We prefer companies with little direct exposure to questionable sovereigns.
After a short-lived period of enthusiasm for financial stocks in late 2010 and early 2011, the second quarter saw the return of bargains in the financial sector as macroeconomic and regulatory uncertainties reduced our sector price-to-fair-value ratio to 85%.
The third quarter did little to assuage investors' fears, as an untenable debt situation in Europe continues to threaten many of the continent's financial institutions. Additionally, the U.S. economy remains listless, with the European situation increasing the possibility of a double-dip recession.
As a result, the aggregate Morningstar price-to-fair-value ratio of financial-services stocks now stands at only 70%, a level we think is indicative of a growing number of attractive stocks within the sector.
On the other hand, investors should not expect to get rich quickly by investing in financial stocks. The major factors contributing to depressed prices--a pan-European debt crisis, continued deleveraging in developed economies, and an uncertain regulatory environment--are unlikely to be resolved soon. The effects of higher capital levels on profitability are yet to be determined, and several U.S. and European institutions are facing multibillion-dollar lawsuits over their mortgage-related behavior during the boom years. We therefore see few catalysts that are likely to drive financial stocks higher in the near term. Instead, buying opportunities are likely to present themselves in the remainder of 2011.
Along those lines, stock selection may be more important in financial services than in any other sector. Much as in 2008, inadequate balance sheet capital and questionable asset quality could mean that many companies' stocks are not as cheap as they might appear, particularly names with significant European exposure. For firms with capital to deploy, the potential to grow will prove valuable, as many companies will struggle to expand their balance sheets and top lines as customers pay down debt and regulators continue to crack down on sources of fee income. Companies with the ability to win market share from troubled peers and those with a presence in developing markets could be great investments at the right price.
As always, we believe competitively advantaged narrow- and wide-moat firms are best positioned to deal with near-term headwinds and thrive at the expense of troubled peers.
The same capital and asset quality issues that U.S. banks dealt with in late 2008 and early 2009 are now manifesting themselves in Europe. With respect to asset quality, Greece was the subject of many investors' concerns last quarter. Today our focus has turned to Italy, whose sovereign debt balance also exceeds the country's GDP. Seven of the major European banks we cover, in addition to the two large Italian banks, hold Italian sovereign debt worth more than 10% of their equity, and four non-Italian banks have made substantial amounts of loans within the country.
Compounding the problem, in our view, are the low capital levels prevailing in Europe. Capital is not an issue from a regulatory perspective--all major public European banks now report core Tier 1 capital levels above 8%--but lofty regulatory capital levels in Europe are obscuring highly variable and generally inadequate bases of common tangible equity. Even after adjusting for divergent derivative accounting, many European banks appear to be overleveraged relative to U.S. banks. We think that leverage in excess of 20:1 or 25:1 leaves banks with too slim an equity cushion to absorb losses, and we see this as especially true in Europe, where bank balance sheet disclosures are generally meager. Only a few European banks meet or exceed the 4%- 5% tangible common equity/adjusted assets level we see as a bare minimum for investments, while virtually all of the U.S. banks we cover do. It should not be surprising that we'd prefer to invest in the few well-capitalized banks on the continent.