After suffering during the financial crisis, bank stocks have come roaring back. Financial Select Sector SPDR—a fund that owns banks such as Wells Fargo—returned 42.3% in the 12 months ending in July, compared with 24.8% for the S&P 500. Investors have embraced bank stocks as it became clear that most institutions had survived the crisis. Can the banks continue recovering?

Yes, say fund managers. They argue that profits are improving as banks avoid shaky loans. “Five years ago, people thought that home prices would never fall, and banks gave mortgages to people who shouldn’t have had them,” says David Ellison, portfolio manager of Hennessy Small Cap Financial Fund. “Now banks are making good loans that should produce profits.”

Ellison argues that we are in the early stages of a long-term recovery that should result in growing earnings and higher stock prices for the banks. He says the current period reminds him of the cycle that began in the late 1980s. At the time, lenders were extending credit to shaky borrowers. 

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Then oil prices sank, and the economy slowed. Dozens of banks and savings and loans went under in the oil patch and around the country. In response, regulators stepped forward, requiring banks to tighten their standards. As a result, the number of defaults declined, and bank profits recovered. From 1991 through 1997, bank stocks soared. After that, regulators eased the rules, and banks began another cycle of misguided loans.

Book values tell the story

The current cycle has several years to run before profits fully recover and the stocks reach their normal value, Ellison says. As an indication that banks may be undervalued, he cites an indicator called book value, which is a measure of assets minus liabilities. During the financial crisis, bank stocks sold for half the book values. Since then the shares have recovered to 110% of book values. In past bull markets, the stocks have reached 180% of book values. “The stocks are still low because investors don’t trust that the earnings will recover fully,” Ellison says.

A stock Ellison likes is Citigroup, which sells for 77% of book value. The giant bank has improved its balance sheet, writing off bad loans and paying down debt, he says. Defaults by borrowers have dropped sharply as the bank tightened its standards. “Citigroup is much safer now than it has been in 10 years,” he says.

Bill Nygren, portfolio manager of Oakmark Select Fund, likes Bank of America, which sells for 70% of its book value. Nygren aims to buy solid companies that sell for big discounts. Bank of America meets his criteria, he says. “They have one of the strongest balance sheets in the industry,” he says.

Weak loan volumes

Nygren concedes that the volume of loans issued by banks remains weak. That is a negative factor because banks earn greater profits when they make more sound loans. Loan volume should improve, however, as the economy recovers and more consumers seek to buy homes and cars. Even if loan volume does not rebound soon, Bank of America’s earnings can continue climbing, he says. Besides its banking operation, Bank of America owns Merrill Lynch, which remains a giant in the business of providing financial advice. Merrill fields an army of brokers who are earning growing profits as aging baby boomers seek retirement advice.

Like the giant institutions, small banks also suffered during the financial crisis. Community and regional institutions focus on making home mortgages and loans to small businesses. Those are recovering, but profit margins are still under pressure. Because of new regulations, banks are forced to hire compliance officers who insure that executives follow all the rules. That imposes a big cost for institutions that have a limited number of employees.

In addition, low interest rates in recent years have imposed a special burden on small institutions. The banks earn profits by taking deposits from customers and then lending the money out at higher rates. When the interest rates on loans are high, banks can record fat profit margins. These days, however, lenders are squeezed because they can only charge borrowers skimpy rates.

Community and regional banks

Despite the headwinds, some community and regional banks have managed to deliver solid returns by following conservative lending policies. To own small banks, consider investing in a fund that specializes in the sector. By buying a fund, you can own a diversified basket of many banks. A solid fund is Alpine Financial Services. During the past five years, the fund returned 9.1% annually, outdoing 78% of peers.

Portfolio manager Peter Kovalski likes to buy undervalued banks that are about to rally because of changes, such as new managements or acquisitions. He says that the rising interest rates of recent months should help banks. “Profits will improve as rates rise and banks can charge more for loans,” he says.

A favorite holding is Pacific Premier Bancorp, which is based in Southern California. The bank has been growing by acquiring failed institutions at rock-bottom prices. Pacific Premier can achieve higher margins by enjoying economies of scale and cutting the operating costs of the institutions that have been acquired, Kovalski says. Another holding is Southern National Bancorp, which has branches in Virginia and Maryland. The bank has been expanding by acquiring branches of troubled competitors.