2 Perfectly Contrarian Bank Plays

11/14/2011 9:00 am EST

Focus: STOCKS

Roger Conrad

Founder and Chief Editor, Capitalist Times

These two companies have enormous potential, proving just how profitable putting your money where they ain’t can be, notes Roger Conrad of Personal Finance.

With Europe battling sovereign-debt woes and the US economy in the doldrums, this may seem like an odd time to recommend banking stocks. However, Arrow Financial Corp (AROW) and First Niagara Financial Group (FNFG) are solid bargains.

Bank stocks have fallen out of favor recently. But lenders that navigate the current turmoil will score big gains when the business climate improves—even if their stocks suffer considerable near-term losses.

As is the case with every bank, Arrow Financial and First Niagara face significant challenges, particularly from falling net interest margins (NIM), or the spread between their price of lending and cost of borrowing.

Much of the weakness in NIM stems from the Federal Reserve’s Operation Twist—a program that aims to keep long-term borrowing rates low by selling medium-term bonds and using the proceeds to buy long-term bonds.

The impact of Operation Twist showed up in flat third-quarter results. Arrow Financial’s third-quarter earnings per share dipped to 46 cents from 48 cents in the previous year. First Niagara’s earnings per share came in at 25 cents, up slightly from last year’s 23 cents (excluding one-time items) but below Street expectations.

Both banks continued to grow strategic operations, control debt, and provide strong dividend coverage. First Niagara’s payout ratio for the quarter was just 64%, while Arrow’s came in at only 52.7%.

Year to date, Arrow Financial’s charge-offs amounted to only 0.03% of its net loans—the best in the business. With a total risk-based capital ratio of 16.31, it’s hard to imagine any bank better prepared for systemic events.

First Niagara is waiting on the US Dept. of Justice to clarify which branches it will have to sell to win approval for its acquisition of HSBC Holdings’ (HBC) branches in Upstate New York. This uncertainty is the primary reason the stock has dropped by more than 30% since early July, compared to a 2% decline posted by Arrow Financial shares.

First Niagara’s risk-based capital ratio remains superior at 12.6 %, total loans grew more than 10%, and the bank faces no outstanding debt maturities until March 19, 2020.

First Niagara’s stock sells for just 66 cents per dollar of book value and yields more than 7%; Arrow’s stock sells for 1.61 times book value and yields 4.3%. Arrow Financial Corp is a buy up to $28; First Niagara Financial is a buy up to $15. [Both were trading well under these price points at press time—Editor.]

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