Our Outlook for the Financial Services Sector

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Over the last few months, it's really been a tale of two related subsectors within the larger financial services space: subprime mortgages and real estate investment trusts (REITs).  

A meltdown in the subprime lending area has stoked fears of a potential collapse in residential housing, and as a result, investors have punished the shares of companies with any ties to mortgages. At the same time, REITs--companies that directly own real estate--continue to defy our expectations, as institutional demand for real estate exposure continues to send share prices to what we believe are unrealistic valuations.

Valuations by Industry
The table below details our valuations for each subsector within the financial services sector, which is an aggregate weighting of our fair value estimates for each stock we cover. Consistent with our overall outlook, we believe there are pockets within the mortgage and insurance sector that are somewhat undervalued, while we believe that REITs continue to be the most overvalued subsector.

Financial Services Valuations by Industry
Segment	Average Star Rating	Average Price/Fair Value	Stocks Covered
Finance	3.12	0.99	30
Insurance (Gen)	3.47	0.92	15
Insurance (Life)	3.06	0.99	18
Insurance (Prop)	2.88	1.02	41
Insurance (Title)	3.50	0.92	2
International Banks	2.65	1.13	37
Money Mngt	2.71	1.08	17
Real Estate	2.00	1.19	3
Regional Banks	3.21	0.98	53
Reinsurance	3.38	0.89	13
REITs	2.08	1.27	75
Savings and Loans	3.23	0.97	13
Securities	2.96	1.02	28
Super Regional Banks	3.56	0.91	9
Data as of 03-15-07

On the mortgage side, several companies (mostly private at this point) that provide mortgages to subprime borrowers have filed for bankruptcy amid an uptick in early payment defaults, which means that this subsegment of borrowers has begun to fall behind on their mortgage payments. This has allowed buyers of these mortgages, such as investment banks or institutional investors, to force the firms that have financed these borrowers to repurchase the delinquent loans. At the same time, the banks that have funded these companies have cut off their lines of credit, making it almost impossible for the mortgage companies to buy back the loans, thus forcing many to file for Chapter 11 amid the resulting liquidity crunch. To make matters potentially worse, many pundits have postulated that this meltdown is the tip of the iceberg for an eventual collapse in the U.S. residential housing market.

While we're the first to acknowledge the tremendous risks in the subprime area, we think that in some cases, investors are starting to throw out the baby with the bath water, so to speak. We've been expecting a slowdown in housing for some time now and have already embedded a somewhat gloomy outlook into our projections. Despite this forecast, though, we still think that some companies with durable competitive advantages--think economic moats--in this space may have been over-sold, and are now offering long-term investors a very favorable risk/return trade-off.

We also think the subprime contagion has spread to the insurance sector, afflicting the stocks of both the mortgage and title insurers. Mortgage insurers such as  MGIC Investment (MTG) and  Triad Guaranty (TGIC) have seen their share prices drop, as many now believe that the mortgage insurers will be on the hook for a mountain of potential mortgage defaults. While we acknowledge this risk, and have modeled these firms' loss ratios somewhat conservatively, we actually think that this fallout provides an opportunity for the mortgage insurers. Now, many lenders are no longer allowing borrows to use "piggy-back loans"--structured as an 80% first mortgage loan, 10% home equity loan, and 10% down payment--to avoid buying non-tax-deductible mortgage insurance. As a result, we believe that there will be greater demand for core mortgage insurance products going forward, providing a boost to these firms' earnings growth. Finally, the shares of title insurers  First American Financial (FAF),  Fidelity National (FNF), and  LandAmerica Group  have also come under modest pressure, and we think if they fall back even further, it could be an opportune time for astute investors to pick up shares in these relatively good businesses at reasonable prices.

As for REITs, though, we're much less enthusiastic. We believe that over the long term, REIT dividends have (and will) contribute the bulk of an investor's total return. As an example, for holding periods of 10 to 35 years, our analysis indicates that dividends contributed between 50% and 80% of total annual REIT returns--and the longer the holding period, the larger the dividend contribution to the total return. In 2006, though, dividends accounted for only 18% of total REIT returns, on average, and the rest came from share price appreciation, as investors almost doubled the price they were willing to pay for REIT earnings.

