4 Second-Chance Stocks to Bank On

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Doesn't everyone want a second chance, and doesn't the likelihood of doing better increase for the truly committed? So, too, in investing.

Companies out of bankruptcy -- and its sibling, the recapitalization -- can offer marvelous odds of reward to risk. While most investors smell only a foul odor, those who love these special situations exercise finely trained noses to select companies formerly flailing but today with flower-fresh post-bankruptcy balance sheets.

Such companies face great pressure not to blow their second chance, so investors can enjoy their first with favorable odds.

Finding freshness in financials
Bankruptcy's more demure sibling, the recapitalization, is also a balance sheet benefactor. The recap is usually a non-bankruptcy bankruptcy. Rather than wait for the sometimes lengthy bankruptcy process, an investor -- say King Kong Kapital -- puts cash into the flailing business to stave off Chapter 11 and earns a super sweet deal to boot. Such deals include some or all of large percentage stock ownership, warrants at highly attractive exercise prices, and preferred stock or traditional debt paying high interest rates. If we buy after and with careful selection, we obtain the new, stronger situation with more upside and less risk.

"Careful selection" is required. Sirius XM Radio (NAS: SIRI) shareholders have suffered through two recaps. The one in 2003 gave creditors more than 90% of the equity in the company. Then, 2009's recap at the hands of John Malone's Liberty Capital (NAS: LCAPA) , while confusing as heck, added insult to injury -- but only if you think bankruptcy trumps solvency.

Nevertheless, Sirius is way too risky. With an unproven business model and uncertain ability to generate enough dependable free cash flow, it remains a speculation for those are willing to lose everything in pursuit of uncertain gains.

Here are four recaps and one recapper that offer investors the first shot at a company's second chance. 

Government recaps
The Treasury performed a garden-variety recapitalization when it used taxpayer money to recapitalize banks and megasized insurer American International Group (NYS: AIG) . When AIG repaid its loans this past January, the Treasury -- you and I -- owned 92.1% of AIG. AIG shares stood at $54 when the recap closed in January, and they finished Wednesday at $22.95, dropping along with the market and the financial sector and also enduring downward pressure from some Treasury department share sales this year.

So? AIG is insanely complex. Insurance is opaque -- who knows how the company invests its float and whether its underwriting makes any sense? But the management is gone that allowed the horrendous CDO investment decisions that Michael Lewis chronicles in The Big Short. Asset sales have boosted capital. Today's investors obtain lower-priced shares with far lower risk.

Other recaps include Goldman Sachs (NYS: GS) , which became a bank holding company; Citigroup (NYS: C) ; and other crippled banks of the credit crisis. If large financial institutions are black boxes, Goldman has to be among the most prominent "What's behind door No. 1?" companies. Many large investment managers have bet big on Citigroup and AIG. While not without risk, those two stocks offer investors favorable reward-to-risk odds in megacaps.

Private bank recaps
Gerald Ford is a Texas-based distressed bank investor with a successful track record. Most recently, he and his Ford Financial Fund LP team recapitalized Pacific Capital Bancorp (NAS: PCBC) , a California bank holding company. Ford and company got an excellent deal that prevented what I like to call "White Friday" -- which is when the FDIC's white vans appear unannounced in the bank's parking lot at 5 p.m. on a Friday, and employees learn that they no longer work for Fat City Penny Bank but rather the federal government.

The financier's fund injected $500 million into Pacific Capital Bancorp on excellent terms -- buying common shares at a split-adjusted $20 (shares are currently trading north of $25), as well as preferred stock convertible into common at $20. It resulted in the fund taking a 91% equity stake and 98% of the voting control of the company. The move was part of a deal that wrote down non-performing loans, giving the bank today an almost free upside on its legacy loan book. Carried on the books at a 90% writedown, these loans appear tantalizing to the special situations investor. That's why the current valuation of 1.5 times market capitalization to tangible book value is overstated.

View from the Hilltop
Ford is chairman of another company, Hilltop Holdings (NYS: HTH) , sitting on a pile of cash and no debt while sniffing around for prey. It recently joined Oak Hill Partners, whose lead investor is the renowned Robert Bass, in effect to recapitalize SWS Group. Under the deal, Hilltop and Oak Hill loaned SWS $50 million each at 8% interest, in exchange for warrants that will allow Hilltop to buy as much as 21.1% in the company at a strike price of $5.75. SWS shares closed Wednesday at $4.93, but we expect more appreciation. Hilltop is a deal at today's prices because it is cash-flow neutral-to-positive yet sells for less than net cash and tangible book value.

Why special situations?
Abhorred recapitalizations can be profitable special situations. As lead advisor for The Motley Fool's premium stock service, Motley Fool Special Ops, I work with my team Mike Olsen (TMFAgewone) and Jim Royal (TMFRoyal) every day to bring members stocks thrown away by market emotion. The best ones such as Pacific Capital Bancorp offer risk largely wrung out and tantalizing and largely free upside.

Not only that, but our time frame for catalysts is usually no longer than one to three years, and often shorter. So with our March 2010 launch, major catalysts are coming up. Add in the recent market drop, and this may be the best time ever to join Special Ops.

And Special Ops, which reopens rarely, just happens to have 1,667 spots available starting Monday. Get on the list to be the first to learn when to join and also to receive my free report and video explaining our strategy and offering an actual, live, current Special Ops recommendation you can buy today with excellent odds of a four-bagger in one-to-three years -- simply the most inefficiently priced stock we've ever seen. Just enter your email address in the box below to get started!

At the time this article was published Tom Jacobs is the advisor of Motley Fool Special Ops, a special situations and opportunistic value service. He smells flower fresh after dumpster diving for special situation stocks. You can follow him on Twitter @TomJacobsInvest. He owns shares of Pacific Capital Bancorp and Hilltop Holdings.The Motley Fool owns shares of Pacific Capital Bancorp, Hilltop Holdings, Citigroup, and AIG. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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