By JACK HOUGH
For stock investors, banks weren't where the money was in 2011.
The KBW Bank Index, which includes 24 U.S. firms, from global giants like Bank of America and JP Morgan Chase to large regional players, plunged 25% in 2011. The broader Standard & Poor's 500-stock index was essentially flat.
This is no repeat of the financial crisis, which exposed U.S. banks as dangerously underfunded and sent the KBW index crashing by more than three-quarters over two years ended March 2009. This time part of the problem is that, with all of the new safeguards in place to prevent a repeat of 2008, banks can't be as aggressive as they once could.
"Banks have much more capital today," says David Rolfe, chief investment officer at Wedgewood Partners, a St. Louis investment adviser overseeing $1.3 billion. "But for the big players, the business simply isn't as profitable."
Smaller banks, however, might present an opportunity for bargain hunters.
In the post-Lehman world, there are basically three sizes of banks: global "systemically important financial institutions," other big banks, and everything else.
SIFIs are banks deemed too big to fail. There are 29 worldwide, including eight in the U.S., and membership in the club isn't optional. It is determined by the Financial Stability Board, a global oversight committee created in 2009. These behemoths face the closest scrutiny and strictest capital demands.
In the U.S., new regulations impose liquidity and stress-testing requirements on all large banks. Banks with assets of more than $10 billion must run periodic stress tests, and ones with more than $50 billion face outside stress-testing.
Strong banks are a good thing for investors in general, of course, but regulators are "erring on the side of caution" with large banks, says David King, an analyst with Newport Beach, Calif., investment bank Roth Capital Partners.
That can stifle stock returns two ways, he says. First, extra money held in reserve can't be lent or invested at a profit. Second, large banks will face scrutiny as they try to return cash to stockholders through dividends and share repurchases.
Big banks face another problem. Customers are depositing plenty of cash into savings accounts and certificates of deposit but demand for loans has been weak.
In the past, a big branch network was necessary to attract deposits, says Mr. King. In the current environment, it's a burdensome expense for banks to carry.
The idea that big banks enjoy economies of scale is largely a myth, says Frederick Cannon, director of research at Keefe, Bruyette & Woods, an investment bank that specializes in the financial sector (and the creator of the KBW Bank Index). What they have enjoyed is a funding advantage, and that is changing.
"For 70 years, regulators viewed large, diversified banks as safer and thus able to make do with lower reserve levels," says Mr. Cannon. "Now they're taking the opposite view."
That leaves strong, small banks--ones with assets below $10 billion--in a position to outgrow and outperform the giants.
And their shares seem inexpensive, analysts say. Small bank stocks did better than big ones in 2011, but not as well as the broader stock market. The KBW Regional Banking index lost 7%.
Mr. Cannon says small banks look inexpensive relative to the book value of their assets--and large banks cheaper still. But the small ones will be better able to turn those assets into profits in coming years.
For stock pickers looking for highly profitable banks, the team of bank analysts at Keefe Bruyette & Woods recommends three for 2012: Bank of Marin Bancorp, based in California; Bryn Mawr Bank (BMTC)
For investors who want banks with high levels of excess capital, either for the added safety or the likelihood that future cash flow will be spent on stockholders in the form of dividends or share repurchases, the KBW team likes four banks: Columbia Banking System (COLB)
Mutual fund investors might consider the PowerShares KBW Regional Banking Portfolio (KBWR),
Alternatively, the SPDR S&P Regional Banking ETF (KRE)
Finally, there is the FBR Small Cap Financial Investor