Taking The Bait

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It's a buying frenzy. A desire to boost earnings with new retail customers, combined with a general pickup in mergers and acquisitions, has rekindled a decades-old trend of bank consolidation. The banking industry has announced $114 billion worth of M&A's so far this year, including the $58 billion blockbuster that brought together

Bank One and J.P. Morgan Chase. Now the pairings are trickling down the asset chain. In late August Citigroup said it was buying its way into retail banking in Texas by acquiring privately held First American Bank. Two days later, Canada's Toronto-Dominion Bank announced it would spend $3.8 billion for 51% of Banknorth Group, based in Portland, Maine, which is itself expanding southward by acquisition.

While the jury is still out on how consolidation will affect consumers, it's clear that merger mania means opportunity for stock pickers savvy enough to bet on the next bank to get scooped up. When word of a takeover gets out, shareholders almost always see a pop in stock price. "Who is the next to go? That's the million-dollar question," says John McCune, research director at SNL Financial in Charlottesville, Va.

One way to narrow the field is to look for markets primed for consolidation. Texas is booming with cross-border business but remains a fragmented market. When Citigroup was circling before it grabbed First American, the rumor was that either Houston-based Southwest Bancorporation of Texas or Texas Regional Bancshares, based in McAllen, Texas, might get poached. Both remain available. To the east, Florida is hot with deposits from transplanted retirees. In June Wachovia, based in Charlotte, N.C., announced it would buy SouthTrust, based in Birmingham, N.C., which has a major Florida franchise. Many banks have already seen their stock prices bid up, which makes them less attractive. Still, targets could include First National Bancshares, based in Bradenton, Fla., and Tallahassee-based Capital City Bank Group. Other banks with a large presence in the state, such as Colonial BancGroup, based in Montgomery, Ala., are also a way into the market.

When comparing banks, consider price-to-book and price-to-earnings ratios, which tell you how much the market is willing to pay for the bank's assets and earnings, respectively. The idea is to seek out ratios that are lower than those of other banks; this indicates that the companies are "cheap" and more likely to be bought. A buying bank typically pays 2 to 2 1/2 times book value when acquiring another company, so look for a price-to-book ratio below 2. Look for companies growing close to their price-to-earnings ratios. Many banks have forward P/E ratios in the teens (the average is 12 1/2 times earnings for regional banks), though not many grow in the double digits. Focus on banks with price-to-earnings-growth (PEG) ratios closer to 1.

And don't forget that if the bank doesn't get bought, you'll still own it. So seek solid management, not too much reliance on mortgage lending (since interest rates are rising) and a healthy dividend payout ratio (dividends paid divided by earnings). That ratio currently averages 43% for the industry. Says fund manager Anton Schutz: "You might as well get paid to wait."

For a less risky way to buy banks, check out mutual funds that specialize in the financial-services sector. Although his Burnham Financial Services Fund is closed to new investors, Schutz recently opened a second fund, Burnham Financial Industries. Others worth a look include T. Rowe Price Financial Services and Davis Financial. But even in a fund, you shouldn't invest more than a small slice of your portfolio in such a narrow set of companies. In other words, don't bet the bank on the bank.