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  1. Home
  2. / Investing
  3. / Financial Services

These Financial Stocks Are Creating Value

And of course, a lot of them are community banks.
By TIM MELVIN Jan 26, 2016 | 01:00 PM EST
Stocks quotes in this article: WTBA, AFSI, FCFS, HCI

I noted when reviewing Aswath Damodaran's work on value creation that he eliminated financial stocks from the study. He disclosed that in his report: "In computing this excess return, I deliberately removed financial service firms from the mix, because computing operating income or invested capital is a difficult, if not impossible task, at these firms. Lest you feel that I am giving managers at these firms a pass on the excess return question, I would replace the excess return spread (ROIC -- cost of capital) with an equity excess return spread (ROE -- cost of equity) for these companies."

That made sense to me, so I sat down and used his cost-of-equity definition to put together a list of value-creating financial stocks. I also added a five-year book value growth component to limit the list to those with a strong record of creating value for shareholders.

The first observation is one that I seem to make any time I look at the financial sector. If you are building a portfolio of high-performing financial stocks, you are going to own a lot of community banks. There are no larger banks on the list, but 23 of the 52 value-creating financials are small banks.

The largest among them, with a market capitalization of $288 million, is West Bancorp (WTBA) in West Des Moines, Iowa. The bank just reported its fifth consecutive quarter of record earnings. The firm is outearning the cost of equity and has an impressive 15% return on equity right now. The bank is not cheap at 195% of tangible book value, but management has done a solid job of running the bank and the stock has almost tripled over the past five years.

AmTrust Financial (AFSI) is the fastest-growing company on the list. The property and casualty insurer has excelled by focusing in niche markets like consumer products warranties, small business workers compensation, directors and officers and other specialty markets they have identified as a low-hazard commercial line. The warranty business focuses on automotive, consumer electronics and appliances, commercial equipment and recreational vehicle and power sports, which have been very strong, and AmTrust is looking to expand this business in Europe. It is easily earning more than the cost of equity and book value has grown by more than 30% a year over the past five years. While not cheap on price to book, this high-growth insurer does trade with a single-digit PE ratio right now.

We can debate the ethics of pawn shops and payday lenders all day, but the simple truth is that they are in demand and very profitable. Because of that, First Cash Services (FCFS) makes my list of financial stocks that create shareholder value. The company has grown its store count by more than 10% over the past decade with a focus on growing market share in Mexico. It recently expanded its presence south of the border by acquiring 211 full-service pawn stores in Mexico, Guatemala and El Salvador. First Cash easily earns more than the cost of equity and book value has grown by 20% annually over the past five years. As with many of the value-creating financials, the stock is not Tim cheap based on book value, but the PE ratio of 16 may be considered reasonable to growth-oriented investors.

HCI Group (HCI) has a few different businesses, but its main line is selling homeowners and flood insurance in Florida. While at first glance that may seem like a horrible business, the simple truth is that we have not had any major storms in several years. HCI easily earns more than the cost of equity and has grown book value by more than 30% on average annually for the past five years. It also owns about $60 million of real estate on Florida's Gulf Coast, including office buildings and marinas. HCI has an additional $20 million to $30 million of retail projects in development. The company just announced a $20 million stock buyback and the shares yield 3.88%, so management is sharing the wealth with shareholders.

Finding the high-performing financial companies can be very rewarding for long-term shareholders, but it occurs to me that there is another way to use the list. If we look for those financial institutions that are not earning more than the cost of equity and isolate those that have an activist investor as a shareholder, you will have a portfolio of companies that may be takeover candidates over the next year or so. I did that quickly, and while the vast majority of the stocks are too illiquid to mention here, I can tell you the underperforming list is a trade-of-the-decade cornucopia of activist targets.

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At the time of publication, Melvin had no positions in the stocks mentioned.

TAGS: Investing | U.S. Equity | Financial Services

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