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The following is excerpted from a recent edition of Value Investor Insight.

With the S&P Bank Index down 50% over the past year, it’s not surprising that opinions – divergent as they may be – are flying fast and furious about whether the worst is over for financial stocks. As helpful as such a public discussion might be for investors, the problem with such arguments is that all financial firms are placed in the same boat, as if Citigroup’s prospects mirror Bancorp Rhode Island’s.

Jason Stock and Will Waller of hedge-fund firm M3 Funds provide a more nuanced perspective on financials. Their investment universe consists primarily of Bancorp Rhode Island (NASDAQ:BARI) type companies, the 1,200 or so publicly traded U.S. banks and thrifts with market capitalizations of less than $500 million. They are by no means unabashed banking bulls – their portfolio is currently more short than long – but the challenges facing the sector are exactly what can create specific opportunities.

“The banking sector has such a poor overall outlook that it creates opportunity for banks that don’t have all the issues we’re concerned about,” says Stock. After scouring the uniform data banks and thrifts must file with regulators, Stock and Waller study regional demographic and economic trends for the banks in focus – “A bank is a levered play on the economy in which it operates,” says Waller – and then visit each market to gauge the health of the local economy.

Such research has confirmed bad prospects for such overbuilt markets as Phoenix, Las Vegas and southwest Florida, while also identifying pockets of strength in border communities near Canada and regions with high education-or government-related employment.

The banks heading M3’s buy list today (see table, below) generally chose to sit on the sidelines and hoard or raise capital in recent years while competitors grew through geographic expansion, launching risky new products or lowering credit standards. These once-considered “stodgy” banks typically sport high capital ratios, low loan-to-deposit ratios, high levels of low-cost deposits and low levels of non-performing assets.

“As competitors struggle to preserve or raise capital,” says Stock, “these banks should take profitable market share and be able to buy back shares at discounts to tangible book value.”

First of Long Island (NASDAQ:FLIC) is a typical example. Its overall cost of deposits is only 1.59%. Its loan-to-deposit ratio is just 59% and it has excess capital to use for continued share buybacks and to make properly priced loans as competitors falter. While the stock trades at 138% of tangible book value, Stock and Waller believe book value is understated due to the fact that the company owns much of the real estate for its branches, carried on its books at a significant discount to its true value.

Similarly conservatively managed is Meridian Interstate Bancorp (NASDAQ:EBSB), the holding company for East Boston Savings Bank, a $1 billion (assets) thrift in suburban Boston. The added twist for Meridian, says Stock, is that the company still has a mutual holding company structure, which essentially means that a majority of its existing shares are still owned by the holding company itself, not the public. With a second-step conversion to become entirely publicly held, an aggressive share buyback program and a generally improving competitive position, the bank’s shares should trade at or above tangible book value over the next three to five years, he says, which would result in a share price more than double today’s level.

For those less faint of heart, Waller and Stock consider the shares of Los Angeles-based First Regional Bancorp (FRGB) to be drastically oversold. At a recent $4.33, the shares trade at 32% of the firm’s $13.50 tangible book value per share, as the market appears to fear that real estate loan losses will require a dilutive capital raise. Waller and Stock disagree and think that while First Regional’s book value may decline up to $3 more per share before the cycle ends, its low-cost deposit base should help support a share price at or above tangible book as the cycle stabilizes. Even with the book-value hit, that would result in a share price of no less than $10.

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Source: Small Banks: Weathering the Storm