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Summary

  • After a 34% increase in 2014, SWS has reached our price target and is now fairly valued.
  • Further, there are several alternative investment options in the banking sector with significantly less risk and more upside.
  • For long-term investors, well-positioned small cap banks are an exceptional chance to participate in a massive wave of consolidation about to hit the sector.

Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Background

In the first half of 2012, we acquired a position in SWS Group (NYSE:SWS) for our model portfolio. After a 34% increase in 2014, we are exiting our stake. With this action, we will lock-in returns of roughly 57% on our first purchase and 51% on the second buy.

Although we remain quite bullish on the community banks, this decision is relatively straight-forward given that the stock has reached our target price. Further, there are several alternative investment options in the banking sector with significantly more upside.

Update

As we originally highlighted in September 2013, we believe SWS is fairly valued at book value or $8-$8.50 per share. Although the company possesses an attractive product set and footprint, five years of poor financial results create a challenge for those who would argue SWS is worth a premium to book value.

In fact, the company was only able to achieve the current valuation due to multiple acquisition offers. Prior to the first proposal ($7.00 per share) by Hilltop Holdings (NYSE:HTH), SWS traded at 75% of book value. Should the current high bid ($8.00 per share) by Espostio Global fall through or the Board determines SWS is better off as a standalone entity and rejects the takeout proposal, we would expect the stock price to collapse. Recall SWS rejected a $7.50 per share offer from Sterne Agee in 2011.

Alternatively, there is a possibility that a higher buyout offer could emerge. For a stronger competitor, SWS represents either incremental scale or a beachhead in the attractive Texas market. By eliminating duplicative costs post-merger, a strategic buyer would likely be able to realize substantial synergies, potentially justifying a bid north of book value. The market is banking on such scenario coming to fruition, as the stock is trading at $8.15, north of Espostio Global's offer.

We are comfortable taking that risk at this point. If the ultimate acquirer ends up paying $8.50 per share, we will miss the last 4.3%. Although we hate to forego any gains, there are a number of small cap banks with significantly more upside.

The Hemlock team follows 47 of the most attractive community banks in the United States. Leveraging our proprietary bank ranking model, we believe Prudential Bancorp (NASDAQ:PBIP), TFS Financial (NASDAQ:TFSL), and Wolverine Bancorp (NASDAQ:WBKC) are attractive opportunities for new money today.

Each firm maintains a strong capital position, improving credit metrics, and is valued a fraction of tangible book value. The substantial liquidity is critical to driving shareholder value as it provides the wherewithal to pay dividends, repurchase shares, and ramp loan growth. Of course, these same characteristics are attractive to strategic acquirers as well.

Consolidation As A Catalyst

As we discussed in mid-February, the banking community is in midst of a challenging situation. Despite a low net interest margin environment, there is limited organic growth opportunities available. Further, rising compliance costs are encouraging banks to increase assets, thereby spreading the expense over a larger base. As banks look to expand, the most logical approach is to acquire smaller peers.

The ambition to expand is multi-fold. In addition to the obvious benefits of scale, the market simply prefers the larger banks. Over the last four years, the stock performance of large cap financial institutions has double small cap returns. As such, smaller banks, on average, are valued at about 90% of book value versus 150% for the national players.

For long-term investors, we believe well-positioned small cap banks, such as PBIP, TFSL, and WBKC, are an exceptional chance to participate in a massive wave of consolidation about to hit the sector.

Summary

There are risks to stock ownership. We focus on opportunities where the risk/reward ratio is dramatically skewed in our favor. Priced well-below $6.00 per share, we viewed SWS as a high upside prospect with limited downside. Today, we see minimal upside and an elevated level of risk. We are locking-in our gains and moving on to the next great opportunity.

Disclosure: I am long SWS, PBIP, TFSL, WBKC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Sell SWS Group, Better Opportunities Abound