FUND WATCH


Bullish on Banks -- Again

The manger of FBR Large Cap Financial and FBR Small Cap Financial funds says the industry -- which he soured on two years ago -- should do well the next three to five years.



Dave Ellison's FBR Large Cap Financial (symbol FBRFX) is up 24% year to date through May 8. More astoundingly, the fund lost only 3% annualized over the past three years, an average of 13 percentage points per year better than a basket of financial-stock funds. The relative performance of his FBR Small Cap Financial (FBRSX) has been nearly as impressive.

How did he manage that feat while tethered to a sector that crashed and burned? Last year, he built up the large-bank fund's cash levels to 50% to 60% of assets. In fact, he soured on the industry two years ago, anticipating a surge in nonperforming loans (those in or near default), which "historically have been a killer of earnings for financials."

Ellison has invested in banks for more than 25 years, first as a Fidelity analyst and long-time manager of Fidelity Select Home Finance. Then he decamped to FBR, where he launched the two bank funds in December 1996.

Recently, Ellison turned bullish on banks again. He has invested nearly all of the cash in his large-company fund and is furiously putting spare cash to work in small financial companies. Why? He looks at banks as an industry that runs in cycles, almost -- oscillating between years as good, simple, profitable lending businesses and stretches of greed and stupidity, in which bankers seem to forget all the lessons of the past. Says Ellison: "The last four to five years the regulators, the Fed, the bank executives, Wall Street analysts and mutual fund managers didn't do their jobs. We had this collective brain cr everybody was along for the ride."

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That era is over now, and he says the industry is in full clean-up mode. Banks are raising capital, sprucing up ailing balance sheets, simplifying accounting, improving risk controls and becoming more transparent. "Everybody has admitted to being an alcoholic, so they're halfway there," he says. "When a company wants to get better and survive, typically it will."

What Ellison foresees is a favorable cycle for banks stretching for at least three to five years. "The next three to five years are a much better time to invest because financials have gotten religion about risk," he says.

Profits won't surge immediately, but that's because the banks are focused first on rebuilding balance-sheet strength to fortify the foundation. "You make money in financials when operating conditions go from ugly to okay, or okay to good, not from good to great," he says. In fact, when profits look great in banks it's probably time to lighten up because of the cycle of banker stupidity.

Ellison compares this early stage in the up-cycle in bank stocks with the early 1990s, when a tide of nonperforming commercial real estate and condominium loans similarly crushed the industry. Brave investors who arrived on the scene after the bulk of the damage was done were rewarded with handsome returns over five years for investing in ugly bank stocks.

Some of the bigger holdings in Ellison's large-company fund are JPMorgan Chase (JPM), Morgan Stanley (MS), Goldman Sachs (GS), Wells Fargo (WFC) and American Express (AXP).

Ellison predicts that "mistakes won't be repeated for five to ten years" because the recent debacle was "such a searing event." But then watch out. He says banks' institutional memories stretch only about ten years. Sooner or later, they'll hit the bottle again.

As much as we admire Ellison, we're reluctant to recommend his funds because of their high fees (the annual expense ratio is 1.88% for FBR Large Cap Financial and 1.49% for Small Cap Financial, according to Morningstar). Look to cheaper alternatives among exchange-traded funds, such as SPDR KBW Bank (KBE), which tracks an index of large bank stocks, and SPDR KWB Regional Banking (KRE), which focuses on small banks. They each charge 0.35% a year.




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