More on Banks

12/22/2006 12:00 am EST

Focus:

Michael Farr

President, Farr, Miller & Washington

Asset manager Michael Farr chimes in with his take on the banking industry. Here, he recommends that investors seek opportunities in the shares of the mega-banks versus their smaller-cap brethren, for a variety of reasons.

"For several years now, professional investors have been predicting a rotation from small-cap stocks into large-cap stocks. So far, it hasn't happened.

"So will 2007 finally be the year in which this rotation takes place? While we have no better short-term predictive abilities than other professional investors, we do believe that the mega-cap, "money center" banks Citigroup (C NYSE), Bank of America (BAC NYSE), and JP Morgan Chase (JPM NYSE) offer far superior risk-adjusted returns when compared to their smaller-cap, regional bank counterparts.

"As the economy and earnings growth continues to slow, investors will begin to favor companies with stable and visible earnings steams. The money center banks are diversified from both a product and geographical perspective. They have highly competitive investment banks and trading arms, large commercial lending platforms, asset management and other fee-based services, and international exposure.

"Consequently, JP Morgan, Citigroup, and Bank of America are not over-reliant on consumer mortgage lending like many of the regional banks. Consumer lending (both credit cards and mortgages) has been the fuel behind the growth in domestic banking for the past several years. Given the backdrop of weaker housing prices and slower consumer spending, we see a change on the horizon.

"Secondly, we believe that increasing consumer loan losses and a flat yield curve will continue to pose very difficult challenges for US banks. Unlike the past several quarters, banks will no longer be able to generate earnings simply by drawing on their loan loss reserves. Deposit growth will come at a premium as banks fight to retain customers in the face of an increasing pool of alternative savings vehicles.

"In this type of environment, size and diversity are incredibly valuable. We expect the money center banks to gain deposit share through aggressive marketing initiatives, while strategically allocating capital to those businesses that provide shareholders with the greatest returns.

"For the past several quarters, the stocks of pure-play asset managers and investment banks have surged while money center banks offering these services have remained stagnant. We believe that by simply assigning a market multiple to the various business segments within the money center banks (an exercise called a "sum-of-the-parts" analysis), it's become strikingly clear that these diversified companies are undervalued. As investors begin to recognize cheaper alternatives for gaining exposure to these booming businesses, the money center bank stocks should rise."

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