FUNDVIEW-Less is more when it comes to bank stocks

By Joseph A. Giannone

NEW YORK, Dec 3 (Reuters) - One of the best performing bank funds says small banks will continue to outpace their bigger, better known rivals.

The Forward Banking and Finance Fund HSSAX.O, managed for the past 11 years by Kenneth Mertz, has avoided household names such as Citigroup (C.N) and Wachovia WB.N in favor of community banks such as PrivateBancorp Inc (PVTB.O) in Chicago, Prosperity Bancshares (PRSP.O) of El Campo, Texas, and Bank of the Ozarks (OZRK.O) in Little Rock, Arkansas

"We saw a new trend in the late '90s that turned out to be correct, which was that the smaller community banks would be the winners in a consolidating industry," said Mertz, chief investment officer of fund sub-adviser Emerald Advisors in Lancaster, Pennsylvania.

That focus helped the $65 million fund outperform all but three bank sector funds in the past year, down 3 percent versus a 62 percent drop by the S&P Financial Services Index.

Over the past 10 years it is the No. 2 bank sector fund with an 8.3 percent total return, according to Morningstar. The S&P 500 is down 28 percent over that period.

Mertz said small banks are run better than their bigger rivals and can dominate their local markets through better service and knowledge about customers. The Forward Fund seeks out strong community banks across the United States, especially where mergers are taking place.

"These banks have a natural advantage: you are providing personalized service the bigger banks cannot," said Mertz, whose companies have an average market value of $1 billion.

For the past 15 years, the banking industry has been swept up in a wave of consolidation fueled by the belief that bigger banks were stronger, more efficient and more profitable. But many acquirers stumbled as customers frustrated by poor service and ownership changes fled to local rivals.

The bigger-is-better view may finally have been put to rest in the past year as the largest U.S. banks, generating massive losses from lending and trading moves, have been forced to scramble for government financing just to stay afloat.

Struggles at big national banks could help drive more business into the arms of community-focused lenders, extending the superior performance of small banks, Mertz said.

There will also be a lot more mergers and acquisitions once the industry stabilizes, a trend that serves as a "sweetener" for bank stock investors, he said.

Mertz said his fund picks banks based on the strength of their local economies, proximity to competitors that are merging, and low levels of loan losses.

Some of his top holdings at the end of October included Texas Capital Bancshares Inc (TCBI.O) in Dallas, Silicon Valley's SVB Financial Group (SIVB.O), and Philadelphia Consolidated Holding Corp PHLY.O.

The fund avoids areas that gorged on construction during the boom years -- California, Florida, Las Vegas and Phoenix -- and are now suffering steep declines in real estate prices.

And though stock markets continue to plunge, the fund remains almost totally invested. Bank stocks, Mertz said, usually recover before data suggest conditions have improved.

"I'm trying to find new banks. I think '09 is going to be a better year than '08 in terms of opportunities," he said. (Editing by John Wallace)