The ones I favor don't extend loans to Greece and don't load up on fancy derivatives. By James K. Glassman, Contributing Columnist February 6, 2012 The stock market as a whole has performed miserably over the past five years—it’s essentially been dead flat since the end of 2006. But bank stocks have done much worse. The exchange-traded SPDR S&P Bank ETF (symbol KBE) has lost an annualized 17.2% over that five-year period. No wonder: The source of the current sluggish economy was the financial crisis of 2008–09, when the value of bank loans was slashed as the real estate market collapsed and the economy fell into recession. SEE ALSO: Glassman's 10 Stock Picks for 2012 Many banks lacked adequate capital—that is, their own money—to back up what they borrowed to make the loans. They took big risks. Lulled by profits during the good years, they let their operations get sloppy and extravagant. And the road back has been a tough one, as share prices reflect. The stock of Citigroup (C) has fallen 94% over five years, and even a reverse split can’t mask the devastation. Bank of America (BAC) has fallen 86%. Beware the giants. Last June, I warned Kiplinger’s readers, Don’t Bank on Bank Stocks. It was a good call. Citigroup lost 28% of its value from June 1 through January 6; Bank of America, nearly half. Now, however, there are some bank stocks worth buying. Not the big money-center banks, such as Citi and BofA, nor the large regionals, such as PNC Financial Services and SunTrust Banks. They’re still feeling the aftershocks of the crisis, they’re vulnerable to the further deterioration of Europe, and, worst of all, their financials are a black box. You can get a good idea of how IBM is faring by looking at its balance sheets and income statements. But even experts can’t fathom many bank-loan portfolios, and profits are deeply affected by such impenetrable decisions as how much bad debt to write off. Advertisement When I queried one of my friends, a former bank CEO who built a solid institution and sold it, about bank stocks, he replied by e-mail: “Jim, I remain convinced that the complexity of their products and the flexibility of their accounting make the financial statements impossible to understand.” And this is a banker trained at Harvard Business School! I once worked for a bank myself, and what I learned was that, as in much of life, success blossoms from simplicity. The formula for success is straightforward: Make good loans and control expenses. Of course, the larger banks have shown that, with rare exceptions, they can do neither. Some of the smaller banks, however, can. But as often happens during severe stock market downdrafts, the good fall to earth with the bad. Thus are bargains created. The banks I favor have a footprint in a single state and, perhaps, a few contiguous ones and usually have assets of $25 billion or less. They don’t extend loans to Greece and don’t load up on fancy derivatives. They focus on home loans, and they know their customers and their markets. Their stock market values are typically less than $2 billion. A good example is First Connecticut Bancorp (FBNK), which went public in June 2011 through a process known as demutualization. Like many small thrifts, First Connecticut, based in a tony suburb of Hartford, was once a mutual savings bank owned by its depositors (even if they didn’t know it). Kevin O’Brien drew my attention to the stock, the ninth-largest holding of Prospector Opportunity Fund (POPFX), which he co-manages. (Stocks in boldface are those I recommend.) Advertisement O’Brien has found a pattern in demutualizations. Shortly after these banks go public, their stocks tend to fall as lucky depositors cash in, then languish at about 70% of book value (assets minus liabilities). O’Brien often buys the stocks when they trade at such favorable prices. Next, as investors come to realize the banks’ value, the stocks rise to close to book value—at which point, O’Brien usually sells. O’Brien’s fund owns about 20 bank stocks, roughly half of which went through the demutualization process. First Connecticut, oblivious to all the bad news from Europe, rose by 21% in the last four months of 2011, while Standard & Poor’s 500-stock index was flat and Bank of America fell by one-third. As of January 6, the stock, at $13, trades at 93% of book value. A great advantage of demutualized community banks such as First Connecticut is that they have high ratios of capital to assets—6.5 to 1 in this case, compared with about 12 to 1 for many money-center banks. An abundance of capital means a cushion if loans go bad, but it also means that a bank can make more loans—or buy back its own shares—to increase the ratio without taking on too much more risk. Another big O’Brien holding is Oritani Financial (ORIT), with 22 offices in suburban New Jersey. Like First Connecticut, Oritani has well-off suburban clients, and it’s selling them such products as short-term home mortgages. Oritani, whose stock yields an attractive 3.8%, is also making more loans to businesses. One of the brighter signs for the U.S. economy is that commercial and industrial loans are on the rise—up 10% for the quarter that ended last September, the biggest jump in three years. Advertisement It may seem surprising, but O’Brien likes banks based in Massachusetts, New York, New Jersey and Connecticut. Although real estate sales have been weak in the Northeast, prices didn’t go through the roof in this region during the housing bubble, as they did in California, Nevada and Florida. O’Brien also believes that many small banks in the Northeast are buyout candidates. There are more than 7,400 banks in the U.S., and consolidation will continue to be a major theme for investors. When community banks combine, cutting duplicated costs is relatively easy. It’s probably no coincidence, then, that the Northeast is the venue for all six of the community banks that Anthony Polini, a veteran analyst for Raymond James & Associates, rates a “strong buy.” One is People’s United Financial (PBCT), with branches in six northeastern states. Based in Bridgeport, Conn., People’s is large, as community banks go, with $27 billion in assets (compared with $2.6 billion for Oritani and $1.7 billion for First Connecticut). Polini likes the bank’s “strong growth in loans and deposits and improved credit quality.” At $13, the stock trades at 91% of Raymond James’s estimate of book value and yields 4.7%. Polini also favors Webster Financial (WBS), based in Waterbury, Conn., with assets of $18 billion. Webster has particular appeal because it has been cutting expenses—an often-overlooked key to bank profitability. In addition, Polini favors Community Bank System (CBU), based in DeWitt, N.Y.; Lakeland Bancorp (LBAI), in Oak Ridge, N.J.; Hudson Valley Holding (HVB), in Yonkers, N.Y.; and New York Community Bancorp (NYB), in Westbury, N.Y., which, with $42 billion in assets, is outside my arbitrary definition of community bank. Of greater interest, its shares yield a hefty 7.7%, a sign of either a bargain or of an institution that could be in trouble. New York carries more risk than the others, but I still find the stock attractive. Advertisement When it comes to larger community banks, I am more comfortable with Bank of the Ozarks (OZRK), a longtime favorite that I mentioned in June. Like the rest of the market, the stock was clobbered over the fall, sinking below $20, then recovered to a record high of nearly $31 late in 2011. With $4 billion in assets and about 80 offices in Arkansas and Texas (the only state outside the Northeast that excites O’Brien), the bank is run conservatively but has registered spectacular earnings gains over the past few years. Compared with the others, Bank of the Ozarks looks expensive, with a price-to-book ratio of 2.5, but I think it’s worth it. In 2009, First Trust Advisors launched an ETF devoted exclusively to community banks. Called First Trust NASDAQ ABA Community Bank (QABA), the ETF holds all Nasdaq-listed banks and thrifts except the 50 largest and any institutions that specialize in foreign lending or credit cards. Its portfolio is headed by People’s United; BOK Financial (BOKF), a strong Oklahoma bank in the heart of energy country; and Commerce Bancshares (CBSH), a Missouri bank with a large commercial loan portfolio and a 2.4% yield. The average market capitalization of the ETF’s holdings is $1.3 billion. Not all community banks will be winners, but I feel more comfortable owning these institutions than the ones that are supposed to be too big to fail.