FBR's Ellison Uses Lessons From Peter Lynch to Get Top Return

By Aaron Pressman

April 22 (Bloomberg) -- David Ellison took about three years

to go from serving customers as a bank teller in upstate New York

to helping Peter Lynch pick financial stocks in the 1980s for the

Fidelity Magellan Fund, the biggest U.S. equity fund of the time.

``They saw I had bank experience on my resume so they said

you're the banking analyst,'' Ellison said in an interview in

Boston. ``And then I got a look at the thrifts that Peter owned

and started crunching numbers.''

Ellison, 46, left Fidelity Investments in 1996 and today

manages the top-performing specialty finance mutual fund of the

past five years, according to data compiled by Bloomberg. The $646

million FBR Small Cap Financial Fund has risen at an annual rate

of 22 percent since April 1999, led by holdings in companies

including Washington Federal Inc. and Hawthorne Financial Corp.

The banking industry and funds that own financial stocks have

benefited from an increase in corporate takeovers and the lowest

interest rates in 45 years, Ellison said. Lynch, 60, who quit as

manager of the Magellan fund in 1990, taught Ellison to separate

good companies from bad companies, and maintain confidence in his

stock picks even if the share prices dropped.

``Peter would say `if you loved it at $10, you should love it

even more at $8,''' Ellison said.

Ellison focuses on companies with market values of less than

$3 billion that have a low cost of capital and a low ratio of

expenses to assets, rather than on companies that are reporting

the highest revenue growth. He also scrutinizes a bank's borrowers

to avoid risky lenders.

Avoiding Risky Lenders

``The ability to raise lower-cost funds means you have to

take less risk to get the same return as someone with higher

costs,'' said Ellison, who works in Boston for Arlington, Virginia-

based Friedman Billings Ramsey & Co.

Washington Federal, a Seattle-based savings and loan with

total assets of $7.5 billion, isn't managed to report the highest

possible quarterly earnings, Ellison said. Since the end of 2002,

the company kept more than $1 billion of its assets in cash

invested in short-term funds yielding less than 1 percent, waiting

for rates to increase before making long-term loans.

``They are hurting profitability because they're managing

their balance sheet in a conservative and thoughtful way,'' said

Ellison, whose fund owned 1 million shares of Washington Federal

at the end of March.

Washington Federal's stock has climbed at an annual rate of

17 percent during the past five years, more than double the

advance of the Standard & Poor's Midcap Financial Index.

Hawthorne Financial

Ellison's fund also is invested in Hawthorne Financial, the

California real estate lender that's being acquired by Commercial

Capital Bancorp. Shares of Hawthorne rose at an annual rate of 34

percent in the past five years.

``They just offer a few products and they pay attention to

credit,'' he said. His fund owned 646,000 shares as of March 31.

Ellison, who got an undergraduate degree from St. Lawrence

University and a business degree from the Rochester Institute of

Technology, invests his own money in all of Friedman Billings'

mutual funds including his own. He hasn't bought an individual

stock for his account in the past four years, he said.

Ellison said his fund holds stocks for about six years on

average. That compares with less than two years for the average

equity fund, according to the Investment Company Institute, the

industry's trade group in Washington.

In the past month, the FBR fund has declined 5.5 percent on

concern that interest rates will climb. The Standard & Poor's

Midcap Financial Index has dropped 2.8 percent.

Market Decline

The 10-year U.S. Treasury note has fallen for four straight

weeks, the longest stretch since 2000, after increases in consumer

prices, retail sales and employment boosted speculation that the

Federal Reserve will raise its benchmark interest rate from the 45-

year low of 1 percent as soon as the third quarter.

An increase in interest rates may actually help financial

companies, according to Ellison. If rates got much lower, banks

wouldn't be able to make a profit on lending.

``The market should be cheering higher rates that will allow

the financial system to continue to lend and make good money,''

Ellison said.

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