From the September 2005 issue of Investment Advisor • Subscribe!

Bank on It

David Ellison of the FBR Small Cap Financial Fund uses a "mathematical hunt and peck" method to find sterling bank stocks

Just in time for the back-to-school season, here is a fund that takes a disciplined approach to investing. The manager stresses good old balance sheet arithmetic for the companies he buys: low expenses, plus solid earnings and reasonable valuations, producing a fund that steadily outperforms its peers. Of course, generating consistent returns is not as easy as the manager makes it look. It takes an analytical, strategic approach, and that's just what you find when you meet David Ellison, the Boston-based president of Friedman, Billings, Ramsey & Co., Inc. Fund Advisors, and portfolio manager of the FBR Small Cap Financial Fund (FBRSX). "We're trying to find companies with a very balanced approach to what they're doing and have those four or five criteria that fit, build a portfolio of 60 or 70 names, and just let it run."

Both Morningstar and Standard & Poor's give this domestic equity fund five stars overall, and that's not surprising given a five-year annualized total return of 24.93% for this no-load fund versus 5.14% for its peers in the S&P 500 Financials Sector Index.

How much money do you manage? FBR manages almost $2.3 billion. The two financial services funds [FBR Large Cap Financial and Small Cap Financial] are about $600 million of that.

Do you co-manage the Tech Fund? Right. It's about $14 million. The Tech Fund is fairly new; it had its three-year anniversary in March.

What is your investment process for the small cap financial fund? You start with all the companies in that universe and look at valuations, price to book, P/E, and other ratios, trying to get at what the earnings power is for each company: what the upside is to earnings and whether they're running on all eight cylinders or only two cylinders. The critical thing is valuation--you've got to have a valuation discipline. Price-to-book and P/E are two critical factors in determining what you're going to own. The third critical factor is a low expense ratio. It's a commodity business, so you don't want the highest-cost operation. You focus on building deposits and having a very good credit discipline. You look to build a very sustainable engine, not at companies that are earning a maximum amount on equity or a maximum amount on assets--[but] companies that have a model that's sustainable.

If I can own companies that are going to grow book value at 10% to 15% a year, that's sustainable, then presumably if the return-on-book or return-on-equity stays the same, then the stock should go up 12% to 15% a year, assuming there's no decline in price-to-book or price-to-earnings. There won't be a lot of turnover in the portfolio because companies don't change. If you have 600 names in the universe of banks, how do you get it down to 50? I'm going to look at the cheapest 300 on P/E and the cheapest 300 on price-to-book--that's the starting point. Which of those have low expense ratios? Get rid of the most expensive 50, and see which ones have a real focus on the liability side--then you look at the companies and what they actually do, you can't really do a mathematical number there. The real value of the company is the ability to raise deposits at a very low [interest] rate and a low cost, because that goes hand-in-hand.

How do you find the banks that are able to raise deposits in such a low-interest-rate environment? You look at the overall cost-of-funds, average deposits per branch, and growth of deposits per year. It's a matter of going through the numbers and whittling down: he's shrinking; he's growing deposits but it's costing him 8%, no good--forget it! He's growing deposits and it's costing him 50 basis points--ahh, I want that one! It's a big mathematical hunt and peck. You want the ones that are growing [deposits] effectively; they're spending most of their time trying to grow the liabilities [deposits] and less time trying to grow the assets, or loans. Obviously you want to make good loans, but for those you can just go out and buy FNMAs or GNMAs. If your cost-of-funds is so low that you can make money by buying CDs at other banks, then you've really got a franchise.

People look at [banks] and say, "Oh, they're making a lot of loans, therefore it's a good company." Anybody can make a loan--what is it costing them to make that loan? How are they financing it? When companies get into trouble--banks and non-banks--it's because their assets go bad. Banks don't fail because their liabilities go away--banks fail because their assets go non-performing and they don't have the earnings to cover the yield on their liabilities. I've been doing this for 20 years; I can look at a bank and in two minutes tell whether I want to own it or not.

When you decide to sell a holding, is it because you see it evolve outside of the box? You sell for two [reasons]: It's moving out of the box and/or the valuation. Getting back to the valuation criteria, valuation is a very big part of the discipline, because it protects the downside. If you're wrong on a couple of names in the portfolio and they go down 20% to 30% or something, there isn't enough horsepower, usually, to make that up.

