Ever since the Great Recession, the financial sector has been the industry that everyone loves to hate, with both citizens and politicians blaming the sector for much of the economy’s woes. But Thomas Villalta, co-manager of Jones Villalta Opportunity (JVOFX, 866-950-5863) and author of “The Large-Cap Portfolio: Value Investing and the Hidden Opportunity in Big Company Stocks,” believes that a number of investor biases are impacting the valuations of many large-cap financials. He says these misperceptions have pushed valuations down to levels that still offer significant upside potential in the coming years, even if the big banks never return to the levels of profitability they enjoyed prior to the downturn.

Behavioral finance plays a large role in how you build your portfolio. Please describe how you use it.

Unlike the small-cap arena, it’s difficult for large-cap investors to develop an informational edge over their peers. For example, Apple (NSDQ: AAPL) has roughly 50 sell-side analysts and another couple hundred buy-side analysts poring over its regulatory filings, examining other publicly available information, and interviewing the tech giant’s consumers and suppliers. When evaluating a company that’s so widely followed, we’re not going to uncover anything that hasn’t already been thoroughly analyzed.

Nevertheless, large-cap stocks can still experience wide swings in valuations, which forces us to assess what might be causing such inefficiencies. We believe these dramatic moves are more likely based on investor psychology than a new piece of material information coming to light.

There are a number of behavioral biases that are prevalent in the stock market. Representativeness bias can take many forms, including scenarios in which investors analyze historical data and extrapolate trends over a longer-term period than is appropriate. Anchoring biases occur when investors fixate on a price target regardless of what new information may undermine their thesis. So there are many avenues by which behavioral biases creep into investment processes. Although we still perform an exhaustive analysis on a company’s fundamentals, our main focus is determining the extent to which a stock’s performance is being impacted by behavioral biases.

Investors are approaching stocks in the financial sector with a number of different biases, including representativeness. Since 2008, the banking industry has performed poorly from an earnings perspective, with sizable charges and writeoffs taken for bad mortgages and other debt, as well as litigation expenses. Investors are having a hard time getting beyond the recent past and imagining what these companies are capable of doing over the long term.

While the financial industry is unlikely to return to earlier levels of profitability, some financial firms’ low valuations make them a compelling investment, even with their reduced profitability.

Can you give a specific example of a bias at work?

We’ve been increasing our weighting in JPMorgan Chase & Co (NYSE: JPM) recently. With financials in general, many investors look at the European sovereign-debt crisis through the prism of the Great Recession and view the present crisis as a reprise of that environment. That’s an inappropriate perspective for investors analyzing domestic banks.

When we look at JPMorgan— even after the trading debacle they recently suffered— concerns about Europe have pushed the company’s valuation to unjustly low levels, especially given our expectations for their ability to generate returns on equity. The company’s market value dropped by almost $30 billion in a matter of weeks. In these types of situations, we wonder why its market value would change so dramatically in such a short period of time. While we know there are problems in Europe, we don’t think they pose a significant risk to JPMorgan’s geographical footprint.

When we look at the underlying value of the company, we don’t expect it to produce the returns on equity that prevailed during the last decade. However, we do believe it can achieve returns on equity of around 10 percent annually, which is quite appealing for a company that’s trading well below book value.

On the regulatory front, how are the Dodd-Frank reforms impacting the financial sector?

Dodd-Frank is significantly impairing returns on equity for many financial companies. In the past, JPMorgan was capable of a 12 percent to 14 percent return on equity, whereas now it’s closer to 10 percent. Profitability has certainly fallen, and while some of it may return, there’s a possibility that some forms of profit simply won’t be seen again. But even if JPMorgan’s return on equity were to fall to 9 percent, that still wouldn’t dissuade us from owning the company’s shares, given its current valuation.

What are some potential positive catalysts for financials?

Any sort of clarity on Dodd- Frank will be helpful, as well as progress toward a resolution of Europe’s debt crisis. Of course, the simple passage of time can also be helpful. As each quarter fades into history, investors can see that what transpires in Europe isn’t necessarily as big an issue for US banks as what the market might have perceived.

As far as the regulatory environment goes, financials probably won’t trade as high as they did a decade ago. For instance, we won’t likely see financial company stocks trading at multiples to book value like they did back in 2006. Instead, most banks will trade between their book value and 1.5 times book value because of the new regulations.

What are some of your other favorite financials?

Wells Fargo & Co (NYSE: WFC) is another holding that’s been negatively impacted by perceptions surrounding the crisis in the eurozone and the impact of new industry regulations. But Wells Fargo doesn’t have a large global footprint, so Europe isn’t much of an issue for its operations.

Bank of America Corp (NYSE: BAC) offers a thornier situation, because it operates on such a large scale and has so many different elements that are affected by regulatory concerns. Although Bank of America has even less exposure to Europe than JPMorgan, it’s still being treated as if the actions in Europe are greatly consequential for its business.

From the standpoint of Bank of America’s loan-loss provisions, investors seem to believe that the more near-term series of data from 2008 to 2011 is representative of what one can expect from the company. But over a longer-term cycle, the company should be able to earn significantly more money than what it’s earning now, given the decline in loanloss provisions. The bank’s shares trade at just one-third of its book value, so it doesn’t need to produce significant returns on equity for investors to realize a solid gain.

Unlike the aforementioned firms, Capital One Financial Corp (NYSE: COF) is largely focused on consumer credit cards. In percentage terms, the company’s shares haven’t fallen as hard as its sector peers, but it has traded lower from its highs earlier this year.

We’re in a very unappealing economic environment where progress comes undone almost as soon as it’s underway. Even so, the overall trend seems to be generally positive. For a lot of the credit card issuers, their customer profile has improved remarkably over the last few years. Many borrowers who were higher credit risks were shaken out in 2008-09. The cardholders that remain tend to be more creditworthy, and the market seems to understand that.