Spotting the Financial Survivors

DESPITE AN ONSLAUGHT of bad news, the financial sector will bottom eventually. Maybe it already has. That means it's time to own bank stocks. But where do the best — and safest — opportunities lie?

There's no doubt that the sector is facing some of the most difficult conditions in memory. This summer's collapse of IndyMac Bancorp set off multiple bouts of near-panic selling. But the widely feared rash of bank failures hasn't materialized. To the contrary, the banking system as a whole seems fundamentally healthy. Richard Bove, the respected banking analyst at Ladenburg Thalman, concluded after IndyMac's collapse that "the system is not anywhere near the danger that existed in the late 1980s and early 1990s" after the savings-and-loan debacle.

Now that second-quarter earnings have been digested and banks have further written down their bad loans and other nonperforming assets, better visibility is beginning to emerge. Worries over the housing market remain a serious drag on the sector. But I have no doubt that eventually financials will recover — and we're much closer to that point now than a year ago. When the recovery really kicks in, and these beaten-down stocks soar, I want to have already added to my positions.

The good news for investors is that the entire sector has lagged — the good banks along with the battered bad. To me, this signals a potentially historic opportunity for calmer, long-term investors, especially those who focus only on the strongest, best-capitalized banks. Not only will these banks be the survivors of the current crisis, but they'll also be in a position to take advantage of the weakness of many of their competitors, buying assets on the cheap to grab market share. I consider this to be a low-risk strategy. Leave Fannie, Freddie and WaMu to the speculators. I want a solid, long-term investment I don't have to lose sleep over.

So who are the best candidates? In a report this summer, Bove drew up a list of potentially troubled banks that garnered him considerable attention (and a lawsuit). But I was interested in the other end of his ranking spectrum: the banks so well capitalized, with such high-quality assets, that they posed almost no risk of failure.

To pick winners, I used an approach adapted from Bove's research. With SmartMoney research assistant Tyler Hill, I looked at nonperforming assets, as disclosed in the banks' public filings, and divided them by the sum of their shareholder equity and reserves against losses. The resulting ratio is a measure of the strength of banks' balance sheets, with a lower ratio indicating greater strength. We considered anything below 5 percent to be exemplary — banks with few nonperforming loans and a healthy cushion of capital.

Some of the banks on our honor roll are primarily asset managers and custodians, focusing on institutional clients. They don't do any mortgage lending, so they avoided the worst of the subprime blowup. Others are in some of the few geographic areas (like New York City) that haven't experienced the worst of the real estate decline. Here are a few finalists that I found especially promising:

Name a venerable midwestern family or institution (including DePauw University, my alma mater) and chances are, its assets are here. You won't find any drive-in banking windows at Northern. It caters to super-high-net-worth individuals and families. Its seemingly stodgy business model has stood it in exceptionally good stead. Its bad-assets-to-capitalization ratio is a minuscule .67 percent — you can't get much safer than that. Meanwhile, Northern has beefed up its international presence with the acquisition of London-based Baring's wealth management unit.

Northern's stock was trading late this summer at $79, only $2 off its 52-week high. But its price-earnings ratio was under 18, well below its average of 21. I expect it to move to a premium as customers flock to its rock-solid balance sheet.