The Best Deals in Bank Stocks

Is it another fake-out, or is the bank-stock rally here in earnest? For sure, the bank stocks' lows of July 15 are looking more and more distant, particularly after the group soared 6.6% on September 8. Investors heaved a sigh of relief over the government's decision to take over ailing mortgage lenders Fannie Mae and Freddie Mac. But then again, the last time we heard this kind of sigh, the elation didn't last long -- it took two months, to be precise, to wear off after the cathartic collapse of Bear Stearns.

Fake-out or not, in the big picture there are good reasons to be optimistic about bank stocks. Chief among them: The decline in home prices is slowing. The Case-Shiller index of home prices in 20 major metropolitan areas is down 19% from its peak in July 2006, but its month-to-month decline peaked in February at 3% and has slowed each month since. In May, seven of the 20 markets saw an increase in prices, and in June, ten of 20 did. Moreover, the bailout of Fannie and Freddie should lead to lower mortgage rates, which should boost demand for homes.

That's not to say that home prices have bottomed, but they don't need to for bank stocks to stage a comeback. After all, the stock market is forward-looking, and stock prices tend to reflect economic trends before the data confirm them. "We're far enough into the problem that reasonable people can place parameters around the range of expected losses," says Tom Brown, a hedge-fund manager who operates the Bankstocks.com Web site. Brown, a former Wall Street analyst, also notes that in the credit crisis and recession of 1990-91, banking stocks bottomed in October 1990, as banks' loan losses were still increasing.

Still, because banks run on borrowed money, a small margin of error can quickly expand to a gulf. Plus, bank executives have broad discretion as to how much detail they disclose about their holdings of mortgages and other assets. That's why banks are often called black boxes.

Below, we look for opportunities among three broad swaths of the banking sector: money-center banks, national institutions that often combine the roles of both traditional banking and investment banking; small, regional banks; and investment banks, which help businesses and government entities raise funds.

Rather than try to profit by investing in the most beaten-up and humiliated names, home in on those companies strong enough to wrest market share from their bludgeoned competitors. That way, regardless of when stock prices recover, the piece of the business you own will be larger next year than it is today. As any former Bear Stearns shareholder could tell you, just because a stock is dirt-cheap today doesn't mean it won't be cheaper than dirt tomorrow.

Large and in charge

As a group, the big "universal," or money-center, banks offer the biggest opportunities. Many boast immense deposit franchises, which offer a low-cost source of funding that won't dry up overnight. And because these guys are part investment bank and part commercial bank, they rely on diverse sources of revenue-bringing in bucks from both buyouts across the globe and the ATM down the street.

Straddling the divide between investment bank and brick-and-mortar bank, JPMorgan Chase & Co. ( JPM) is scooping up new business with ease. Its already-formidable investment-banking division gained market share for a song with the company's acquisition of Bear Stearns in May for $2.2 billion, or $10 a share. Standard & Poor's analyst Stuart Plesser says he can already see evidence of JPMorgan's increasing share in residential and commercial mortgages and in consumer banking. "Particularly in the commercial area, companies want to work with a strong bank that they know they're not going to have to worry about," he says.

Management's openness about troubled assets earns it extra credibility. "I think they've been the most forthright in the industry about their problems," Plesser says. The company has been much more aggressive in shoring up its cash reserves and balance sheet than some other banks, which have done "skimpy reserving," he says. After jumping 4.9% on September 8, the stock, at $41.55, is down only 5% for the year-in this industry, that's a pittance. It trades at 13 times estimated 2009 earnings of $3.29 per share.

A strong deposit base can provide a floor for banks with a high exposure to risky loans. "There's nothing you can do with wacky accounting rules to change the fact that deposits are deposits," says Ladenburg Thalmann & Co. analyst Dick Bove. With deposits of $785 billion, Bank of America ( BAC) has the biggest base in the country, accounting for nearly 10% of all bank deposits. Thanks to a series of regional-bank purchases, BofA is like a supersize regional bank itself. Jeff Arricale, manager of T. Rowe Price Financial Services fund, says that customers are moving to Bank of America in a flight to quality, and "it has the pick of the litter in terms of making loans."

The company's outsized book of loans may still cause it some pain. Bank of America has a $120-billion home-equity portfolio and a $62-billion U.S. credit-card-loan portfolio. It finished its $3-billion acquisition of distressed mortgage lender Countrywide Financial in July, making BofA the nation's biggest mortgage lender. Although Countrywide lost $2.3 billion in the second quarter, BofA executives say they expect the mortgage lender to contribute positively to profits before the end of 2008.