By David Sterman
From the Occupy Wall Street crowd to Wall Street investors, few sectors of the nation's economy have been as reviled in recent years as the banking industry. And that's created some buying opportunities for the latter group.
Six months ago, analysts noted that banking stocks were incredible bargains and due for a rally as names such as Bank of America, Morgan Stanley and Citigroup traded well below tangible book value-a virtually unprecedented occurrence in the post-war era. Six months later, a hoped-for rally has failed to materialize.
That's because significant headwinds continue to buffet the space. Europe, for example, perpetually teeters on the brink of a meltdown, creating potential havoc for global financial institutions. Here in the U.S., our nation's largest banks just saw their debt downgraded by ratings agency Moody's, which will raise each of the nation's largest banks' cost of capital.
Still, it's hard to deny the deep value appeal of banks. In relation to book value or projected future profits, they have rarely been this inexpensive. So investors have started to beef up exposure to this sector. But some are taking a relatively safer route via the non-major banks.
"Clearly the U.S. economy has some risk because of Europe," cautions S&P Capital IQ's Erik Oja, "but the regional banks are less volatile and risky than the big banks as they have almost no direct international exposure."
Just like their bigger rivals, these regional banks are also quite inexpensive on terms of trailing profits or book value. Most regional banks trade for less than ten times projected 2013 profits, and right around tangible book value, too.
Equally important, they are poised to show steadily improving results on the heels of a slowly rebounding U.S. economy. In just a few years' time, these banks could profit from a resurgent housing sector, a less cautious consumer and a noticeable uptick in small business lending.
As an added kicker, an eventually stabilized economy should lead to a resumption in the ongoing trend of the past decade of industry consolidation, according to analysts. S&P's Oja contends that many small banks will be hard-pressed to comply with all of the regulations put forth by the pending Dodd-Frank legislation, which "will drive a lot of the smaller banks into the arms of the bigger banks."
Looking to find the best stock to own in the group? Don't bother. Regional banks tend to trade in lock-step because they're exposed to the same pushes and pulls from the U.S. economy. That's why an ETF approach makes more sense. ETFs focused on regional banks give you exposure to the whole group without the need to track lending activity at one particular institution.
Three ETF Plays
Though there are a number of ETFs that have some degree of exposure to regional banks, two of them provide the most direct access to the leading regional players, and a third ETF worth exploring is focused on the leading community banks: The iShares Dow Jones U.S. Regional Banks Index Fund (IAT), the SPDR S&P Regional Banking ETF (KRE) and the First Trust NASDAQ ABA Community Bank Index Fund (QABA).
iShares Dow Jones U.S. Regional Banks Index Fund (NYSE Arca: IAT)
This is a cap-weighted fund, which means that the bulk of its $95 million asset base is tied up in bigger regional banks. For example, the top seven holdings account for 57% of the fund's portfolio, led by U.S. Bancorp's 22.2% stake, which is double the next largest holding, PNC Financial. Rounding out the top seven are BB&T Corp., SunTrust, Fifth Third, M&T, and Regions Financial.
The recent economic distress has actually played right into the hands of these banks. More than 400 small banks have been seized by regulators since the summer of 2008, and many of the choicest assets have been snapped up by the larger regional banks, often at a fraction of what it would have cost to build a local customer base from scratch. "The opportunity to cherry-pick desirable assets at distressed prices should bode well for the banks steering the performance of this ETF," notes Morningstar analyst Timothy Strauts.
SPDR S&P Regional Banking ETF (NYSE Arca: KRE)
The big drawback of the iShares fund is the 0.47% expense fee, which can start to eat into profits for investors that look to trade in and out of the ETF. The SPDR S&P Regional Banking ETF, on the other hand, carries a slightly more reasonable 0.35% expense ratio and provides better access to a broader spectrum of regional banks and not just the biggest players.
For example, the average holding in the iShares Dow Jones fund is valued at around $10 billion while the typical SPDR fund holding is just $2 billion. In fact, more than three-fourths of the 71 holdings are considered to be small-cap banks, according to Morningstar. Still, it's a relatively large fund, with more than $1 billion in assets in the fold. No single bank accounts for more than 2% of the fund.
First Trust NASDAQ ABA Community Bank Index Fund (Nasdaq: QABA)
This fund seeks to mimic the performance of the Nasdaq OMX ABA Community Bank Index-but with a twist. The fund avoids the top 50 largest banks in that index, providing a greater focus on the nation's small, local banking franchises. The median-sized bank in this fund is around $550 million, just a fraction of the much larger regional banks found in the other two ETFs mentioned above.
However, note that this ETF, with just $11 million in assets, trades less than 10,000 shares a day, and should be best viewed as a longer-term investment vehicle rather than a short-term trading instrument. The 0.60% expense ratio is also a bit higher than its larger, more liquid rivals. The fund has been in existence for three years and in that time has been less volatile than many other ETFs--shares have tended to trade in the $20 to $25 range during that timeframe.
All three of these funds have registered gains of between 5% to 10% year-to-date. And more gains may lie ahead because regional banks sport attractive valuations and appear poised for a recovery in profits as the U.S. economy slowly strengthens.
Craig Siegenthaler, who follows regional banks for Credit Suisse, says a rebound is already underway. He has found that the number of non-performing loans at many banks has been steadily dropping. More importantly, lending activity appears to be picking up: In a just-completed survey of loan officers, 70% noted rising applications for business loans, up from 65% in a survey conducted in March 2012. Even housing-related lending is perking up. "This tells us that pockets of construction demand are beginning to emerge," Siegenthaler notes.
With limited exposure to the crisis in Europe and clear signs of rising banking activity, the timing may be right to load up on these ETFs.
David Sterman has worked as an investment analyst for nearly two decades. He was a senior analyst covering European banks at Smith Barney and was research director for Jesup & Lamont Securities. He also served as managing editor at TheStreet.com and research director at Individual Investor magazine.