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Bank Stock Hotness Leaves Behind a Ho-Hum Market: John Dorfman

Without attracting much notice, regional bank stocks are having a banner year.

They are up 28 percent through June 18, ranking among the best of the 154 industry groups in the Standard & Poor’s 500 Index. This hot performance was achieved in a cool market: The S&P 500 as a whole is close to unchanged for the year.

Small and mid-sized banks tend to have fewer derivative- securities risks than money-center banks do. Many of the regional banks avoided the stupidity of no-documentation loans and the treacherous waters of subprime lending.

The regional banks I like now aren’t exactly household names. They include Bank of Hawaii Corp. in Honolulu; First of Long Island Corp. in Glen Head, New York; and Republic Bancorp Inc. in Louisville, Kentucky.

Should you consider investing in bank stocks even after they have had a big move this year? In a word, yes. Financial stocks fell so hard in 2008 that even after a substantial bounce in 2009 and 2010, many remain moderately priced.

The big question isn’t whether regional bank stocks are still cheap. Clearly, many are. The real issue is whether the banks can restore their profits to a decent level.

Last week I studied the data for 238 publicly traded U.S. banks, using the Bloomberg database. Profitability measures for most still looked feeble, even though the Federal Reserve has been giving banks a hand by keeping short-term interest rates unusually low.

Rich Spread

Banks make most of their profits by lending money at a higher rate than they pay to borrow it. The spread, of course, is banks’ life blood. By keeping rates low for an extended period, the Fed is making sure that banks don’t have to pay much to borrow.

And yet, as of the end of their latest fiscal years, banks on average earned only 0.48 percent on their assets. As a young man, I was taught that a 1 percent return on assets was good for a bank. Only 38 banks in my survey did that well.

Likewise, I learned that a 15 percent return on equity is a good figure for any business, bank or nonbank. Only 18 of the 238 banks could muster that much. The median return on equity was 4.3 percent.

Luckily, conditions are improving. It seems to me that the banks are making real progress, albeit from a low point. In the past, the early stages of economic recoveries have been good times to invest in bank stocks.

Banks I Like

Let’s examine a trio of regional banks that I like. None of them has fully participated in this year’s bank-stock rally. Indeed, two of them have barely budged. I think that is more a function of analyst neglect than lack of merit.

Bank of Hawaii mainly serves its home state, and has the benefits and drawbacks associated with an economy dependent on tourism. The bank places lots of automated-teller machines in McDonald’s restaurants, something I’m surprised we don’t see more of here on the mainland U.S.

Through 2008, Bank of Hawaii showed earnings per share increases eight years in a row. In 2009 earnings fell to $3 a share from $3.99 a year earlier; analysts expect a rebound to about $3.28 this year. Non-performing loans are 0.8 percent of all loans, putting the institution in the top 10th of all U.S. banks in this regard.

As a sweetener, it has a dividend yield of 3.7 percent.

Record Earnings

First of Long Island has an even lower percentage of non-performing loans, at 0.5 percent. The company marched through the recession with no downturn in earnings, and analysts expect it to post record earnings of $2.30 a share this year, up 25 percent from last year. The bank’s dividend yield is decent, at about 3 percent.

Republic Bancorp operates mainly in Kentucky, and also does business in Indiana, Ohio and Florida. It has shown exceptional growth and profitability in the past, but has drawn fire from critics.

In 2009 the Federal Deposit Insurance Corp. issued a cease and desist order telling the bank to stop charging what it said were excessive rates on tax-refund loans. Republic was the fourth-largest issuer of such loans nationwide at the time, according to a Bloomberg News story.

Some critics have complained that Republic gets too much of its revenue from overdraft charges.

I don’t necessarily deny these criticisms, although the bank does, in part. My judgment is that Republic will earn decent profits even after ending the disputed practices. Last year it reported about a 1 percent return on assets and 25 percent growth in net income.

That was no fluke. Republic has achieved profit growth that good or better several times in the past decade. This year analysts expect a 41 percent jump in profits to a record $2.85 a share.

Disclosure note: I have no long or short positions in the stocks discussed in this week’s column, personally or for clients.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

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