An Underdog Stock to Crush the Market

In the current stock market, the banking sector is downright hated. You may have even cringed when you read the word "banking." Hold your hate for a few minutes, though, and I'll explain why the bank I'm thinking of is a great underdog story and why I think it will crush the market.

Better than the big underdogs
With the economic gun they hold to the government's head, the too-big-to-fail banks don't seem like good underdog candidates. Yet the numbers show that the market is pricing them as such. Of the four largest banks (JPMorgan Chase, Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , and Citigroup (NYSE: C  ) ), only Wells Fargo trades above a price-to-book ratio of 1.0.

Put another way, Citigroup lost close to $30 billion in 2008. It would have to suffer through two more 2008s for its price-to-book value to reach 1.0. That's some serious market hate.

Though I am bullish on the big banks, investing in them takes a leap of faith. Even a sub-1.0 price-to-book value is expensive if there's enough toxic junk hidden on the opaque balance sheet.

Fortunately, the underdog bank I'm thinking of is much smaller and more transparent than these banks. But I'll warn you, as you move down the ladder to smaller U.S. banks, things get simultaneously more risky and less risky.

Here's how they're more risky. The FDIC's latest problem-bank list rose to 888 banks (out of 7,574). You won't find the megabanks on this list. If you add up the total assets of all 888 banks, they'd total less than a third of the assets of Wells Fargo, the smallest of the Big Four. There are a lot of scary small banks out there with shaky balance sheets. And since the FDIC's problem-bank list is confidential, we can't just scan the list before we buy; we need to do our own due diligence and watch out for potential land mines. Remember, these banks don't have the too-big-to-fail safety net.

Yet, overall, I find investing in smaller banks to be less risky than the big banks. Here's why. Of the 7,574 FDIC-insured banks, more than 400 trade publicly on major U.S. exchanges. So while there are only a handful of choices in the too-big-to-fail camp, there are hundreds of smaller banks to choose from. And, in general, the smaller the bank, the lower its ability to engage in exotic Wall Street derivatives.   

With all the similarly modeled banks to choose from, we can afford to be picky with the banks we buy. There's certainly money to be made in finding the ugly banks that will eventually turn around. This desire is what fuels interest in short-of-perfect regional banks Flagstar (NYSE: FBC  ) , Synovus (NYSE: SNV  ) , and Regions Financial (NYSE: RF  ) .

Each of these banks has been unprofitable over the past 12 months. Each still owes money to the government under TARP. And each still has elevated levels of bad loans on its books.

An underdog stock to crush the market
Compare that to the tinier-still underdog bank I want to highlight -- Financial Institutions (Nasdaq: FISI  ) , the owner of New York state-based Five Star Bank.

Like Flagstar, Synovus, and Regions, it's had its share of problems. It recorded a big loss in 2008, but has recovered and now trades for a P/E ratio of 10.5 and a price-to-book of 1.1. It took about $38 million in TARP funds, but has paid it all back with interest. And Financial Institutions not only has a low level of bad loans, but also has reserves equal to almost three times those bad loans.

Now that's the type of beaten-down underdog I'm looking for -- the kind that's firmly in the middle of a comeback! For another underdog idea or two, check out our free report "5 Stocks The Motley Fool Owns -- And You Should Too." In it, I detail a stock that's still an underdog despite systematically crushing the market. Click here for instant access to the report.