4 Undervalued Financial Stocks for the Long-Term Market

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning, I sit down with Morningstar U.S. market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead.

So, there are two big things on your radar this week, Dave: banks and the Fed meeting. And let’s start with banks. It’s kind of a fluid situation. Recap a little bit what happened last week, starting with the big banks pledging deposits to troubled First Republic Bank. Walk us through why it happened and what the response has been so far.

Dave Sekera: Well, good morning, Susan. And I think “fluid” is the understatement of the day at this point. So last week what we saw is a group of large banks teamed up to make a deposit of $30 billion into First Republic Bank. First Republic Bank, being one of those regional banks, it was under the most pressure from deposit runs. And essentially this was a way that the large banks were able to recycle those deposits that were coming out of the regional banks, being sent to the large banks, and send them back to the regional banks. And that was really a way to try and solve for the bank runs that we were seeing.

Now, the initial response was definitely very positive. We saw a lot of the regional banks trade up in the stock market. However, First Republic did make a couple of disclosures regarding that latest liquidity injection. And what that really revealed to the market was just the extent of the deposit flight that they had seen, and in fact, that also led us to reduce our fair value on that stock. So once that happened, then almost all the regional bank stocks did take another leg down in the markets at the end of last week as the market really just continues to try and grapple with the extent of the bank runs and what that means for those different banks going forward for their valuations.

Dziubinski: Now also last week, Credit Suisse suffered a loss of confidence, and then over the weekend, UBS stepped in to buy the bank in what UBS officials called an “emergency rescue.” What happened there?

Sekera: Well, I think this is just another example of showing just how fast a banking crisis can play out for individual banks. Yet having said that, in my mind, I think this is a separate but related event. And so the bank runs in the U.S., they may have been the catalyst that kind of finally brought the issue to bear here for Credit Suisse, but if you take a look at Credit Suisse’s stock, it’s already been on a long downward trend for several years. Its stock had been going down, the company was losing money last year, projected to lose money this year and next again, and more importantly, its credit quality had actually been dwindling for a while.

But I think what really drove it under at the end of the day is that they did report over a hundred billion dollars worth of withdrawals in the fourth quarter last year, and those withdrawals were continuing this year. And it finally got to the point, with the credit quality dwindling, the other banks, they just stopped lending and trading with Credit Suisse. And so that’s really what resulted in what I actually look at this as being what’s called a takeunder. So UBS is buying Credit Suisse. They’re paying about 75 cents a share. By way of background, that stock had fallen; it was down at $2 a share last Friday. So a big discount even to where the market was pricing it last.

But in addition, the Swiss National Bank, they also had to put a guarantee for the first $9 billion of losses behind that to get that deal done. And then on top of that, the Swiss regulators had also wiped out, I think, about $16 billion in debt. And that debt actually was specifically structured to be a capital buffer and absorb losses.

And lastly, one other thing about this deal, which I don’t think I’ve actually seen in transactions like this in the past, there’s what’s known as a material adverse change clause such that if the credit default swaps, that’s the cost to ensure debt at UBS, increases by over 100 basis points or by over 1%, that UBS could walk away. So I think the market’s going to take some time to really digest this transaction and really figure out what this means for the rest of the European banks.

Dziubinski: Dave, what does this Credit Suisse situation mean for U.S.-based investors?

Sekera: Well, with this out of the way, I still think that we have a rough road ahead of us here in the U.S. So as you noted, investors this week, now they’re going to be able to turn their attention away from the European banks and back to our own banking issues, which are still playing out. We’ve got the Fed meeting later this week. And on top of that, we still think that the tightening monetary policy will weigh down the U.S. economy later this year.

I don’t want to be too negative because I still want to make sure that investors realize that. according to a composite of our equity coverage, the U.S. markets are still trading at about a 12% discount to fair value. I just think it’s going to take some time until we start seeing leading economic indicators turn around and start moving back up. And I think with leading economic indicators moving back up, that’s going to be the signal the market is really watching for in order to begin a more durable rally to where we see fair value.

Dziubinski: Let’s talk about one more bank-related issue for looking ahead this week. Do you expect to see more of these regional banks facing these liquidity issues? Are we on the brink of another financial crisis like 2008?

Sekera: The short answer is no, I don’t think we’re on the brink of another 2008 global financial crisis. I do think there is a high risk that there can be some additional bank failures here in the U.S., but it shouldn’t be systemic. And when I think back to what happened back in 2008 during the global financial crisis, this situation doesn’t really have the same dynamics.

So when you think about what happened back then, a lot of the really large banks owned the mortgages, the CDOs—or credit default obligations—CDOs-squares, which were credit default obligations of credit default obligations. And at the end of the day, a lot of this stuff was worth zero or just pennies on the dollar. And those write-downs were so large and so much more than they had potentially even modeled for, that they essentially wiped out the capital levels across these banks.

Now, we do know that banks now do have some losses in their hold-to-maturity accounts, but these losses are much more manageable. They’re within kind of the realm of what a bank would model in. So for example, even like the 10-year U.S. Treasury, if you bought that when interest rates were at their tightest and you have it in a hold-to-maturity account, it’s still going to be worth somewhere in the low 80s today. Whereas back then, like I said, a lot of that stuff they owned was actually worth zero at the end of the day.

