Financial Stocks: Do You Dare?

Try these guys on for size: Regional banks are busy buying and lending.

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Are you interested in some financial-stock exposure but spooked by Europe's nagging problems and some globally overexposed U.S. banking giants? One potential fix is to think small.

"Regional" publicly traded banks, or chains with a presence in midsized and lower-population markets, currently represent good value investments, particularly as alternatives to large money-center banks such as Citi (ticker: C) and Bank of America (BAC) and investment banking giants JPMorgan (JPM) and Morgan Stanley (MS).

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"There has been a general dislike for financials because of the European crisis and because low interest rates are a challenge. Banks are avoided because of the headlines. At street level, where they're lending, they're doing well," says John Fox, co-manager of Fenimore Asset Management's FAM Value Fund.

Regional banks not only have limited exposure to the compromised European financial system, but the best of the crop survived the 2008 U.S. crisis with limited scarring from toxic mortgage-backed securities and the subprime mortgage market implosion. They've now got the solid balance sheets to prove their resiliency. Declining delinquencies and lower loan-loss provisions have boosted the performances of many regional banks.

In fact, the 2008 crisis created a buyer's market for regional banks that wanted to (and needed to) grow through acquisition, says Fox. He's focused on names that have been smart buyers: SCBT Financial (South Carolina Bank & Trust) with ticker SCBT, Home BancShares (HOMB), Bank of the Ozarks (OZRK), and M&T Bank Corp. (MTB).

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Why buy? Because interest-rate margins are squeezed, banks have to grow revenue by taking on more assets. It also allows the buyers, in some cases, to extend their geography. Fox points to HOMB, whose deals gave it more branches in Florida. "I'm a long-term bull on Florida as more baby boomers retire," says Fox.

As for MTB, it bought Wilmington Trust when that target got hit by construction loans. But what MTB acquired, says Fox, was "great franchise mortgage banking."

Of course, squeezed loan spreads due to persistent ultra-low interest rates negatively impact all banks, but regional banks are able to make up for some of that lost revenue through a pick-up in mortgage business. In the first quarter, for example, Fifth Third Bancorp (FITB) reported that refinancing activity doubled. M&T Bank Corporation (MTB) reported a 24 percent jump in mortgage revenues and PNC Financial Services Group (PNC) was close behind with an 18 percent rise in mortgage revenues.

Certainly, it's not been a straight climb higher for this sector.

Broader sector performance reflects the uncertainty. The SPDR KBW Regional Banking ETF (KRE) is off just over 1 percent over the past three months, although it's outperforming the SPDR KBW Bank ETF (KBE), which is down nearly 6 percent over the same stretch.

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Also worth watching: Regional banks could be affected by proposed rules to raise capital requirements. Bank capital under current rules remains strong and most banks will exceed their capital ratios under the new rules "by the end of this year and, for the banks that do not exceed the target this year, we believe they will by year end 2013," said RBC Capital Markets analyst Gerard Cassidy, in a research note.

Some analysts see stock-price ripples as opportunity. "Mid-cap regional bank stocks are down 6% on average over the past quarter due to a return of concerns pertaining to global macroeconomic events. Due to their lack of direct exposure to these risks and favorable relative positioning in the new regulatory paradigm, we continue to see several attractive opportunities," said Stephen Scinicariello, UBS analyst, in a research note.

While regional banks today appear to be less risky than major money-center banks, they are still highly susceptible to the cyclical nature of their credit lending business. Spotty U.S. economic news incites caution.