A Top Manager Gets Back into Banks

As a young bank analyst at Fidelity Investments in the 1980s, David H. Ellison learned a simple lesson from the great mutual-fund manager Peter Lynch: If things at a company are getting better, you want to own its stock. Ellison, who today runs two top-rated financial funds, the $284 million FBR Small Cap Financial (FBRSX) and the $46 million FBR Large Cap Financial (FBRFX), says things are improving for banks, especially small ones that can benefit from better credit conditions and consolidation in the industry. "We're in the process of going from ugly to O.K. in banking," Ellison says in the Boston office of FBR Capital Markets. "If you ride the right horses, you will do all right."

Prominent investors including Jeremy Grantham and Robert Rodriguez are wary of bank stocks, and star analyst Meredith Whitney has warned that banks will have to post additional reserves to cover real estate losses. Ellison contends that while overall borrowing volume is down, banks are lending to creditworthy customers and earning higher profit margins after competitors such as mortgage companies were wiped out in the financial crisis and housing bust. "This is the best time to be making loans I have seen in my career," he says.

Ellison believes the financial-regulatory bill, awaiting Senate approval after being passed by the House on June 30, will have a limited impact on small banks. That's because they don't invest in hedge funds or engage in proprietary trading, activities the legislation is designed to restrict. He has bought more shares in Washington Federal (WFSL) and Provident Financial Services (PFS), two of his top holdings.

The rules will "attack" the profits of some of the biggest banks in the short run, Ellison says. "Over time, will they find a way to work around them? Of course. That is what they do. Considering what the big banks cost the taxpayers, they got off pretty lightly." 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 (BAC), JPMorgan Chase (JPM), and Wells Fargo (WFC) were the large-cap fund's top positions as of Mar. 31.

Ellison, 52, has run the two FBR funds since 1997. The small-cap fund returned 12 percent a year in the decade ended June 30, second-best among its industry peers behind the Burnham Financial Services (BURKX) fund, according to Morningstar (MORN). The large-cap fund gained 6.3 percent a year, compared with 2.3 percent for the average financial fund.

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 nonperforming loans would crimp banks' earnings. He started putting money back into bank stocks in early 2009 after concluding that "the world was not coming to an end." The small-cap fund had 94 percent of its assets in stocks as of Mar. 31, data compiled by Bloomberg show.

Ellison contends that a continuing shakeout in the industry will eliminate weak players and allow the surviving institutions to gain size and strength. Consolidation will provide greater benefits to small banks because some may be able to double or triple in size. Says Ellison: "I want Darwin to pick my guys."

The bottom line: Ellison thinks the worst of the financial crisis has passed and that the small and large banks that survived will be highly profitable.

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