After lagging the market for years, US financial stocks surged after Donald Trump’s surprising win in the US presidential election. Investors can still profit from investing in banks; in our view, many of the best opportunities now lie in the micro-cap banks the rally left behind.

Banks led the market up in the fourth-quarter rally, on widespread hopes that faster economic growth, rising interest rates, lower taxes and bank deregulation would boost their earnings. On average, banks with at least $1 billion in assets returned 26% in the quarter. But micro-cap banks—those with less than $1 billion in assets—on average, returned just 10%, as the left side of the Display below shows.

Micro-Cap Banks

That return gap does not reflect fundamentals, our research suggests. Micro-cap banks are likely to benefit just as much from faster economic growth, corporate tax cuts, deregulation and rising interest rates as larger banks.

Rather, micro banks were left in the dust for a technical reason: Very few of them are included in bank exchange-traded funds (ETFs), which generally buy larger, more liquid bank stocks. When the bank rally began, many investment managers that were underweight banks rushed to add exposure by buying bank ETFs, and banks included in the ETFs soared far ahead of those not included.

We could see the impact of ETF membership within our own holdings of micro-cap banks. Those included in bank ETFs rose 32% in the fourth quarter of 2016, while those not in bank ETFs rose 19%, as the right side of the Display above shows.

This performance gap widened an already large valuation gap between micro-cap banks and larger banks. Valuations for the most expensive group of banks, have soared from 1.7 times tangible book at the end of the 2015 to 2.1 times tangible book at the end of 2016, as the next Display shows. Valuations for micro banks, by contrast, rose from only 1.1 to 1.2 times tangible book value.

Micro-Cap Banks

Put another way, regional bank valuations rose from about 57% higher than micro-cap bank valuations to 82% higher. Such huge valuation gaps are highly unlikely to persist. We see two main drivers of a normalization in relative valuations.

First, the huge valuation gap is likely to encourage takeovers of micro-cap banks at higher premiums to their trading prices. Many boards of micro banks have resisted selling in recent years, on hopes of getting a higher price. The valuation gap allows larger banks to bid higher without diluting their own stock. That’s why stocks in acquirers rose after deals were announced in the fourth quarter, though historically, acquirers’ shares have usually fallen after takeover announcements. If the pace of and premiums for takeovers rise, shares of many micro banks may rise in anticipation, narrowing the valuation gap.

Second, if bank earnings grow more slowly than investors now expect, the bank stocks that have rallied most on hopes of an earnings boost (generally larger, more liquid and more expensive bank stocks) are likely to fall most. We think such disappointment is likely in the short term: Economic growth is likely to be slower than many investors expect, which would slow lending growth; and bank deregulation is likely to be narrower and take longer to implement. Indeed, our research suggests that deregulation is more likely to increase banks’ capital flexibility and to slow growth in compliance-related expenses, rather than reduce such expenses. Over the next few years, however, we see significant earnings upside for banks, both the larger, more liquid banks, and micro-caps.

In short, in the period ahead, we see less risk and greater upside in micro banks. That’s a compelling combination.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by Michael Howard – Alliance Bernstein