Our Outlook for the Financial-Services Sector
Melting and minting.
Stock Strategist
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Much of the second-quarter action in the financial-services world centers around ready money, cheap debt, and private equity. Public companies, particularly those that are undervalued, underleveraged, or both, have been targets for private buyers. Typically, we'll see a healthy stream of IPOs as well to balance out the privatizations. But over the past quarter, the focus has been squarely on the takeouts. The most notable IPOs (and pending IPOs) in financial services have been, no surprise, in private equity.
Back in the days of commodity money--when gold and silver reigned supreme--there was a regular cycle of melting and minting that kept currency values relatively stable. When the value of the gold in the minted money exceeded the value of the coins themselves, the coins were melted. And when the value of the minted currency rose, the gold could once again be minted into coins and enjoy higher purchasing power.
This same cycle of arbitrage helps keep the value of publicly traded companies comparable to their private counterparts. When public companies become cheap compared with the value they might fetch on the private market, they are taken private (melted). Conversely, when the assets could be worth more in a public structure, the firms can be taken public (minted).
But the second quarter has been a story of all melting and very little minting. The REIT industry is a case in point. There has been only one REIT IPO this year despite high valuations of public REITs (median price/FV = 1.11; see table below). On the flipside, we've seen numerous REITs taken out, such as Archstone-Smith , which is being sold to a private partnership at nearly a 100% premium to our fair value estimate. And private equity firms continue to hover over the REIT sector, leading us to expect more deals in the offing.
The primary drivers of this trend are the large amounts of money flowing into private equity funds and the availability of cheap debt. But other factors are also at work. We believe some of the money chasing REITs has come from pension funds that have lower return requirements than public equities have historically delivered, making even overvalued (by Morningstar standards) REITs look attractive. We also see some dis-economies of scale as REITs own large portfolios of properties and have to work within the boundaries of REIT laws, which mandate high payout levels and constrain frequent property sales. In an environment like today's, the yield-hungry public REIT investors lose out to the larger private buyers who may be able to maximize the value of the properties by selling them rather than managing them.
Although IPOs are scarce, it should come as no surprise that two of the most high-profile IPOs we have been following are related to private equity. We cover Fortress Investment Group , which is an alternative asset manager running hedge funds and private equity. Since we initiated coverage on Fortress in April, the firm has been trading at a substantial premium to our fair value estimate. Similarly, we have been following the Blackstone (BX) IPO. My colleague Jeff Ptak has written on the excitement surrounding this offering and the firm's phenomenal profitability. The initial offering price valued Blackstone at 38% of assets under management, which is higher than any other money manager on the market today. Now, even Congress wants a piece of the pie. The Senate Finance Committee recently introduced a bill that could raise tax rates on private equity operations like those of Fortress and Blackstone.
Valuations by Industry
One of the effects of private capital in the public markets has been a runup in the valuations of possible takeout candidates. The same theme runs through consolidating industries as well. As the data below illustrate, the industries that we deem most overvalued on a price/fair-value basis have seen significant merger and acquisition activity.
| Financial Services Valuations by Industry | |||
 | | | |
| Segment | Average | Median Price/Fair Value | Stocks Covered |
 | |||
| Finance | 3.12 | 1.00 | 31 |
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| Insurance (Gen) | 3.24 | 0.85 | 17 |
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| Insurance (Life) | 2.72 | 1.05 | 18 |
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| Insurance (Prop) | 2.92 | 1.03 | 39 |
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| Insurance (Title) | 3.00 | 1.02 | 2 |
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| International Banks | 2.53 | 1.10 | 40 |
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| Money Mngt | 2.41 | 1.10 | 19 |
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| Real Estate | 1.75 | 1.26 | 4 |
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| Regional Banks | 3.22 | 0.98 | 50 |
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| Reinsurance | 3.14 | 1.00 | 14 |
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| REITs | 2.44 | 1.11 | 73 |
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| Savings and Loans | 2.79 | 0.99 | 14 |
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| Securities | 2.67 | 1.06 | 78 |
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| Super Regional Banks | 3.40 | 0.91 | 10 |
 | |||
| Data as of 06-15-07 |
Both real estate firms and REITs have been affected by the takeout boom, as we mentioned above. Money management stocks have been riding high on demand for public investments, and firms like Fortress have played a role in these firms' rich valuations. The announced private equity deal for Nuveen Investments is already driving up values for its peers in the money management industry. Similarly, international banks are not immune from consolidation. European giant ABN Amro (ABN) is in the middle of a tug of war between Barclays (BCS) and a consortium of banks led by Royal Bank of Scotland.
