A Guide to Today's Financial Stock Bargains

Investing in the domestic financial services sector might sound daunting, especially in light of the recent volatility in this area of the market. Moreover, the sector is vast and diverse. A legitimate question is, how can an investor pick winners without stumbling on the losers--especially at a time when there have been so many of the latter?

My colleagues and I cover banks from more than 15 countries, and we can confirm that the U.S. financials sector is one of a kind. The range of choices for investors is truly unmatched in any other market, and one could spend an entire career investing solely in this large basket of stocks. Recently, these choices have been growing exponentially, thanks to the mortgage turmoil that has sent many investors running for the hills. Here's a brief sector overview for investors who are new to this market or viewing it with interest from afar. In the process, I will also offer a few investment ideas culled from our most recent analyses of undervalued stocks.

Large Banks
The three largest banks in the United States, J.P. Morgan Chase JPM, Citigroup C, and Bank of America BAC, like international banks Royal Bank of Canada RY or Deutsche Bank DB, operate as financial conglomerates with various business lines such as retail banking, corporate and investment banking, brokerage, and asset management. Each has a sizable international presence and boasts better diversification than their smaller competitors. The most international is Citi, with operations in more than 100 countries and more than 40% of revenue sourced from abroad. Bank of America is the least international, with less than 20% of the revenue coming from outside the U.S.

The large banks hold mortgages on their books, but those tend to be high-quality assets with very low loss levels. The large banks also took part in the recent leveraged buyout boom by funding deals. Nevertheless, my colleague Ganesh Rathman, who covers the large banks, thinks that they are well positioned to weather any credit woes that might arise from the LBO business. Rathman is bullish on the large banks, and he thinks that all three are good buys right now.

Superregional Banks
Although several acquisitions have blurred the borders, superregional banks tend to focus on specific geographies in the U.S., such as the Midwest, the Southeast, or the West. They have very little international exposure, but most of them strive to diversify their revenue streams by offering multiple products. Some of the superregional banks have sizable investment banking, asset management, and mortgage operations. We count nine super regional banks in the U.S., although Wachovia Corp. WB is on its way to large bank status. The best performers in this group are Wells Fargo WFC and US Bancorp USB, with returns on equity reaching 20% and 22%, respectively. The worst performer is SunTrust Banks STI with an ROE of 12% in 2006. My colleagues Jaime Peters and Ryan Lentell think that BB&T Corp. BBT and US Bancorp are on sale.

BB&T is southern banking giant with toes in several businesses. It owns one of the largest insurance brokerage businesses in the United States, and insurance commissions make up the largest proportion of BB&T's noninterest income, a business Peters loves. The stock is cheap because of a combination of fears: rising credit losses, a compression in the net interest margin, and investors' fears that John Allison (BB&T's chief executive) will do some crazy merger of equals. However, Peters believes the market's fears are overblown: credit losses are simply returning to normal from an unsustainably low rate, the net interest margin compression is a temporary problem from the flat yield curve, and Allison has publicly stated there are no banks among its equals that would interest the bank at the present time. BB&T generates a boatload of cash flows and trades below our estimate of its fair value.

US Bancorp is one of the most profitable banks we cover. It has developed a diversified revenue base and repeatedly produces returns on equity in excess of 20%. Lentell admires management's goal of returning at least 80% of earnings to shareholders annually, achieving 10% long-term earnings-per-share growth, and maintaining returns on equity above 20%. Lentell thinks these significant self-imposed hurdles are shareholder-friendly, and achieving them should create shareholder value. In his opinion, the firm's efficient and diversified franchise is the key to its consistently strong financial results.

Community Banks
Judging by the sheer number of players, this is the largest segment in the financial services sector. Morningstar has an extensive coverage list of the group, with more than 50 community banks under coverage.