Financial Services: Outlook Improved but Still Overpriced

The Morningstar US Financial Services Index has significantly underperformed the Morningstar US Market Index over the previous year, returning 1.3% compared with 19.4%, but outperformed in the previous quarter, up 18.2% compared with the market’s increase of 12.8%. After the recent rally in stock prices, the median North American financial sector stock trades at a 6% premium to its fair value estimate compared with about a 30% discount at the end of the first quarter of 2020. Many financial sector stocks are fairly valued, according to our assessment, with the few North American financial sector stocks that we cover that are trading at meaningful discounts to our fair value estimates having company-specific issues and are turnaround stories.

Financials outperformed in the fourth quarter - Morningstar

Our overall industry call on banks has largely played out. At the end of the third quarter, banks were the most undervalued industry in the North American financial sector with around 67% of the banking stocks we cover being rated 4 or 5 stars at that time. After the strong rally in the fourth quarter, less than 10% of our North American banking coverage is now rated 4 or 5 stars. The outlook for two of the primary drivers of banking profitability, interest rates and loan charge-offs, has recently improved. Long-term interest rates as represented by the 10-year U.S. Treasury rate have recently been over 0.9% compared with an average of close to 0.65% in the third quarter.

Most financials are fairly valued - Morningstar

Long-term interest rates have risen - Morningstar

Net charge-offs have also remained under control, and the unemployment rate has improved. While the unemployment rate will likely remain high for the foreseeable future, and net charge-offs should significantly increase in coming quarters, the surprisingly strong announced effectiveness of COVID-19 vaccines should lead to a more rapid recovery in the economy. Furthermore, any additional government stimulus could help consumers and businesses meet loan payments until the economic recovery gains traction.

Charge-offs remain under control - Morningstar

Industries in the financial sector besides banks are fairly valued and in differing stages of an earnings recovery. We expect earnings to grow in 2021 for nearly all financial industries. The industry where earnings may decline for some companies is capital markets, as trading and investment banking revenue were fairly strong in 2020.

Top Picks

American International Group AIG Star Rating: ★★★★ Economic Moat Rating: None Fair Value Estimate: $59 Fair Value Uncertainty: High

American International Group announced upcoming changes to its management team and its intention to separate its property/casualty and life insurance operations. At the start of March 2021, Peter Zaffino will take over as CEO, with current CEO Brian Duperreault moving to executive chairman. Arguably, Duperreault’s work as CEO remains unfinished, but Zaffino has been a key lieutenant in the company’s turnaround efforts, and we see this move as confirmation that AIG will maintain its positive course. From a strategic point of view, we also like AIG’s announced intention separate its life insurance operations.

Berkshire Hathaway BRK.B Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $253 Fair Value Uncertainty: Medium

We are impressed by Berkshire Hathaway's ability to generate high-single- to double-digit growth in book value per share. We believe it will take some time before Berkshire succumbs to the impediments created by the size of its operations and that the ultimate departure of CEO Warren Buffett and Vice Chairman Charlie Munger will have less of an impact on the business than many believe. We are always looking for opportunities to put money to work in the name. Berkshire currently has a ton of cash on hand and a disciplined share-repurchase program in place, making it an ideal defensive name in a slowing economy or down market.

Wells Fargo WFC Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $45 Fair Value Uncertainty: High

Wells Fargo comes with a lot of baggage, which is one reason we believe the stock is so cheap. The risks are real, and the company is still in turnaround mode. However, the valuation is extremely undemanding, and Wells would have to become and stay the worst bank under our U.S. coverage forever for today's valuation to make sense. This is harsh, and we think the odds are in Wells' favor to outperform these expectations. We do think things are fundamentally changing with new CEO Charles Scharf, and some positive momentum could finally start to build for Wells during 2021 and into 2022.