5 Scary Bets With Huge Upside

File these stocks under "high risk, high reward." That said, it's my belief that the best area to find market-beating returns right now is in banks.

And we can find many of these banks right here in the U.S. without having to speculate on the viability of troubled foreign governments like Greece, Portugal, and Spain.

Why is there opportunity in these banks? For a host of reasons:

• Many investors are once bitten, twice shy on banks following the 2008 meltdown and bailout.
• There's a good valuation spread between the "troubled" banks and the "healthy" banks.
• The market's sentiment on individual banks can move from "troubled" to "healthy" pretty quickly, leading to nice returns.

I'll break down the opportunities into two areas: the too-big-to-fail group and the smaller, regional bank group. In all, I'll show you five scary bets with huge upside and weigh in on which ones offer enough upside to trump the fear factor.

Troubled too-big-to-fail banks

Source: Capital IQ, a division of Standard & Poor's. P/TBV = price to tangible book value.

In the land of too-big-to-fail, Bank of America and Citigroup are generally regarded as the most likely to need another helpful hand from the government. You can see it in the higher valuations of the more market-respected banks. Wells Fargo's (NYSE: WFC) price-to-tangible book value is almost twice that of B of A (1.06 in the table above) and Citi (1.02). US Bancorp (NYSE: USB) is almost three times.

In general, the bigger the bank, the more inscrutable the balance sheet (i.e., the more derivatives, "financial innovations," and hidden risk). That said, Citigroup may be in its own class. If you tried to take Peter Lynch's advice and sketch Citi's business model with a crayon, you'd end up with a Rorschach test. Bank of America isn't far behind, if at all.

Financial regulation didn't fully defuse these ticking time bombs, so there is real risk of another 2008 scenario. Maybe that's why last month the Fed rejected B of A's plan to raise its penny-a-quarter dividend. And why Citi will only catch up to that meager dividend payout after its reverse stock split in May.

On the other hand, investors getting into post-crisis banks when skepticism is high can make a killing. See bank stocks in the 1990s after the S&L crisis. 

Is the bet worth it? : I believe shares of B of A and Citi are worth it now. There's real risk, but the chances of price-to-tangible book values doubling (to over 2.0) before the next big crisis are good. Especially if they're able to raise their dividends to more normal levels. But I'd seriously consider cashing in at least some of my profits if that double occurs.

Troubled smaller banks

Source: Capital IQ, a division of Standard & Poor's. P/TBV = price to tangible book value.

The nice thing about the American banking system (at least for investors) is that there are hundreds of publicly traded banks operating under the same basic business model -- borrowing at one interest rate (e.g., deposits) and lending at a higher one (e.g., loans for homeowners and businesses).

As I noted earlier, things get exotic at the level of Bank of America and Citigroup, but they tend to get more vanilla the smaller the bank. Your community bank simply doesn't have the Wall Street clientele to support most of the Wall Street shenanigans.

There's still plenty of room for trouble, though, in making risky loans and using semi-exotic financial instruments.

Like B of A and Citi, the three banks above are all trading at price-to-tangible books between 1.0 and 1.5, well below their 10-year highs. On an absolute basis, I generally start to get interested at price-to-tangible book values below 1.5, so each is bargain-priced.

But now for the bad news. Synovus, Huntington, and Regions each took TARP bailout money from the government. Only Huntington has paid it back so far. It's also the only one that's eked out some profit over the past 12 months.

Drilling further into Huntington, its nonperforming loans have dropped from 5.2% of total loans in 2009 to 2% in 2010. That's a good sign. Also, I see that those non-performing loans are more than covered by allowances (i.e., Huntington's already taken the earnings hit on them).

Is the bet worth it? : In the community and regional bank space, I usually like to stick with the ones that weathered the financial storm better than any of these three did. I also usually prefer the comfort of dividends higher than 1.5%, 0.6%, and 0.6% for Synovus, Huntington, and Regions, respectively. That said, I'm warming up to the possible turnaround situation at Huntington. If its share price dips below $5 a share, I'll be very tempted to look more closely and pick up shares.  

The takeaway
Of the five scary banks above, I think Bank of America and Citigroup offer enough upside to justify a buy at today's prices. Of the smaller banks, Huntington is more intriguing to me than Synovus and Regions because it's more surely on the road to recovery.

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