For bank stocks, think small

March 20, 2014, 2:54 PM UTC
Illustration: Guy Billout

When it comes to bank stocks, the rising fortunes of the “too big to fail” lenders have dominated the headlines since the financial crisis. But lately regional banks have quietly outperformed their larger counterparts: For the 12 months ended in mid-March, the S&P Regional Banks Select Industry Index had gained 27%, easily topping the 19% increase in the S&P Financial Select Sector Index. Even after that impressive run-up, experts still see a lot of value in the regional category.

Smaller banks offer a far more direct play on the slowly improving U.S. economy than, say, Citi or J.P. Morgan Chase. A typical regional bank’s customer base consists primarily of retail customers and local businesses; there is little foreign exposure. Erik Oja, a banking analyst at S&P Capital IQ, estimates that the combination of a continuing U.S. recovery and rising interest rates should boost regional bank earnings by 6% in 2014. The key is the willingness of consumers and businesses to take out new loans — a major source of profits. “Accelerating loan growth will likely be the next catalyst to push the stocks higher,” says Citigroup bank analyst Josh Levin. In 2013 loans made by regional banks grew by 4% — well below the long-term average annual rate of 7%, notes Levin — leaving plenty of room for additional loan growth.

Another crucial component of regional bank earnings that’s on the upswing is “net interest income” — the difference between what regional banks charge on loans and pay on deposits. As the Federal Reserve continues to taper its massive bond-buying program, the spread between short- and long-term interest rates is widening, resulting in fatter profits for banks. Oja calculates that net interest income for regional banks will grow by 2.7% in 2014, a major improvement from the near-0% growth rate in 2013.

Since banks’ prospects can vary widely by local economy, investors need to be selective. One favorite of Credit Suisse analyst Craig Siegenthaler is First Horizon National, a Memphis-based bank with a market capitalization of $2.8 billion. Siegenthaler, who has an outperform rating on the stock, believes that First Horizon will see significant improvement in its net interest income in the coming year. He estimates that the shares will rise by 9% over the next 12 months.

With an $8 billion market cap and a forward P/E of just 12, Ohio’s Huntington Bancshares is trading “at a deep discount to peers” despite solid operating fundamentals, says Morgan Stanley analyst Ken Zerbe. He has an overweight rating on the stock and sees 10% upside over the next year. New York’s Signature Bank is not similarly cheap; it trades at 19 times next year’s estimated earnings. But the lender, which has a market cap of $6 billion and targets privately owned businesses and high-net-worth individuals, has been gaining market share. Goldman Sachs analyst Ryan Nash, who rates the stock a buy, thinks those gains will continue and sees the shares rising by 15% over the coming year.

A former compensation consultant, Janice Revell has been writing about personal finance since 2000.

This story is from the April 7, 2014 issue of Fortune.