A Guide to Today's Financial Stock Bargains

Investing in the domestic financial services sector might sound daunting, especially in light of the recent volatility in this area of the market. Moreover, the sector is vast and diverse. A legitimate question is, how can an investor pick winners without stumbling on the losers--especially at a time when there have been so many of the latter?

My colleagues and I cover banks from more than 15 countries, and we can confirm that the U.S. financials sector is one of a kind. The range of choices for investors is truly unmatched in any other market, and one could spend an entire career investing solely in this large basket of stocks. Recently, these choices have been growing exponentially, thanks to the mortgage turmoil that has sent many investors running for the hills. My colleagues at Morningstar have published several articles over the past few months explaining recent events and highlighting our top picks. I'd like to step back and provide a brief sector overview for investors who are new to this market or viewing it with interest from afar, examining the various segments contained under the wide financials umbrella. In the process, I will also offer a few investment ideas culled from our most recent analyses of undervalued stocks.

Large Banks
The three largest banks in the United States,  J.P. Morgan Chase (JPM),  Citigroup (C), and  Bank of America (BAC), like international banks  Royal Bank of Canada (RY) or  Deutsche Bank (DB), operate as financial conglomerates with various business lines such as retail banking, corporate and investment banking, brokerage, and asset management. Each has a sizable international presence and boasts better diversification than their smaller competitors. The most international is Citi, with operations in more than 100 countries and more than 40% of revenue sourced from abroad. Bank of America is the least international, with less than 20% of the revenue coming from outside the U.S.

The large banks hold mortgages on their books, but those tend to be high-quality assets with very low loss levels. The large banks also took part in the recent leveraged buyout boom by funding deals. Nevertheless, my colleague Ganesh Rathnam, who covers the large banks, thinks that they are well positioned to weather any credit woes that might arise from the LBO business. Rathnam is bullish on the large banks, and he thinks that all three are good buys right now.

Superregional Banks
Although several acquisitions have blurred the borders, superregional banks tend to focus on specific geographies in the U.S., such as the Midwest, the Southeast, or the West. They have very little international exposure, but most of them strive to diversify their revenue streams by offering multiple products. Some of the superregional banks have sizable investment banking, asset management, and mortgage operations. We count nine super regional banks in the U.S., although  Wachovia Corporation  is on its way to large bank status. The best performers in this group are  Wells Fargo (WFC) and  US Bancorp (USB), with returns on equity reaching 20% and 22%, respectively. The worst performer is  SunTrust Banks  with an ROE of 12% in 2006. My colleagues Jaime Peters and Ryan Lentell think that  BB&T Corporation (BBT) and US Bancorp are on sale.

BB&T is southern banking giant with toes in several businesses. It owns one of the largest insurance brokerage businesses in the United States, and insurance commissions make up the largest proportion of BB&T's noninterest income, a business Peters loves. The stock is cheap because of a combination of fears: rising credit losses, a compression in the net interest margin, and investors' fears that John Allison (BB&T's chief executive) will do some crazy merger of equals. However, Peters believes the market's fears are overblown: credit losses are simply returning to normal from an unsustainably low rate, the net interest margin compression is a temporary problem from the flat yield curve, and Allison has publicly stated there are no banks among its equals that would interest the bank at the present time. BB&T generates a boatload of cash flows and trades below our estimate of its fair value.

US Bancorp is one of the most profitable banks we cover. It has developed a diversified revenue base and repeatedly produces returns on equity in excess of 20%. Lentell admires management's goal of returning at least 80% of earnings to shareholders annually, achieving 10% long-term earnings-per-share growth, and maintaining returns on equity above 20%. Lentell thinks these significant self-imposed hurdles are shareholder-friendly, and achieving them should create shareholder value. In his opinion, the firm's efficient and diversified franchise is the key to its consistently strong financial results.

Community Banks
Judging by the sheer number of players, this is the largest segment in the financial services sector. Morningstar has an extensive coverage list of the group, with more than 50 community banks under coverage.

