The Banking sector has taken a beating this year because of the subprime mortgage fiasco. More share price decline is to come as bigger banks continue to write off billions of losses from bad mortgages. Smaller public community banks that do not even have subprime mortgages on their books are being punished as well.

The market is sometime quite “irrational” when it makes no distinction in pummeling a good stock from a deservingly bad one because of guilt by association. If history repeats itself, now would be a good time to pick up cheap shares in these smaller banks to see double to triple digit returns in the next two to four years. Similar situations have happened at least three times in the Banking sector as small banks were dragged down because of issues with bigger banks and an irrational market sentiment.

By owning an index of small community banks during the 1980s, between September 1982 and July 1986, an investor could have made over 250% returns. This same index of small banks would have made over 188% between November 1990 and October 1993. Another scenario appeared during 2000 when small banks were punished because of losses by big banks during a difficult rate environment. Over the next four years, the share price of the smaller banks skyrocketed once the market realized its errors with the smaller banks.

Today, with the subprime mortgage meltdown, the opportunity presents itself again. It can not be any clearer that the market is incorrect about smaller community banks that have nothing to do with subprime mortgages. Once again, profitable small banks are being indiscriminately being punished for the problems of mega-banks.

The challenge for the investor is whether to buy individual small community bank stocks, or a fund containing small banks. Big returns can be made in this situation by scanning for currently profitable small banks that have taken a beaten in share price, but do not have anything to do with subprime mortgages.

There are many small banks that only make loans to small businesses, involved in commercial real estate or non real estate financing and investments that make them immune from the subprime residential lending in the long run. These small banks will rebound once the market realizes this. Stocks like BUSE, CNB, VCBI, PRSB, CFR, NYB, EWBC and SMTB are examples of small banks that have no or very little exposure to subprime mortgages.

Owning an index or fund of small banks should make significant returns as well if an investor does not want to spend too much time researching individual banks. It is a conservative approach because diversification is achieved if a few banks in the basket may have subprime mortgage exposure. One such banking index containing small banks is KBW Regional Banking ETF (KRE). There are other banking funds and ETFs like Regional Bank HOLDRs (RKH), but they have too many of the big banks with the subprime issue as part of their holdings.

The opportunity is there to profit from the current decline in small bank stocks because of the subprime and housing fiasco the big banks are suffering from. Investors will have to make a move before the rest of the market realizes that the small banks are unjustly punished. As always, do your due diligence.

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