Investing - Bank Stocks: NEW YORK, Jan 13 (Reuters) - Bank stocks face plenty of challenges this year as profit growth slows, but muted expectations and high dividends make them a safer investment that shares in other industries, according to analysts at Keefe Bruyette & Woods.

"We have some serious head winds in '06 -- margin pressure will be a factor, fee growth will decelerate and credit costs will actually rise -- but none of this is a surprise," KBW bank stock strategist Diane Merdian said.

By comparison, expectations for shares outside the banking sector may be unreasonably high and subject to revision, she said.

A small investment bank specializing in financial services, New York-based KBW recommends investors maintain market-weight holdings in banks in the year ahead. Merdian recommended a bias toward big banks, which are much cheaper relative to small and mid-cap banks and thrifts.

Merdian acknowledged she had been leaning toward an "underweight" rating before commencing year-ahead meetings with KBW's analysts, since bank stocks are historically expensive relative to the benchmark S&P 500 Index.

Bank stock price-to-earnings ratios are about 83 percent of the broader S&P 500, KBW said, compared with a median of 70 percent over the past decade.

This year presents a number of challenges for most banks, including the need to boost reserves as loan losses rise while fee and loan growth slow. Overall, big bank earnings are expected to rise 8 percent, down from 10 percent in 2005.

Yet bank stock yields are twice that of the S&P 500, which means total shareholder returns should be competitive with that of the broader market, Merdian said.

KBW's top picks for this year include Citigroup Inc. (C.N: Quote, Profile, Research) and Washington Mutual Inc. (WM.N: Quote, Profile, Research), large banks with relatively cheap stocks, high yields and more limited downside. The firm also touts Bank of New York Co. (BK.N: Quote, Profile, Research), a trust and custody bank whose market-related revenue growth should outpace costs.

Small bank stocks, Merdian noted, are less attractive after several years of outperformance based on faster growth and speculation about takeovers.

That outperformance has made small bank stocks more expensive and forced big banks to pull in their horns, since stock swap takeovers have become prohibitively pricey.

Last year, only 29 U.S. banks of more than $500 million in assets were acquired, down by half from 2004. Transaction pricing rose to historic highs relative to earnings and book value.

Most big banks will continue to sit on the sidelines, KBW said, but a more difficult environment may prompt some struggling small banks to sell. One solution for suitors is to offer cash or a higher mix of cash, which makes deals less dilutive to earnings.

"The recent pickup in bank M&A activity will continue into 2006," KBW said, "though most of the activity will be market fill-in and market-extension acquisitions of regional and community banks and thrifts by other banks of the same size."

Copyright: Reuters 2006. All Rights Reserved.

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