Looking forward, we see this trend continuing until private capital no longer sees public firms as juicy targets. A cooling off could come as a result of rising interest rates, rising stock valuations, a downturn in the economy, or any similar development. But since we can't predict just when the music will stop, we have been sticking to our discipline of finding pockets of value in the markets. And although rich valuations abound, we think there are a number of attractive financial-services investments available right now.
Financial-Services Stocks for Your Radar
We have highlighted stocks across several very different parts of the financial-services industry, all of which we believe are trading at a significant discount to their fair value estimates. The table below gives a summary of a few of our current picks.
| Stocks to Watch--Financial Services | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | P/FV |
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| Western Union |  | $32 | Wide | Below Avg | 0.66 |
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| MoneyGram |  | $34 | Narrow | Average | 0.83 |
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| Bank of America | | $70 | Wide | Average | 0.70 |
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| Marsh & McLennan | | $45 | Wide | Average | 0.70 |
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| Brandywine | | $41 | Narrow | Average | 0.71 |
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| Data as of 06-22-07. |
We believe the market leaders in the money transfer industry-- Western Union (WU) and, to a lesser extent, MoneyGram --are undervalued. In our opinion, the market is overly concerned about near-term pressures in the U.S.-to-Mexico corridor that have arisen due to the immigration debate and the slowdown in the construction industry. Long term, we expect these two companies to exploit their scale, networks, and brand advantages and to benefit from the rise in the global immigrant populations.
The future also looks bright for bank technology providers such as Fiserv (FISV), Jack Henry (JKHY), and CheckFree . Fiserv and Jack Henry are well-positioned to exploit their sticky core processing relationships with banks to cross-sell an increasing array of ancillary products such as online banking and remote deposit. We have raised our fair value estimate for both companies significantly in the past year, in part based on these opportunities. CheckFree, which is focused on electronic bill payments and has built a commanding lead in this scalable business, will benefit as more and more consumers put away their checkbooks and pay their bills online (see more in our Software Sector Outlook). The impending spin-off of Metavante, a subsidiary of Marshall & Isley that plays in both the core processing and electronic bill payments space, may be an intriguing opportunity for investors, depending on the market's valuation.
Turning to banks, the big three continue to look very inexpensive. In particular, we think Bank of America (BAC) is a steal at today's prices. We believe the bank is being unfairly punished for its acquisitive nature. Also contributing to its low valuation are macroeconomic factors such as the inverted yield curve, considered to be unfavorable for banks. Since 2003, the bank has made several high-profile acquisitions including FleetBoston and MBNA and is looking to add LaSalle Bank to its portfolio for $21 billion. The market believes that the bank destroys value via these big acquisitions, but we disagree. Even accounting for the eventual deterioration in credit quality, the bank looks cheap based on fundamental metrics such as earnings yield, dividend yield, and book value. At $50 a share, an investor is getting the retail and commercial banking business at a modest discount and getting the bank's entire wealth management business thrown in for free.
We are also bullish on the prospects for Marsh & McLennan (MMC). We sense revenue and cash flow potential like a coiled spring within the firm and believe that the market valuation is driven too much by recent results. We expect insurance brokers like Marsh to benefit as the industry compensation debate recedes and as insurance rates recover down the road. For the company as a whole, we believe that the firm's 2004 regulatory crisis had an upside. Marsh & McLennan has been cleansed and humbled. It is leaner, meaner, cleaner, and ready to grow. The firm's broad risk management perspective and heightened customer focus should prove valuable as its complementary Marsh, Kroll, and Mercer business units work to solve customer risk-management problems.
Last but not least, we are even seeing a few opportunities in REITs. Because office REITs in urban markets have been the flavor du jour of private equity investors, office REITs in suburban markets have not seen the same runup in stock prices. In fact, some of these suburban landlords, such as Brandywine Realty (BDN), have seen their shares decline despite the presence of strong market conditions. We believe Brandywine specifically represents one of the best buys in REIT-land, and we expect it to benefit from favorable trends such as the relocation of more office staff to the suburbs. We also believe the REIT's regional focus gives it clout with tenants and leasing agents in the Northeast--one of the strongest markets in the country.
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