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Small is beautiful when it comes to returns of U.S. bank stocks Add to ...

Smaller, regional U.S. banks often escape the attention of investors. Their chief executives aren’t household names, regulators aren’t breathing down their necks and their financial setbacks don’t rock the financial world. These are good things – and they have been rewarding shareholders.

To be sure, the behemoths – as represented by the S&P 500 diversified financial services index, which includes JPMorgan Chase & Co, Bank of America Corp. and Citigroup Inc. – have been performing wonderfully for investors.

The index has risen 23 per cent in 2013 and a dazzling 73.5 per cent over the past year as they continue to recover from the steep selloff during the financial crisis.

But the smaller regional banks, with market capitalizations generally about a tenth the size of the biggies, have been showing some remarkable mojo of their own.

These stocks, which include BB&T Corp., KeyCorp, Zions Bancorporation and Fifth Third Bancop, have outperformed the diversified banks by about 3 percentage points since the start of May, when markets began to fret over the potential for a shift in stimulus policy from the Federal Reserve. Their year-to-date gains are nearly 26 per cent.

Even better, the news hanging over them isn’t as worrisome. U.S. regulators are proposing tougher rules for the biggest U.S. banks, going beyond the Basel capital rules designed to prevent a repeat of the 2008 crisis.

From Bloomberg News on Wednesday: “The eight largest firms, including JPMorgan Chase & Co and Morgan Stanley, would need to retain capital equal to at least 5 per cent of assets, while their banking units would have to hold a minimum of 6 per cent....”

In the case of Morgan Stanley, estimates from Goldman Sachs suggest a $14-billion shortfall that could require three years worth of retained earnings. Translation: Those rising dividends that investors have been yearning for might have to wait.

In contrast, UBS analyst Stephen Scinicariello this week previewed the start of the earnings season for regional banks with a 13 per cent boost to his share price targets. He also nodded to long-term bullish themes, such as an improving economy, better housing data and the potential for the Fed to raise interest rates sooner than expected.

“Regional banks should remain relatively well insulated from both global macroeconomic and regulatory risks,” Mr. Scinicariello said in a note.

He thinks relative value is particularly compelling for KeyCorp, Fifth Third and Comerica Inc. Yes, the strong performance this year could lead to some setbacks ahead, but he recommends looking at any substantial dips as buying opportunities.

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