The M&A activity in the banking sector is expected to pick up in 2011 as banks are expected to face several revenue growth headwinds in the coming days. Reuters

The merger and acquisition (M&A) activity in the banking sector is expected to pick up in 2011 as banks are expected to face several revenue growth headwinds in the coming days.

Over the past 3-4 months, the traditional M&A environment has begun to heat up with larger deals transpiring.

In December 2010, BMO Financial Group (NYSE: BMO) agreed to buy Milwaukee-based Marshall & Ilsley Corp (NYSE: MI) for $4.1 billion and Hancock Holding Co. (NASDAQ: HBHC) struck a deal to acquire Whitney Holding Corp. (NASDAQ: WTNY) for $1.5 billion stock..

In January 2011, Comerica Inc. (NYSE: CMA) said it will buy Sterling Bancshares, Inc. (NASDAQ: SBIB) for $1 billion in stock.

"We anticipate we are in the early stages of significant banking consolidation that will last approximately five years. Over this period we expect that the consolidation among the top 20 banks will be dramatic," RBC Capital Markets analyst Gerard Cassidy wrote in a note to clients.

Similar to the periods following the recessions of 1990-91 and 2001, which included a normalization of the industry's credit costs, the analyst believes many banks over the next five years will experience revenue and earnings growth pressures that will lead them to consider acquisitions more aggressively.

"Additionally, during this time period many banks will come realize the best alternative for its shareholders will be to sell out, in our view," Cassidy said.

Similar to today's banking environment, the industry in 1990 was reeling and stock price valuations reflected the uncertainty as the top 50 banks price to book value bottomed out at about 0.85 times. This pricing environment preceded a massive M&A wave that lasted for the next 4 years and saw thousands of commercial banks fall by the wayside.

Cassidy noted that investors can achieve outperformance relative to the bank and S&P 500 indices by waiting for deals to transpire then selectively buying the buyers in the days following the acquisition announcement.

Generally, investors tend to buy the shares of potential acquisition targets and then monetize them after acquisition announcement as generally the acquirer will pay a premium price for the target company.

However, Cassidy urged investors to buy the stock of the acquiring company 2-3 days following the acquisition announcement as the M&A activity in the early stages of economic growth historically have added shareholder value for not only the acquired company, but also for the surviving entity.

"We believe BMO Financial Group's acquisition of Milwaukee-based Marshall & Ilsley was the inflection point in this M&A cycle turning it from a "buyers" market to a "sellers" market. Additionally, in the aftermath of a premium deal we contend that other perceived acquisition targets benefit from a scarcity premium," the analyst said.

"Using our strategy investors would have achieved a 10.2 percent return in BMO versus 3.9 percent return in the BIX and 4.6 percent in the S&P 500," the analyst wrote.

Interestingly, after the merger announcements, the stock of the acquirer declined due to investors' concerns over pricing of the deal or efficient use of capital.

For instance, in the BMO situation, many investors believed that the company overpaid for Marshall & Ilsley, given the uncertainty surrounding the loan portfolio. As a result, selling pressure intensified and the stock price took an immediate hit.

But, the analyst said the investors should take the low price environment of an acquiring bank stock as a buying opportunity.

"We believe investors should utilize the period of weakness in the acquiring bank stock price in the days following the announcement of an acquisition as a buying opportunity," Cassidy said.