As we said last quarter, we believe that a large part of this demand for REIT shares has come from institutional investors, who have been increasing their exposure to real estate assets to between 5% and 10% of their portfolios. To us, this idea seems a bit convoluted at this juncture, with current REIT dividend yields running at less than 4%, on average. Even considering modest growth in dividends, this would still imply that over time--and many institutional investors have very long time horizons--the bulk of their future real estate returns will likely hover around the midsingle digits. Considering that we believe that real estate investments are still cyclical, we think there is far more risk in a relatively modest REIT return than a virtually guaranteed return on a U.S. Treasury bond, which is presently yielding almost 5%. Click here to see our recent in-depth report on the REIT sector.

Financial-Services Stocks for Your Radar
Given our outlook on the mortgage sector, and our belief that many high-quality companies in this space have been thrown on the trash heap, we think that  Countrywide Financial ,  Bank of America (BAC), and Washington Mutual (WM) are presently priced to offer potential investors attractive long-term returns. Even better, Bank of America and Washington Mutual both have nice dividend yields, at 4.2% and 5.0%, respectively. As such, we believe that investors are being paid generously to wait for these firms' valuations to improve. We also believe that investors should put mortgage insurer MGIC Investment and title insurer First American Financial onto their radar screens.

Stocks to Watch--Financial Services
Company	Star Rating	Fair Value Estimate	Economic Moat	Risk	P/FV
Countrywide		$46	Narrow	Avg	0.79
Bank of America		$67	Wide	Avg	0.77
Washington Mutual		$52	Narrow	Avg	0.81
MGIC Investment		$76	Narrow	Avg	0.79
First American Financial		$61	Narrow	Avg	0.86
Data as of 03-22-07.

Despite a housing slowdown, which we've been anticipating, we still think Countrywide has a strong long-term future as the largest mortgage bank in the country. We think one of the bright spots is the firm's mortgage servicing portfolio, which reached $1.3 trillion at the end of last year. This portfolio provides a nice stream of relatively stable cash flows, which in 2006, produced almost $6 billion of cash. We also think that Countrywide's diversification into complementary--and less cyclical--businesses, such as banking and insurance, will help it weather the ups and downs of the mortgage market.

As one of the largest domestic banks, Bank of America generates hefty profits from its vast array of businesses. We think its retail bank, though, remains the crown jewel, as it boasts more than $180 billion of non-interest-bearing deposits. This provides the bank with a lower cost of funding than competitors, which serves to help boost owners' long-term returns. Our valuation isn't calling for Herculean growth assumptions, and yet the stock still remains within 5-star territory.

While we expect difficulties in Washington Mutual's mortgage operations to mask the performance of some of the other business units in the near term, we think the firm's retail bank continues to perform relatively well. In addition, we've been pleased by the firm's moves into new product offerings, with its 2005 purchase of credit-card issuer Providian. Best of all, though, management appears committed to returning excess capital to shareholders, given that it recently repurchased more than $2.7 billion worth of its stock, and continues to grow its dividend.

We think MGIC Investment's recently announced deal to acquire fellow mortgage insurer  Radian (RDN) will have the effect of creating a truly giant player in the mortgage industry, further strengthening MGIC's economic moat. What's more, as we mentioned above, demand for MGIC's core mortgage insurance product could be on the rise, as lenders are beginning to refrain from utilizing "piggy-back loans." We've modeled relatively conservative loss ratios for MGIC, but the stock is still undervalued, in our opinion.

We think First American Financial is gradually transforming itself into a global provider of real estate information services. Thirty years ago the company was a network of fragmented title insurance offices and agencies. Today, in addition to being the largest provider of title insurance and closing services, First American markets mortgage and property information and specialty insurance. Risk mitigation and business solutions are offered via majority-owned First Advantage Corporation , which we think will have the effect of muting some of this cyclicality in the insurance business, further boosting long-term returns.

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