Small-cap stocks, or those with a valuation between $300 million and $2 billion, have long been a popular choice with retail investors due to the fact that they are both primed for exponential growth yet have more stability than a risky penny stock. And one of the most popular sectors in small cap investing in 2013 is the financial sector.
While tech has certainly grabbed the lion’s share of attention the last few years, especially since it emerged as the most valuable sector by market cap, financials has been making a steady comeback this year. In the small cap market, financials has been a particularly strong performer. Equities.com’s Small Cap Financial Stars, which tracks companies that meet specific criteria for expected strong performers, is up 33.67 percent on the year, slightly better than the Russell 2000’s 32 percent return, and much better than the S&P 500’s YTD return of 25.2 percent.
The return coincides with the general betterment of the economy. This is to be expected, after all. Small cap financial stocks tend to be as straight-up a play on the market as a retail investor can get. If an investor thinks the market is due to rebound, small-cap banks represent a straight value play on that assumption.
Investment Bank Investing: Profitable, But Opaque
To be sure, investment bank plays can net a nice return. Despite their myriad legal issues and some $13 billion in settlements, JP Morgan Chase and Co. (JPM) has still netted a m27.32 return YTD. But don’t think that means the profits of JP Morgan are any kind of play on the economy’s strength.
Banks have traditionally made money loaning money back and then making money off the interest rate. Not so with investment banks. “Investment bank’s lending abilities have been mitigated by themselves or their investors,” explains Equities.com’s quantitative analyst Nicholas Bhandari. “They’re making the majority of their money from a variety of other activities.”
Loans as a Reflection of the Economy
Small commercial institutions, unlike investment bank plays, derive almost all of their revenue from the business of lending. If the economy is good, people default less, repay more, and banks revenue increases.”In that way, they’re directly tied to how the economy is doing,” Bhandari says. One of the surest signs an economy is in recovery is how the lending sector is behaving. And regional banks are one of the most straightforward illustrations of a healthy economy. Commercial banks are as pure a manifestation of the economy as one can get, and thus well suited for a value investor who’s a market bull.
Putting the "Region" in Regional Banks
As their name implies, finding a string regional bank plays is not a strictly macro endeavor. Commercial banks are also tied intimately to the region in which they operate. Retail investors should carefully consider what region the play they’re investing in primarily operates.
Bhandari says some particularly interesting regional banks can be found wherever growth is expected. He specifically cited regions where fracking is occurring (such as the Bakken Shale and Texas) and recovering cities like Pittsburgh, who possess lower unemployment and opportunity for higher growth than the national average.
What Else Should Retail Investors Look at With Regional Banks?
When it comes to picking a commercial bank play, traditional metrics serve well. Balance sheet, assets, the sort of thing business schools have been teaching for eons. As regional banks are such a clean play on the economy as well, it also helps to look at that one thing everyone looks to in a strong economy: growth. In short, retail investors are well-served to look for banks that are growing.
A growing economy means a growing bank means a growing investor portfolio – at least for an investor optimistic about the economy as a whole.
Pessimists? Well... there’s always investment banks.
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