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Talking Points: Have Financials Gotten Cheap Enough?

The sector got pummeled in 2011, but not without cause.

Morningstar, 02/01/2012

The Issues

Financials of all stripes, but banks in particular, got destroyed in 2011. The financial stocks in the S&P 500 Index were down about 23% collectively through November, which was far worse than the overall index’s 5% loss. After rebounding in 2009 and 2010, financials were taken down by Europe’s sovereign debt crisis, lingering balance-sheet woes, and anemic growth prospects.

This environment is somewhat reminiscent of the early 1990s’ hangover from the S&L crisis. Back then, banks reeled from the collapse in commercial real estate values. Similarly to today, bank stocks sold at single-digit P/E ratios as they struggled to work through bad loans amid weak economic growth.

Yet this crisis has arguably been worse, with potentially longer-term ramifications. The 2007–08 credit crisis leveled the housing market, which is much larger than the commercial real estate market. Plus, the S&L crisis was more regional, while this has been global, and it has ravaged the financial system. This combination, coupled with a down housing market, could curtail loan demand for years.

The Points

While the operating environment may remain challenging for years to come, this is potentially priced into the stocks. Currently, the stocks in the S&P 500’s financials subsector trade at an average price/fair value, or P/FV, of just 0.67, as estimated by Morningstar equity analysts, versus an average 0.82 P/FV across the coverage universe.

Banks generally have far stronger balance sheets than they did before the crisis began four years ago, but risks remain. For example, Bank of America BAC must still worry about the $2 trillion in mortgages that it and acquisition Countrywide Financial originated from 2004 to 2008.

In the 1990s, banks recovered partly by leveraging up their balance sheets and earning high returns on equity. Given the tougher capital requirements coming down the pike, this is unlikely to be repeated. Thanks to low yields, the profit outlook for banks also looks weak relative to the early 1990s. Bank of America’s most recent net interest margin was just 2.3%, and it’s unlikely to improve anytime soon given the Fed’s pledge to keep rates close to zero until at least mid-2013.

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