Smaller Banks with Room to Grow

Now is the time to steer clear of the big boys

Looking for a bank stock to invest in? Think small. Large banks Wells Fargo (WFC ) and J.P. Morgan Chase (JPM ) have warned of earnings shortfalls in the second quarter. Others may follow as they continue to digest lousy loans and venture-capital investments. And, with fewer fees being generated from initial public offerings and merger activity, banks' earnings may continue to be sluggish. Yet the Keefe bank index of the 24 largest bank holding companies is up over 17% in the past year, vs. an 18% fall in the Standard & Poor's 500-stock index. "The sector as a whole looks relatively fully valued," says Edward Najarian, bank analyst at Merrill Lynch.

That's why smaller is better. Since many regional banks never funded dicey syndicated loans or underwrote IPOs, their earnings are expected to hold up. "The fundamentals of a select group of mid-caps are really shining right now," says Lori Appelbaum, regional banking analyst at Goldman Sachs. But how does one identify a strong mid-cap regional? Look for banks with strong sales cultures, growing corporate deposits, strong long-term credit quality, and those that focus on expanding profitable products such as checking and money-market accounts.

Many consider Commerce Bank (CBH ), based in Cherry Hill, N.J., to be the best retail bank in the country. While most banks are shutting down branches and wooing customers to the Internet, Commerce--with $9 billion in assets--has taken the opposite tack. In the next five years, it plans to open 100 new branches. CEO Vernon Hill bases his approach on Home Depot (HD ) and Wal-Mart Stores (WMT ). While most banks are raising fees and lowering service, says Hill, "We're going to expand our way to prosperity on the service model."

Branches are open seven days a week, and the bank offers free checking. So far, the strategy has worked. Commerce's revenues have grown 25% a year, and per-share earnings 17%, over the past five years. Its deposits are growing at a 25% annual clip--the highest in the country--vs. a national average of under 1%. David Winton, an analyst with Keefe, Bruyette & Wood, expects Commerce's current stock price of $67 to hit $85 within a year.

POWERFUL KNOWLEDGE. Increasing deposits can be tough anywhere, but doing so in rural or Rust Belt regions is remarkable. Such is the case with Buffalo's M&T Bank (MTB ), which has Warren Buffett's Berkshire Hathaway as its largest shareholder. Before a 10-for-1 stock split on Oct. 5, the stock traded thinly at over $520. Now at $75, it has been featured on several Wall Street analysts' buy lists. M&T is known as a technologically savvy bank with a strong track record in cross-selling products. "A lot of banks have no clue who their customers are," says Brock Vandervliet, an analyst at Lehman Brothers. "But that [knowledge] is one of the most powerful parts of M&T's franchise."

TCF Financial (TCB ), a $3.3 billion market-cap bank, has made it easy for consumers to open new accounts by putting two-thirds of its 350 branches inside Midwest supermarkets. Merrill's Najarian is projecting annual earnings-per-share growth of 14% for the next two years, compared with an 8% rate for mid-cap banks in general.

For a touch of glamour, there's always the bank to the stars, City National (CYN ) in Beverly Hills. The bank, which has generated 10% to 12% annual EPS growth over five years, recently sold off its troubled syndicated loan portfolio. Lehman's Vandervliet thinks the $42 stock could rise as much as 25% within a year.

Whether the appeal is glamour, service, Buffett, or checkout lines, for now, smaller is better in bank land.

By Debra Sparks

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