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Peter Lynch's Lesson Leads Ellison Back Into Banking Stocks

David Ellison learned a simple lesson from legendary mutual-fund manager Peter Lynch as a young bank analyst at Fidelity Investments in the 1980s: If things at a company are getting better, you want to own its stock.

Ellison, who today runs two top-rated financial funds at Friedman Billings Ramsey & Co., said things are improving for banks, especially small ones that can benefit from improving credit conditions and consolidation in the industry.

“We’re in the process of going from ugly to OK in banking,” Ellison said in an interview at his Boston office. “If you ride the right horses, you will do all right.”

Investors such as Jeremy Grantham and Robert Rodriguez remain bearish on lenders as ongoing struggles with delinquent residential and commercial debt have bank failures on pace to exceed last year’s 140, the most since 1992. Ellison, who moved about 60 percent of his funds into cash in 2008, has added to top holdings including Washington Federal Inc. and Provident Financial Services Inc.

The U.S. financial-regulatory bill, awaiting Senate approval after being passed by the House on June 30, would have a limited impact on small banks because they don’t invest in hedge funds or engage in proprietary trading, activities the legislation is designed to restrict, Ellison said.

The overhaul will create uncertainty for larger banks without crippling their profits, said Ellison.

Getting Off ‘Lightly’

“Considering what the big banks cost the taxpayers, they got off pretty lightly,” he said.

In May, the Treasury Department estimated it would spend $105 billion on the Troubled Asset Relief Program, or TARP, created to aid the financial system after the September 2008 collapse of Lehman Brothers Holdings Inc.

Ellison, 52, started in banking with a summer job during college as a teller in his hometown of Middletown, New York. After earning a bachelor’s degree from St. Lawrence University in Canton, New York, and a master’s in business administration from Rochester Institute of Technology in Rochester, New York, he joined Boston-based Fidelity in 1983, where he oversaw the Fidelity Select Home Finance Portfolio from 1985 to 1996.

The fund gained an average of 21 percent a year in the decade ended Dec. 31, 1995, compared with 15 percent for the Standard & Poor’s 500 Index, data from Chicago-based Morningstar Inc. show. Ellison worked under Lynch, Fidelity’s best-known stock-picker, whose Magellan Fund surged 29 percent a year from 1977 to 1990.

‘Profits Matter More’

Ellison recalled that he once hesitated to tell Lynch to keep a bank stock in the portfolio because he didn’t like the company’s management. Lynch listened to Ellison and replied, “But do you think the company is getting better?” When Ellison said yes, Lynch decided they should hang on to the stock.

“I learned a lesson,” Ellison said. “People matter. Profits matter more.”

Ellison has run the $287 million FBR Small Cap Financial Fund and the $46 million FBR Large Cap Financial Fund since 1997. The small-cap fund returned 12 percent a year in the decade ended June 30, second-best among its industry peers behind Burnham Financial Services, according to Morningstar. The large-cap fund gained 6.3 percent a year, compared with 2.3 percent for the average financial fund.

The holdings of the small bank fund have a median market value of $1.3 billion, compared with $33 billion at the large- company fund, data compiled by Bloomberg show.

Cashing Back In

Ellison beat 98 percent of his rivals two years ago when he shifted three-fifths of the small-cap fund into cash because he was concerned that rising non-performing loans would crimp banks’ earnings. He started putting money back into bank stocks in early 2009 after concluding “the world was not coming to an end.”

The fund had 94 percent of its assets in stocks as of March 31, data compiled by Bloomberg show.

Washington Federal, the small-cap fund’s fourth-largest holding, illustrates the trend in credit quality Ellison anticipates. Non-performing assets fell to 3.9 percent in the first quarter from a peak of 5 percent in the second quarter of 2009, the Seattle-based bank said in April.

“Management is encouraged by improving asset quality,” the company wrote in its earnings report.

Ellison added shares of Washington Federal and Jersey City, New Jersey-based Provident Financial, his third-largest holding, in the first quarter.

Bad loans across the industry will be paid or written off over time and replaced by newer and better ones, Ellison said.

Creditworthy Customers

Banks are lending to creditworthy customers and earning higher profit margins after former competitors such as mortgage companies were wiped out in the financial crisis and housing- market decline, he said.

