HOW TO PLAY IT: Banking on Financial Stocks

ISSUE: While third-quarter earnings reports present a mixed picture for financial services companies, big declines in bank stocks offer tempting bargains for investors.

Are banks beyond repair? The largest U.S. financial companies did little to answer that question, delivering a mixed bag of quarterly results.

Earnings rose at Bank of America , Morgan Stanley , Citigroup and Wells Fargo . Meanwhile, JPMorgan Chase & Co and BlackRock Inc said profit fell, while Goldman Sachs Group had a rare loss.

But they all have one thing in common: Severely depressed share prices, which means rarely seen bargains for the brave.

For investors who remain worried about the banks -- and there is plenty to be worried about -- analysts say there is opportunity in sector funds and in other corners of the financial services sector.

GO CHEAP

Bank stocks are decidedly out of fashion. The KBW Banks Index plunged 85 percent between its February 2007 peak and the depths of the financial crisis. After falling 28 percent this year, the index trades at about 1.3 times tangible book value, versus a long-term average of 3 times book value.

For the brave, it means shares are available at rarely-seen valuations, said Gary Townsend, a former federal bank examiner and Friedman Billings Ramsey analyst who manages $40 million at Hill-Townsend Capital in Chevy Chase, Maryland.

We think we've seen the bottom. We can't expect them to get much cheaper, he said. It could be a while before the banks and their stocks are safely out of the woods, so near-term gains could be small.

There are signs that bargain hunters have begun wading in, pushing the BKX up 6 percent from its two-and-a-half-year low, reached on Oct. 3. Citi shares are up 27 percent in that period.

Some investors say third-quarter results offer some positive signs. Many banks beat profit expectations. Earnings on average are up 15 percent over the same period last year, and balance sheets are much improved since the financial crisis. Lending activity is also rising.

The outlook for the financial sector is steadily improving; it is not deteriorating despite understandable fears from all corners of the globe, said Robert Albertson, chief strategist at Sandler O'Neill.

Several investors and analysts said JPMorgan, US Bancorp , and Wells Fargo are well-positioned to benefit from a recovery in the sector thanks to their scale and healthier balance sheets.

Others said investment banks Morgan Stanley and Goldman, having just endured the toughest markets in years, are poised to thrive when financial markets rebound because they are stronger, leaner and have fewer competitors.

BASKETS

With continued uncertainty -- from new regulation to Greek debt -- investing in dozens of banks through exchange-traded funds could trim risk for investors who believe financials are over-sold and are willing to wait.

Top rated bank ETFs include the $4.3 billion Financial Select Sector SPDR , the $317 million iShares Dow Jones U.S. Financial Services Sector ETFS and the $500 million Vanguard Financials ETFS

But do some legwork before buying. Investors have to dig in to see how these index funds are constructed, S&P Capital IQ analyst Todd Rosenbluth said.

For example, the SPDR bank fund concentrates more than half of its assets in 10 companies, while iShares invests 38 percent in its top 10. That means the SPDR fund's performance is closely tied to that of JPMorgan, Citi and Wells Fargo.

Investors in this case, wouldn't get the benefit of holding smaller banks, which don't have exposure to the world's sovereign debt woes and have performed better in some cases.

Investors can get exposure to smaller banks through the First Trust Nasdaq ABA Community Bank ETF , which has 61 names, the largest of which represents 5 percent of the fund.

GO SMALL OR ALTERNATIVE

Big bank margins have been squeezed by near-zero interest rates and low long-term yields and Dodd-Frank reforms target risky but lucrative businesses bank businesses, like proprietary trading.

That's turned some investors off to big banks altogether. But there are other ways to invest in the sector and take advantage of the sell-off.

Jeff Bronchick, founder of Cove Street Capital, a El Segundo, California firm managing $350 million, described himself as a value investor, someone who normally would eagerly scoop up beaten-down stocks. The economic and regulatory challenges facing banks, he said, are too daunting.

It's better to avoid the dragon than slay the dragon, he said.

Bronchick owns Jefferies Group Inc , among the few brokers that did not become a bank during the crisis and small Ohio bank First Financial Bancorp

Anton Schutz, Mendon Capital Advisors founder and manager of the $39 million Burnham Financial Services Fund , suggests a portfolio of small banks yielding 5 percent, such as New York Community Bancorp , Valley National Bancorp , First Niagara Financial Group .

Asset management giant BlackRock Inc is another financial services-related option. The firm's stock has lost 21 percent of its value this year, but its business would thrive if asset prices rebound.

You can take advantage of this beat-down, Schutz said.