Stock Quotes in this Article: ASBC, FII, MORN, VLY, WBS

BALTIMORE (Stockpickr) -- The financial sector has had its fair share of problems in the last few years. From massive devaluations during the height of the recession to troubled earnings in 2011, investors have had reason to steer clear of financial stocks. But that doesn’t mean that financials should be avoided wholesale or that there aren’t significant opportunities to collect gains from this group of stocks. There are.

Since financial stocks have a stronger tie to the economic conditions than most, they’re more susceptible to sentiment swings than other sectors are -- after all, shifts in interest rates or stock valuations can deeply impact a bank or asset manager’s earnings in a given quarter. By that same token, however, this sector is equally able to snap back when conditions improve quickly.

And all of the uncertainty in this market is providing a perfect example of that right now.

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    Black clouds forming over the financial sector have prompted short sellers to go on the offensive, taking hefty positions in a handful of financial sector names. That’s creating an attractive short squeeze opportunity this summer.

    In case you’re not familiar, a short squeeze is the buying frenzy that ensues when a heavily shorted stock starts to look attractive again to investors, causing share price to skyrocket. One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which estimates the number of days it would take for short-sellers to cover their positions. The higher the short ratio, the higher the potential profits when the shorts get squeezed.

    Naturally, these plays aren’t without their blemishes -- there’s a reason that these stocks are being heavily shorted. But for investors looking for exposure to a speculative play with a beefier risk/reward tradeoff, these could be powerful upside plays for the coming year.

    Here’s a look at five financial sector names that look like prime short-squeeze candidates right now.

     

    Morningstar

    Mid-cap investment research firm Morningstar (MORN) made a name for itself in the mutual fund world but has since expanded its reach to become one of the broadest providers of investment research for both retail and professional investors. Today, the five-star Morningstar Rating is one of the most widely used measures of a fund’s attractiveness.

    Despite Morningstar’s investment expertise, short-sellers are betting against this stock in droves; the company’s current short ratio of 19.31 suggests that it would take nearly a month for shorts to cover their positions at current volume levels.

    Morningstar has done a good job of adjusting its focus, shifting from primarily covering mutual funds to including coverage of stocks, ETFs and now bonds. At the same time, the firm has expanded its offerings, acquiring innovative service-driven financial information products such as Footnoted and building out an asset management business. Because Morningstar’s offerings tend to be service-driven, the firm’s margins are both healthy and fairly inelastic to economic headwinds. That’s a good thing for investors right now.

    While added pressure has been levied on ratings firms, that’s really not what Morningstar’s business is. As a result, the company should be able to skirt any negative impacts. A debt-free balance sheet and hefty cash position should help smooth any earnings bumps that come along. This evening’s earnings call should shed some additional light on this firm’s financial position -- and it could be a short-squeeze catalyst.

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    Valley National Bancorp

    New Jersey-based regional bank Valley National Bancorp (VLY) has had a fairly mixed year in 2011, staying fairly flat between the first trading day of January and today. That performance has attracted the shorts to this stock, ratcheting up Valley’s short interest ratio to 25.9 -- suggesting that it would take more than five weeks for short sellers to close out their positions in this stock at current volume levels.

    A short ratio that high exponentially increases the potential for a squeeze in shares.

    Valley’s business is centered in New York and New Jersey, where the bank operates around 200 branches. Financially, Valley is an attractive banking firm. Not only does the company sport the deep double-digit margins commonly sported by regional peers, it also has a loan book that’s primarily made up of borrowers who pose excellent credit risks. That fact dramatically increases the earnings quality of this stock.

    The biggest concern for shareholders is Valley’s dividend. At present, the firm’s generous 5% dividend yield may be a little bit too generous -- the company’s payout ratio is extremely high right now. That said, this bank’s earnings potential could certainly reduce the risks of a dividend cut. Tomorrow’s earnings call should be telling.

    Valley shows up on a June list of 10 Liquid Bank Stocks With Highest Dividend Yields.

    Webster Financial

    Another Northeastern regional banking name we’re looking at this week is Webster Financial (WBS), a small-cap bank that operates approximately 180 branches in New York, Rhode Island, and Massachusetts. Unlike Valley National, Webster drank the Kool-Aid during the height of the housing bubble, writing lower quality loans to capture higher-yields on its investments. As a result, this stock’s fundamentals got hit hard when the floor fell out of the housing market.

    Even though lending quality was poor a few years ago, that’s largely changed. Webster learned to hike up its standards though pain -- considerable write-offs meant that the company had to issue dilutive equity to boost its capital reserves. As painful as that may have been for shareholders, the stopgap measures appear to have worked well.

    With much of the company’s problems already worked out of its balance sheet, Webster is now able to capitalize on the more attractive parts of its business: exposure to New England’s affluent lending base. Short-sellers have pushed Webster’s short ratio up to 11.25.

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    Federated Investors

    Asset manager Federated Investors (FII) is the investment advisor for 136 funds, which the firm markets to banks, brokers, and retail advisors. The firm’s mutual funds represent approximately 85% of the firm’s $300 billion in assets under management.

    Don’t be fooled by that high AUM number -- around 75% of those assets consist of money market funds, which generate lower fees than riskier alternatives. Even so, that hefty exposure to money market investments does mean that Federated is a big beneficiary of any flight to quality.

    While the company has worked to diversify its asset base in recent years, the path to higher-margin products has been slow going if only because money market assets are so large for Federated. Investors should expect that asset mix to evolve slowly. Ultimately, a history of strong dividend payouts and a capital-light business model should put this firm on the way to growth in 2011.

    At present, Federated sports a short interest ratio of 15.22. That’s a number that suggests short sellers have a time to cover of more than three weeks given current volume levels. Federated reports its second quarter earnings numbers on Friday.

    Federated, one of Tweedy Browne's top holdings, shows up on a June list of 5 Financial Stocks Analysts Hate.

    Associated Banc-Corp

    Associated Banc-Corp (ASBC) is a regional banking company based in Wisconsin. With 280 branches in Wisconsin, Illinois and Minnesota and more than $20 billion on its books, this small-cap firm is one of the largest banks in the mid-West. That hasn’t spared shareholders from aggressive shorting; at present, Associated Banc-Corp has a short interest ratio of 12.47.

    With a geographic footprint centered in states where real estate prices were more muted, Associated Banc-Corp doesn’t face the same challenges seen by regional banking names in “high-growth” states like Florida or California. For that reason, the company is in reasonably strong financial health right now, particularly given the equity offering that management recently undertook.

    Not surprisingly, an equity offering is like chum in the water for shorts – particularly in the small-cap banking space, where earnings quality and analyst coverage are often lacking. Associated Banc-Corp is no exception to that rule. Still, the firm’s historical conservatism and reasonably strong loan book should keep shares from any sort of catastrophic tumble. Shorts seem to be overblown right now.

    Associated is one of the top holdings of RS Investment Management.

    To see these plays in action, check out the Financial Sector Short-Squeeze portfolio at Stockpickr.

    And to find short-squeeze plays of your own, be sure to check out the Stockpickr Answers community for insights and investment ideas.

    -- Written by Jonas Elmerraji in Baltimore.

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

    Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.