Big gains to be made off small-cap financial stocks

Big gains to be made off small-cap financial stocks
Winners emerging amid the extended housing slump, says fund manager David Ellison; companies taking share 'from the guys that screwed it up'
JUN 01, 2011
One upside of the prolonged property downturn is that good bets can now be found in the small-cap financial sector, according to David Ellison, manager of the $300 million FBR Small Cap Financial Fund Ticker:(FBRSX). Mr. Ellison, who has managed the fund since it was launched in 1997, is approaching the small-cap financial sector almost as an antique appraiser browsing through a flea market. “I've never done anything but invest in financial stocks, and the large sample size of about 600 [small-cap financial] companies is an advantage because there's a lot of stuff happening right now,” he said. Unlike many of the more diversified large-cap financial institutions, the smaller financial sector companies, such as regional and community banks, are more directly linked and exposed to the problems facing the housing market. In constructing a portfolio of about 65 stocks with market capitalizations of less than $3 billion, Mr. Ellison divides the universe into four broad categories. The first category is represented by what he described as “strong companies in weak markets.” For example, BankUnited Inc. Ticker:(BKU) is a well-managed and well-capitalized Miami Lakes, Fla.-based bank holding company. “We're looking for companies that can take advantage of the upset in the industry that has come as a result of the FDIC-forced consolidation,” he said. “These are the companies that will take share from the guys that screwed it up.” The second broad category includes companies that are still viable, but trading at discounts due to issues such as bad loans still on the books. This group is represented by a company such as Astoria Financial Corp. Ticker:(AF). The third category is similar to the second category, “but in worse shape,” he said. While financial sector stocks traditionally have traded at between one and two times book value, the stocks in this category can be found trading as low as 30% of book value, he explained. An example of a stock from this category is Banner Corp. Ticker:(BANR), a bank holding company. The final category in the portfolio is represented by a mix of property and mortgage real estate investment trusts, credit collection agencies, home builders and mortgage insurers. Many of the home builders in this category have been able to survive recent losses because of the look-back tax rule that allows them to offset present losses with the big gains from the market's heyday. “If you're going to lose money, it's important to have first made money,” Mr. Ellison said. One of the companies in this group is KKR Financial Holdings LLC Ticker:(KFN), a specialty finance company. The basic appeal of the strategy right now, according to Mr. Ellison, is that even though housing is still in decline, there will be continued consolidation, which ultimately helps strengthen the industry. “Right now real estate is the worst part of the U.S. economy,” he said. “But longer-term, things will get better, and this is a portfolio with a play on the recovery and stabilization of the housing market.” Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. For more information, please visit InvestmentNews.com/pmperspectives .

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