance, says Daniel Arnold, another analyst at Sandler O'Neill who covers small-cap banks. While some banks whose shares have outperformed the market are ready to raise capital, shares of a lot of small-cap names have still lagged. That's holding some institutions back from selling shares, says Arnold; they're hesitant to raise capital at current stock valuations because doing so would dilute their earnings per share.

Bogoslaw is a reporter for Bloomberg BusinessWeek's Finance channel.

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