Funds Betting on Beaten-Down Regional Banks

As the fallout from the subprime-mortgage crisis and credit crunch has continued to spread, the latest victims have been regional banks. In the early stages of the crisis, most of the market's attention centered on mortgage lenders such as Countrywide Financial CFC and Wall Street giants such as Merrill Lynch MER and Citigroup C, which had to write down the value of billions of dollars of subprime-tainted securities on their balance sheets. Regional banks took some hits, like all financial firms, but for a while it seemed that they might be spared the worst of the damage.

In recent months, though, things have deteriorated rapidly for many regional banks, especially those with a lot of mortgage exposure in hard-hit areas of the country such as Florida and California. With housing prices in those formerly hot markets in free-fall and delinquencies and foreclosures on the rise, these banks are facing tremendous financial pressure and huge mortgage-related losses. In early May, National City NCC had to raise $7 billion in outside capital to shore up its balance sheet. On June 2, superregional bank giant Wachovia WB forced out its CEO, whose 2006 acquisition of California-based mortgage lender Golden West is a big factor behind the bank's current financial woes. The latest blow came on June 12, when KeyCorp KEY announced that it's slashing its dividend and raising $1.5 billion in capital. National City's stock is down 68% for the year to date through June 12, Wachovia is down 48%, and KeyCorp is down 47%, with many other regional banks down 20% or more.

Which mutual funds have been most affected by all this turmoil? Or, looking at it another way, which funds are making the biggest bets on a rebound in regional bank stocks? To find out, we looked at the funds with the largest combined percentage of their portfolios in seven prominent regional banks that have been particularly hard-hit in this crisis--National City, Wachovia, KeyCorp, SunTrust Banks STI, Regions Financial RF, Fifth Third Bancorp FITB, and Huntington Bancshares HBAN. Each of these banks is suffering because of significant exposure to mortgages, and each of the stocks is down more than 20% so far this year.PAGEBREAK

Not surprisingly, the funds with the biggest stakes in these beaten-down banks are financial-sector funds specializing in bank stocks. The top seven funds on the list fit this description, led by Senbanc SENBX, with 20.21% in the seven stocks, followed by Fidelity Select Banking FSRBX at 13.66% and Rydex Banking RYKAX at 12.66%. When we eliminate sector funds and look only at diversified funds, the results are a little more interesting. Here are the 10 diversified funds with the biggest combined percentage of assets in the seven stocks noted above, including each fund's category, size, and percentile rank in its category for the year to date through June 10.

Biggest Diversified Holders of Prominent Regional Banks
	Category	Size ($Mil)	Bank %	% Rank Cat YTD*
Hennessy Cornerstone Value HFCVX	Large Value	154.8	6.86	98
Schneider Value SCMLX	Large Value	305.8	6.61	53
DWS Dreman High Return Equity KDHAX	Large Value	6,991.0	6.36	88
Dreman Contrarian Large Cap Value DRLVX	Large Value	7.8	6.00	88
DWS Dreman Concentrated Value LOPEX	Large Value	52.5	5.96	92
Federated Strategic Value SVAAX	Large Value	754.5	5.64	84
Forward Sierra Club Stock SCFSX	Large Growth	40.6	5.63	80
Delaware Pooled Large-Cap Val Eq DPDEX	Large Value	8.9	5.58	82
Dean Large Cap Value DALCX	Large Value	15.0	5.42	74
Touchstone JSAM Inst Large Cap Val CIJLX	Large Value	12.8	5.37	98
* As of 6-10-2008.

Nine of the 10 are large-value funds, which is not surprising given that banks are generally perceived as "value" stocks. More specifically, this list is dominated two groups: funds that focus on high dividend yields and funds with a contrarian strategy.

The top fund on the list, Hennessy Cornerstone Value HFCVX, uses a purely quantitative strategy in which manager Neil Hennessy buys the 50 highest-yielding stocks that meet certain minimum criteria for market cap, valuation, and earnings growth. Hennessy rebalances the portfolio just once a year, in the first quarter, and this year KeyCorp, Regions Financial, Wachovia, and National City all made the cut because their plunging stock prices have pushed up their yields. Another fund on the list, Federated Strategic Value SVAAX, also uses dividend yield as one of its main criteria, and Wachovia is among its top 10 holdings. (Its top holding is US Bancorp USB, a superregional bank that has avoided major mortgage-related damage.) Both of these funds have yields that are among the highest in the large-value category.PAGEBREAK

This list also includes several funds run by contrarian managers, who look for stocks that are deeply out of favor. Three of the top five funds on the list are managed by David Dreman, a legendary contrarian who has compiled a great long-term record by going against the flow and picking up stocks when they're most beaten-down. All three of these funds have similar portfolios that include big positions in Wachovia and KeyCorp, both of which are certainly facing their share of troubles. The number-two fund on the list, Schneider Value SCMLX, is managed by Arnie Schneider, less well-known than Dreman but similarly successful with his contrarian approach. National City and Wachovia are among this fund's top 10 holdings, as are beleaguered mortgage securitizers Fannie Mae FNM and Freddie Mac FRE.

It's not exactly a shock to see that these funds haven't done very well so far in 2008. None of them are ahead of their category for the year to date through June 10, and eight of the 10 are in their category's bottom quartile (with another one just missing). As noted above, several of the funds, including Schneider Value and DWS Dreman High Return Equity KDHAX, have very good long-term records, but the nature of contrarian investing means that they'll sometimes be badly out of sync with their peers. A respectable case can certainly be made that these regional bank stocks are undervalued right now--four of the seven have 5-star Morningstar Ratings as of June 11--but the skittishness in the market makes their short-term prospects uncertain.

David Kathman is a fund analyst with Morningstar