Q: What is your investment philosophy?

A: We are value investors with a twist. The uniqueness of our approach is the focus on the US banking and financial services sector. We believe that superior risk-adjusted returns can be generated by selectively investing in small and mid-cap banking and financial services companies. I’m looking at companies with market caps ranging from $500 million to about $20 billion. That is just about every name in the field with the exception of CitiBank (C: chart), JPMorgan Chase (JPM: chart), or Bank of America (BAC: chart).

The banking industry is considered to be a fairly slow growth sector, but it has continuously generated earnings growth from 8% to 11% per annum and dividend yields ranging from 2% to 4% per annum. The sector has produced annual total returns of 10% to 15%, compared to the broader market returns of about 10% over the past 30 years. This is something that most people are not aware of.

Also, the banking industry often has been a hot bed for merger and acquisition activity. Ten years ago there were 14,000 banks in the country. Today we have 9,000 and expect that number to contract to 6,000 over the next 10 years. There are from 200 to 300 mergers a year. Typically, these mergers occur at 15% to 40% market premiums. I like to buy banks at P/Es ranging from 10 to 13 times earnings, which I believe eventually will either trade or be bought out somewhere around 15 to 20 times earnings.

I believe that the greatest opportunities in the banking sector are in the small and mid-cap stocks. Because of their size, they do not receive much coverage from Wall Street researchers. That provides us with the opportunity to identify and take positions in stocks that are undervalued. Investors turn to RASARA to accomplish a number of different objectives, such as adding total return to the marketlike
returns of their core equity allocation. Bank stocks also serve as a buffer to the downside risk in a broader core equity market allocation. Most importantly, RASARA offsets the underexposure of investors to a sector that has historically outpaced the broader equity benchmarks.

Q: What is your universe in terms of loan portfolios, regional exposure, commercial or individual banking? For example, can Capital One, which is credit-card company, or General Motors Acceptance Corporation or SunTrust be part of your portfolio?

A: I’m more inclined to go into a bank that SunTrust (STI: chart) would be interested in acquiring at some point. For example, Atlanta-based SunTrust acquired Tennessee-based National Commerce, which had been in our portfolio for a number of years.

My interest is in small to mid-cap regional banking companies rather than credit-card or insurance companies. In terms of overall opportunity, I consider the small and mid-cap banking sector an investing sweet spot. You have historically stable earnings growth and from time to time you experience a considerable amount of merger and acquisition activity. That's RASARA’s investment focus.

For example, I owned Summit Bancorp in New Jersey, which was acquired by Fleet. I chose to hold on to Fleet, which was subsequently acquired by Bank of America. We buy one bank and if we like the future prospects of the acquirer, we hold on to it and it is subsequently acquired by another bank.

The beauty of investing in small and mid-cap banks is that you don't need a merger to take place in order to make money. With rumors of consolidation, like in the cases of Wells Fargo (WFC: chart) and Golden West Financial (GDW: chart), two California banks, you witness a shift in perceptions, and often valuations are driven by perception. Someone like me thinks that this consolidation doesn't make sense, but that's not going to stop me from exploiting possible price movements.

Q: What were the factors driving this consolidation historically and forwardlooking?

A: If you compare the US banking industry to Canada, Europe, or the major Asian countries, you'll find a handful of banks in these developed countries and 9,000 banks in the US. Comparatively speaking, by number of banks per million people, the US is considerably overbanked.

Banking industry excess capacity limits revenue growth prospects generated by economic activity. Revenue expansion can be achieved via consolidation of smaller institutions. Through acquisitions, banks are able to provide services and operate more efficiently with much lower expense margins.

Q: In many ways the banking sector reflects the economic activity structure in the country. In the US small companies drive the bulk of economic activity in terms of transactions. Even though we may be overbanked, could competition still be reasonable at a local level?

A: That's very true. On the one end, each year 200 banks merge or apply to. On the other end, 100 new banks are formed each year, mainly community-based banking institutions. Consolidation of a couple of entities tends to create excess management. This management typically ends up going out and forming new banks. From the consumer standpoint, consolidation leads to depersonalization and has fostered a demand for more personal banking services at the lower end of the spectrum. That’s why these small community-based operations are formed each year.

Q: So you mainly invest in acquisition targets before they become targets?

A: Yes, but that is just part of it. I’m not just looking for takeover targets. The broader market tends to overlook the opportunities in the banking industry. It treats the industry as a seasonal or cyclical play as opposed to an ongoing play, and that's what makes me different from a lot of the other managers. My mandate is to look at the banking sector, and I find value in the sector regardless of the phase or the state of the economy.

Most investors think in terms of the impact of interest rates on the net interest margins of banks. Typically, investors rush into bank stocks when they think margins are going to expand and run out on the expectation that margins may contract. But it is really not that simple.

There are two components to bank revenues. Banks derive net interest revenues from commercial and industrial loans, small business loans, consumer lending, commercial real estate lending, and mortgages. But another vehicle is the non-interest revenue, which includes service charges on deposits, banking fees, trust operations, insurance and brokerage operations. The two components together, within an investment portfolio, create a less volatile revenue stream than the typical investor realizes.

A traditional bank would have net interest revenue from 75% to 80% of total revenues A more diversified bank like Fleet had interest revenue of 50% to 75%. Some specialized or niche banks, such as State Street Bank (STT: chart), which is considered a processing or trust bank, or to a degree the Bank of New York (BK: chart), have net interest revenue of less than 50%.