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Bank Stocks Expected to Shine, Especially the Tarnished Ones

The strong second-quarter earnings reported by Goldman Sachs confirm the success of efforts to revive the banking industry as a means of reviving the economy and financial system. Goldman's stock has also perked up, but David Ellison, a portfolio manager specializing in the financial sector for FBR Funds, is lukewarm on it, even though he admires the company greatly.

"They know what they're doing," he said of the bank's management. "They're continuing to write down stuff while making money in other areas. They've been able to work through the system and take advantage of the Darwinian process" that has sent many institutions to their demise.

But when it comes to benefiting from the rally that he foresees continuing in financial shares in the years ahead, a development he discussed earlier this week, he prefers companies that are a bit more the worse for wear.

"I don't have a problem owning the stock, but there's not a lot to go from here," he said about Goldman. Noting that it has recovered from less than $50 a share in November to the $150s, he wants to know: "What's going to get better at Goldman to drive the stock to $200?"

Goldman's business is likely to keep improving, but what he's looking for are companies that are just embarking on the journey from "ugly to OK to great."

Some of his examples are "the other guys that everyone talks about," including three of the four large consumer and commercial banks that are likely to be left after the shakeout - Wells Fargo, Bank of America and J.P. Morgan Chase. Conspicuous by its absence from his list of selections is the other member of the quartet, Citigroup.

Some smaller banks whose stocks he owns are Capital One, KeyCorp, Comerica, PNC Financial Services and State Street, and he likes shares of some insurance firms that were caught up in the financial maelstrom last year, such as Travelers, whose inclusion in the Dow Jones industrial average I discussed a few weeks ago, and Prudential.
As a fund manager specializing in bank stocks, Ellison would be expected to have a bullish bias toward the sector, but he has expressed reservations before, such as in this New York Times story early last year, when he issued a timely warning to investors to avoid banks with heavy exposure to home mortgages.
That gives his recommendations more credibility, and his rationale for liking the sector seems sound: Today banks are on the right side of the abyss, and the survivors of the crisis should benefit from the absence of all of their rivals who did not make it out alive.

"Their competitive position is the best I've seen it," Ellison said. "Banks offer better rates than money-market funds, and it's fairly easy to raise money at low cost. That means higher spreads, and that will help accelerate charge-offs of bad loans."

The tighter regulatory system that he envisions also should help banks, he said, by helping everyone else, much as the recent rescue programs seem to have done. The best backdrop for the industry and its shareholders, he said, is "a safer economy where people can have jobs and buy homes."