Are there outside factors that would affect that, for instance, quality of the loans deteriorating because of the economy? Typically that's a big part of the valuation issue. If people are afraid of credit they're going to move away from it, but generally it's the old, "unemployment is at 5% and people say it's horrible," but 95% are employed. If you make loans with any sense of prudence, you're not going to run into a credit quality problem. Most people don't buy a home to default; most people don't take out a credit card loan to not pay it off.

It's the [companies] that go off and do crazy things like assume that making home loans at 110% of value is a good deal. All of a sudden it's 80% of the portfolio and they wonder why they get into trouble. I don't own those kinds of things. There's plenty of that--I could have a whole portfolio full of companies like that--and wouldn't be able to sleep at night. I tend to want to own the companies that are very balanced and are going to give me a decent return. I'm not looking for 80% to 90% a year--I'm looking for 10% to 12% to 15% a year, maybe more, maybe less, and I'm trying to be mindful of the downside, because this industry doesn't give you the opportunity to make up a tough year, so I prefer to give you 80% of the upside and 20% of the downside. I'm willing to give up some of the upside and some of the high-flying names [when, for instance] everybody says, "Oh it's great; it's a new paradigm." The stocks go crazy and then two years later, nobody talks about it.

The idea is to do it that way over long periods of time. That's why you look at the portfolio--it's pretty stable, the names don't change, and when they do change, they change typically for two reasons: the valuation, or there's been some change in management or strategy that moves it away from where I want to be. It's a very disciplined approach; it can be very boring in the sense that things don't change in the portfolio. If the stock's up 10% on some short squeeze I'll sell some, but that doesn't happen but once a quarter; if there's a takeover rumor or if the stock is up I may sell some. The names in the portfolio today are probably the names that have been there--some of the names have been there since I started the fund.

So, that explains your low turnover? And it will stay that way. That's the style of the fund.

Can you talk about the Fed's rate increases and how they're affecting your sector? For the sector as a whole, I've been a little disappointed that the stocks haven't gone down. Generally the portfolios of both funds are ahead of the bank indexes; in most cases they're ahead of general indexes year to date, so the funds have done well, considering. You'd think that with the rate rises, they would be underperforming by a little bit, given energy prices and everything else, but the rate rises have had very little impact--even on some of the more leveraged companies, because the rate rises have been slow, very predictable, and from that point of view it's been very well done [by the] Fed in terms of not creating any dislocation.

So it's going to move a little bit, but nothing too dramatic? Sure it's going to move a little but if you look at it from a short-term point of view, we've had a compression of spreads primarily because of the timing effect; the assets are rolling up [more slowly] than the liabilities. A lot of the [prime-rate based loans] had floors, and the prime has gone from 4% to 6.25%. They weren't earning 4%, they were probably earning 5%. As the prime went down, their yields didn't go down, they tended to widen; as rates went up their spreads started to shrink. So from a macro picture you want rates to go up, in a sense. Back when the Fed was at 1% and prime was at 4%, it was too low. The economy in the last 20 years has become so much more financial-services-oriented in terms of how it operates--the lending, borrowing, and depository functions--that if rates were to get too low the banks would start to say, "Well, I don't want to make that loan because I can't make any money."

More normalized rates? I'm not sure what normal is, but 1% is too low--4% is better than 1%. If you're a financial services company, even though you don't like rates going up because you think your stock may go down, ultimately, longer term for the economy and the lending business, you want the economy to be healthy, you want the well-run companies to be able to make money and do well. A credit cycle is good because it allows me to benefit as an owner because I own the better companies [that are] going to take share from these others that get into trouble and therefore, as an equity owner, I'll probably benefit from that. There are trillions of dollars in loans, trillions of dollars in deposits--plenty of share to be had. The question is: Who is going to take share--under what environment? You're not going to take share when mortgage rates are at 1%, because there's no profit. If mortgage rates go to 6% or 7% and people are getting into trouble, the [bank] that has the best credit controls, the best expense controls, the lowest cost-of-deposits is going to be taking share because those other [banks] aren't going to be able to make any loans anymore.