“This is the best time to be making loans I have seen in my career,” Ellison said.

His comments echo those of Bruce Berkowitz, manager of the $14.4 billion Fairholme Fund in Miami, who bought stakes in banks, including Charlotte, North Carolina-based Bank of America Corp. and Regions Financial Corp. in Birmingham, Alabama, starting in the fourth quarter.

“The institutions that have survived to this point will rise from the ashes,” Berkowitz said in an April interview.

Credit problems appear to have peaked in the first quarter and are likely to shrink throughout the year, said Gerard Cassidy, a Portland, Maine-based analyst at RBC Capital Markets.

‘Piles of Garbage’

“The banks are working through the piles of garbage,” Cassidy said in a phone interview.

Some of Ellison’s rival managers are shunning bank stocks as too risky, saying the economy and real estate market could weaken further over the next year.

“We don’t think we are through with the pain,” said Barry James, whose mutual funds have “very limited” bank stocks, in a telephone interview from Xenia, Ohio. James’s $642 million James Balanced Golden Rainbow Fund beat 95 percent of rivals in the past five years, data compiled by Bloomberg show.

Grantham, chief investment strategist at Boston-based GMO LLC, held no bank stocks in is $13 billion GMO Quality Fund as of Feb. 28. Two credit-card issuers were its only financial company stakes, data compiled by Bloomberg show.

Rodriguez’s $993 million FPA Capital Fund owned no bank shares as of March 31. Based in Los Angeles, FPA Capital is the best-performing U.S. diversified mutual fund over the past 25 years, according to Morningstar.

U.S. home prices could fall 6 percent to 8 percent before reaching a bottom in 2011, Patrick Newport, an economist for Lexington, Massachusetts-based IHS Global Insight wrote in a June 29 note to clients.

Economic Outlook

The Congressional Oversight Panel said in February that a wave of commercial real estate loan losses over the next four years “could jeopardize the stability of many banks, particularly community banks.”

An economy that expands 2 percent to 3 percent a year will be enough to support an improving credit climate, Ellison said. The U.S. is expected to grow 3.2 percent this year and 2.9 percent in 2011, according to the average estimate of 66 economists surveyed by Bloomberg.

The KBW Bank Index climbed 16 percent this year through July 9 on speculation that industry profits will rise, while the S&P 500 lost 2.3 percent.

Iberiabank Corp., the small-cap fund’s ninth-biggest holding, has taken advantage of the consolidation trend. The Lafayette, Louisiana, company acquired two failed Florida-based lenders in November, Orion Bank and Century Bank, adding $2.5 billion in deposits and 34 branches.

The Federal Deposit Insurance Corp. closed 90 banks this year as of July 9.

“I want Darwin to pick my guys,” Ellison said.

Industry Shakeout

A continuing shakeout will eliminate weak players and allow the surviving institutions to gain size and strength, he said. Consolidation will provide greater benefits to small banks because some may be able to double or triple in size, Ellison said.

Acquisitions may accelerate because U.S. banks are better capitalized in the wake of the financial crisis and have limited opportunities to expand internally, analysts at Keefe, Bruyette & Woods wrote in a June 30 note. They listed 38 banks as likely buyers, included Washington Federal, Iberiabank and another Ellison holding, Memphis, Tennessee-based First Horizon National Corp.

The U.S. banking bill may come to a Senate vote this week. The legislation would create a consumer protection agency at the Federal Reserve, give the government more authority to unwind failing financial firms and impose new requirements on over-the- counter derivatives markets and the banks that trade them.

Short-Term Pain

The rules will “attack” the profits of some of the biggest banks in the short run, Ellison said.

“Over time, will they find a way to work around them? Of course,” he said. “That is what they do.”

Among big banks, Ellison favors those with a large base of customer deposits, which provide the companies a cheap and stable source of funding. Bank of America, New York-based JPMorgan Chase & Co. and Wells Fargo & Co. in San Francisco were the large-cap fund’s top positions as of March 31.

Smaller banks have “fewer moving parts,” Ellison said. “These guys are the basic American lenders. They will grind through it.”

To contact the reporter on this story: Charles Stein in Boston at cstein4@bloomberg.net

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