(MONEY Magazine) – What do you do when you're a sector fund manager and your sector hits the skids? Well, if you're David Ellison, manager of the three-year-old FBR Financial Services fund, you stick with the value-oriented strategy that made you one of the decade's top managers.

After all, Ellison, who also runs FBR Small Cap Financial, has been down this path before. In 1990, when he was running Fidelity Select Home Finance, his fund lost 15%. Then the Federal Reserve began cutting interest rates. One year later, he returned a dizzying 65% and landed in the top 3% of funds. He stayed in the top 11% for the next five years. Writer Jeanhee Kim recently spoke with Ellison to get his perspective on today's bank stocks. One thing stands out: While big bank deals grab the headlines, Ellison believes that small local operations offer the best values.

Q. Financials have been leaders through the 1990s. Has their reign ended?

A. For the past 12 months we've been in a very difficult environment for banks, with big declines in rates, troubles in Russia and Asia, and a refinancing boom that is disastrous on their balance sheets because the banks must spend heavily to attract new borrowers. We're out of favor, but eventually we'll be back. Banks are a significant part of the world mosaic in terms of capitalism.

Q. Aren't falling rates usually good for banks?

A. We've reached a point where a decline in rates is no longer a positive for banks because the spread between the cost of borrowing funds and what banks can charge customers has been squeezed thin. If rates go lower, meaning if the 30-year long-bond yield goes down to 3%, the time we spend getting to that point is going to be rough. You'll have a lot of refinancing and pressure on margins and earnings.

Q. It sounds as if you'd like to see rates go up.

A. The market's knee-jerk reaction to a rise in rates is that they are bad, so they sell bank stocks in anticipation, but at this point, a rise in rates is a positive, and I can take advantage of that by buying the financial stocks as they decline.

Q. How do you define cheap?

A. I've always been one to look at price/earnings and price/book ratios. I want to buy the lowest P/Es I can find with very low risk in terms of credit quality. For small-caps, that means 75% to 80% of book value and 18 to 19 times earnings--which isn't that cheap in the larger scheme but is for companies of this size. For bigger caps, I look for two times book and 12 to 13 times 1999 earnings. The bottom line is that if you look at 50 to 60 companies that have the same relative credit-quality risk and the same relative deposit pattern, I'm going to own the ones that have the lowest P/Es.

Q. So what banks meet your criteria now?

A. I like New York-area thrifts like Astoria Savings, Staten Island Savings and Roslyn Savings. Consolidation is a big part of the banking business, and these banks have done acquisitions well. There were no screwups. All the computers worked. These are banks dealing with customers; they have to maintain trust and community pride.

I always look at return on equity to help figure out the kind of growth I can expect. My portfolio's ROE is somewhere between 10% and 15%. Judging from their return on equity, I expect Astoria to grow about 14% annually, Staten Island 12% and Roslyn 12%.

Q. What else do you like?

A. Looking beyond New York, I like Union Planters, based in Tennessee. The bank is buying other banks. It's selling at two times book and 13 times earnings with an ROE of 19%. And FirstFed Financial in Santa Monica, another traditional thrift, selling at 1.4 times book and nine times earnings, that should grow at 12%.

Q. Right now big banks seem to be doing better than smaller ones. Why aren't you focused on them?

A. I own a little bit of BankAmerica and Citigroup because this is a financial sector fund and they're a big part of the sector.

Q. That's not a very enthusiastic endorsement.

A. There's always been this belief that bigger is better, but there's no empirical evidence that this is true. Is ROE higher? The thrifts have the same ROE as these guys. Plus, I can tell you to whom the thrifts are giving loans, but with the bigger banks I don't know that. Also, many big commercial banks are earning fee income from things like investment banking, currency trading, loan-syndication fees and venture-capital gains.

That kind of income is market-driven and unsustainable. I prefer traditional forms of income, like bank account fees and mutual fund fees.

The big bank mergers didn't add relative value. I haven't heard anyone saying that all these synergies are making their earnings grow any faster. They're bigger. So what?