What had happened was that, back then, the banks had no confidence in any other bank. No one really knew what anyone else’s balance sheet looked like. And so that really reduced their confidence in the financial viability. And so we really just saw the entire financial system just freeze back then. I think now it’s not so much a question of is this really systemic across all of the banking universe? I think the real question for the market now is based on what’s happened, what are these regional banks going to be worth going forward?

Dziubinski: Finally, let’s get to the second thing on your radar this week, and that’s, of course, the Fed meeting. So in light of what’s been going on with banks as of this morning, what are the expectations of what the Fed’s going to do?

Sekera: Well, right now, if I pull it up, the market’s pricing in a 55% probability of a 25-basis-point hike this week. So, a little bit more than a coin flip at this point. Although I would note the volatility of whether it was 50 basis points a couple of weeks ago, going down to no change, back up to a 25-basis-point change is probably the most volatile I’ve seen as long as I can remember. So I think the Fed’s in an especially tough spot.

You have to remember, Chair Powell was very hawkish two weeks ago in a lot of his public commentary. The market was pricing in a 50-basis-point hike as recently as two weeks ago. That’s completely off the table right now. But the thing is, with the banks under pressure, the Fed may not want to add to this pressure. And so I think it’s going to be interesting to see what they signal this week, whether they do or they don’t, and then what the commentary’s going to be.

So my concern to be is that if the Fed doesn’t hike this week and doesn’t increase by 25 basis points, I do think there’s a potential that the market could interpret that as a signal that maybe the banking situation behind the scenes might even be worse than what we can see publicly. And of course, there’s also the possibility that we could see stocks move up very rapidly, just because at that point maybe the markets are going to be more encouraged that this monetary policy-tightening cycle is over.

Dziubinski: Let’s move on to some new research from Morningstar. Our analysts have obviously been taking a good hard look at the banks they cover against the backdrop of these liquidity challenges. What changes have they made to their ratings as a result?

Sekera: Well, the first thing we did was to increase our Uncertainty Rating on those stocks that faced the greatest risk of potential bank-run scenarios. And at this point, it’s really much harder to really forecast the outcomes and the possibilities that could happen for these banks at this point. So what that increase in the Uncertainty Rating does is it just now requires to have a much greater margin of safety before those stocks will move into 4- and 5-star rating territory.

Dziubinski: Let’s move on to the picks portion of our program. You mentioned earlier in this segment that you don’t think we’re in for a repeat of 2008. Today you’ve brought along some picks that you think have been unduly pulled down in the bank carnage. And the first name on your list is Discover Financial DFS. What do you think of the stock today?

Sekera: Sure. So as just a little bit of background, I do think this is a good opportunity in order to look for those stocks that have been pulled down, which probably have different business models and aren’t required on deposit funding like we see across the regional banks. So a couple of the different areas that we’re highlighting will include the investment banks, the asset managers, the credit card providers, and the technology service providers. And when I think about these companies, their business models are very different than the banks.

And so taking a look at Discover, specifically Discover the credit card company, it is a 4-star-rated stock. The dividend yield is a little bit below 3%, but it does trade at a 30% discount to our fair value. So Discover does use some deposit funding, but I think that if it’s needed, they can go back and start using a lot of the credit card securitization products that are available to them in the public markets. And if they do see some deposit flight, I don’t think that that’s going to end up really blowing up their business model.

Dziubinski: Now, next on your list is Goldman Sachs GS. Now interestingly, Warren Buffett and Berkshire Hathaway stepped in during the 2008 financial crisis to shore up Goldman’s capitalization and liquidity. How does the firm look today?

Sekera: Well, Goldman Sachs’ stock is currently rated 4 stars and it trades at a 25% discount to our fair value. It does pay over a 3% dividend yield, which I do think is a little attractive in today’s environment. But when I think about Goldman Sachs, I really think about the composition of its revenue and how different it is from the banks.

So 20% of the revenue comes just from the investment banking business, another 45% from their trading divisions, 20% from their asset management, and then 15% from wealth management. Again, lots of different types of revenue streams, completely different from the banking sector. So again, I think this is interesting at this point.

Dziubinski: And then your third pick that you brought today is Blackstone BX. Tell us about that one.

Sekera: Blackstone stock also rated 4 stars, trades at a 26% discount, has a very attractive dividend yield of over 5%. And when I think about Blackstone, it is one of the world’s largest alternative asset managers, over $950 billion in assets under management. And you really invest in four different core businesses between private equity, real estate, credit, and hedge funds. So a lot of different segments that I think are separate enough from the banking world and don’t have any kind of these downside risks that I think that, at the end of the day, because it’s such a different business model, I would expect this one to start doing better.

Dziubinski: And then the last stock you’re picking this week is Fidelity National Information Services FIS, which is actually a tech firm whose products cater to the financial-services industry.

Sekera: Yeah. So that stock is rated 5 stars at this point, trades out a 38% discount, and has a 4% dividend yield. And so I think the key here, as you mentioned, it is really more of a technology company with three different main business lines. So related to, but not necessarily reliant upon, the banking system. So the first business line they have is payment processing services for the banks. They do record-keeping and other services for other different types of investment firms. And then lastly, they do payment processing services for retailers.

Dziubinski: Thanks for your time this morning, Dave. Be sure to join us again on YouTube next Monday at 9 a.m. Eastern, 8 a.m. Central. And while you’re at it, subscribe to Morningstar’s channel. Have a good week.