Where would this fund fit in a typical investor's portfolio? There are four big groups in the market: financial services, technology, healthcare, and energy. Those are the four areas where there are a lot of companies. You need a large enough sample size to be able to compare business models. If you're looking at the auto business with three domestic companies, there isn't enough of a sample size to know what's good and what's bad. If you had 600 companies, you're going to know what works and what doesn't. You can look at the performance of the companies, and track them over time, and because the sample size is so great, you can pick out 60 or 70 companies that make sense and create this portfolio. I think financial is one of those four groups, so from that point of view, you'd want it to be 25%, assuming that you were not smart enough to choose which one of those was going to be hot this year. You'd want to have 25% in each one of those and spread it out that way. Financial services is a growing part of our economy versus manufacturing or mining, which are increasingly done offshore, so in terms of the overall economy it is a bigger part of the economy, therefore it should be a bigger part of a domestic portfolio.

You think that a financial services fund like this would fit in up to 25% of a portfolio? I think the ideal thing would be for somebody to find four fund managers and each one is going to specialize in one of those groups. I'm going to take my money and put it into this fund, and find a look-alike in technology, in healthcare, and in oil, and that would be the portfolio.

What has done well in the fund, and what hasn't and why? Washington Federal has not done as well over the last year or so; people view that as being very rate sensitive, so people are afraid of the rate sensitivity and therefore the stock has not done as well.

What about holdings that have done better than you expected? Sterling Financial (STSA) has done well out in Spokane, Washington. That's one of the ones that was out of the box and moved toward the box, improved return on assets and equity; driven by expense reduction, margins have been a little better, become more commercial-bank-like, and I guess there's been a little takeover speculation. Franklin Bank Corp. in Texas (FBTX) has done well, primarily because of oil--it's in Texas--and there have been some takeovers, the economy is doing better, they don't have credit quality issues, they made a few acquisitions that looked okay, and the valuation is still reasonably low relative to the group. Was I predicting that when I bought it? No, I bought it because it fit the mathematical criteria.

But nobody objects to a happy surprise. Right. All of a sudden oil goes up and people love Texas. All right, fine! I've owned People's Bank of Connecticut (PBCT) for years. New management came in and they've started to move toward what I tend to like, which is what other people tend to like. Hudson City Bancorp (HCBK) in New Jersey did a mutual holding company conversion (MHC)--where they go half-public; then they go public [with the other half] and there's a lot of accretion because of the way the MHC works. Say you sell 100 million shares, half of the company. You calculate book value and EPS [with a theoretical] 200 million shares but you only have half of the equity, because you only went half-public. They sell the other 100 million shares, the share count [for P/E and price-to-book value] doesn't change, and all that capital they raised in the second step comes to [shareholders] free.

These are all companies that are between $500 million and $10-$20 billion in assets, not market cap; they're small community banks. Why would you want to own these? Because they have a [low] expense base, they can take share and maintain share. People assume that the bigger companies are going to come in and take share. Typically the bigger companies have a high expense base; some of these executives get paid more than these little companies earn. A typical commercial bank would have an expense ratio as a percentage of assets in a year of roughly 3%. At Hudson City it's less than 1%.

Is it because the bigger banks have investment banking, etc.? The consultants have a great chart that says (pointing): This is executive pay, this is assets; as assets rise, executive pay rises. Hudson City is here and Citicorp is here (points higher). The CEO of Citicorp makes 50 times [what Hudson City's CEO makes] but it's the same yield on assets, same cost of funds, same ATM fees. What's the difference? He has a higher expense [base]. There's no empirical evidence that bigger is better in this business; if anything, bigger is worse because it creates those layers of expenses and the entitlement of getting paid more.

What else do advisors need to know about the fund? The style is not going to change--it's a discipline on deposits and liabilities. If you're going to be in financial services long term, those are the kinds of companies you want to own. The investment environment is very revenue-oriented. CNBC and The Wall Street Journal [report] "revenues were higher than expected." Does that mean they made any money? Are they giving away the product to bring in the revenue? Nobody talks about what the profits are. It's revenue-centric as opposed to balance-sheet-centric. What I'm trying to do is own companies that are operating as you would operate: prudently, meaning that you're in an economy that is financial- and currency-oriented. You work, make $8, spend $7, and save a buck; every year your balance sheet is going to get better. Theoretically the guys that are best off at the end have the best balance sheets. The ones that forget that assets and liabilities are important don't do as well. I'm trying to own companies that focus on that.

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

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