Community banks tend to focus on one state, or even on one city or county. In general, community banks gather deposits from individuals and small businesses and lend them to commercial clients. They tend to rely on spread income to turn a profit, and fees comprise less than 30% of revenue, on average. If we had to name one product that has been the bread and butter of these banks in recent years, we would have to say commercial real estate loans. Yet, some community banks like  TCF Financial  and  BankAtlantic  also cater to individuals and have large consumer loan books. We think both TCF and BankAtlantic are very cheap right now for the same reason--credit concerns. Mr. Market fears that TCF doesn't have enough reserves to protect it from unexpected loan losses. BankAtlantic, on the other end, has enough reserves but the market apparently doesn't like its exposure to construction projects in Florida. We prefer to take a long-term view on these banks, however, rather than focusing on what might turn out to be short-term hiccups. TCF's reserves might lead to ugly numbers in the next few quarters and BankAtlantic's construction loans might cause some headaches, but the long-term prospects for both banks are positive and we think that the fair values of both are higher than where the stocks trade right now.

This segment also includes specialty shops like  Cathay General (CATY), a firm that focuses on Chinese-Americans in Southern California and is currently, also, on sale. We think Cathay is cheap partly because it flies under the radar and partly because it has large exposure to California real estate. Nevertheless, Cathay is a well-managed bank with solid underwriting standards and long history of decent performance. Catering to Chinese-Americans is a profitable business and, in our view, not as competitive as mainstream banking. I think the value in this franchise is sound and clear.

 FirstFed Financial Corporation  is another specialty player on my coverage list. FirstFed's main business is Option ARMs (unconventional mortgages) in Southern California, which was one of the hottest real estate markets during the recent boom. I think investors have overreacted to the risk of loan losses, and as a result, FirstFed is now a bargain. While I think loan losses are set to rise over the next few years, the business model is still very attractive and remains intact despite all the turmoil in the mortgage market. I expect FirstFed to return to its historic profitability levels after the dust settles.

Credit Cards
In the U.S., you can get a credit card from multiple providers, and your bank won't always be your first choice. The large banks are among the largest card issuers, but  American Express (AXP) and  Discover Financial (DFS) are putting up a decent fight. Card companies have been in the hot seat lately, as many investors became concerned about their prospects following the mortgage debacle. After all, why would people keep spending money on their credit cards if they cannot afford their mortgages? While these are legitimate concerns, we think they are short-lived. Even if the U.S. slips into a recession, the long-term prospects of the card companies aren't as bleak as many expect. Credit quality of card loans is going to deteriorate and growth will slow over the next five years, but we account for all of that in our models and we still think that the card companies trade below the value of the cash flow we expect them to produce in the long run. We like American Express at current prices, but Discover and  Capital One Financial (COF)--whose diversification into regional banks makes it less sensitive to its card business--also look very attractive.

Mortgages
The headlines in this segment have reached all corners of the world. If you haven't heard about the turmoil in the U.S. mortgage market, you have probably been on a long vacation. The U.S. mortgage market is truly one of a kind, mostly thanks to a financial innovation called securitization. Ironically, securitizations are at the center of the current turmoil. Once a bank originates a mortgage, it can either keep it on its books, sell it, or securitize it. The players who securitize mortgages usually obtain short-term financing to fund the warehousing of these mortgages from the time of origination until the actual securitization takes place. This funding is subject to covenants and can be terminated under certain circumstances. Unfortunately, many companies experienced these circumstances over the past few months and ended up in a liquidity crunch that has resulted in bankruptcy. Mr. Market's reaction was merciless, sending almost any company that depended on securitizations to the penalty box.

My colleague, Erin Swanson, covers  Countrywide Financial , the largest mortgage lender in the U.S. It has been caught in a barrage of negative sentiment surrounding its ability to borrow money to fund its operations. Swanson thinks it will not only survive, but that it will emerge stronger in the future. In nutshell, Swanson argues that with the departure of many players from the mortgage market, those who will stay in the market for the long run, like Countrywide, will benefit in a consolidated market. In addition, Swanson finds great comfort in the fact that Countrywide doesn't rely entirely on short-term funding, but rather has a diverse funding base unlike several of the mortgage lenders that have "walked the plank." Countrywide is one of our top picks.

Specialty Finance
Today, financial wizards can securitize almost any type of financial assets. We cover a group of companies that invest in securitized airline loans. We also cover  AmeriCredit , a firm that specializes in car loans, which are also extensively securitized. One of our top picks in this segment is  Capital Source , which specializes in lending to midsize companies in the health-care, real estate, and leveraged buyout markets. My colleague Jim Sinegal, who covers CapitalSource, thinks the company and its dividend appear to be in good shape, and CapitalSource is well positioned to take advantage of current fears in the capital markets. Sinegal argues that when credit spreads widen, companies like CapitalSource can charge higher interest rates on loans, potentially improving net interest margin in future years.

To be sure, the U.S. financial services sector is vast and complex. But investors shouldn't let this complexity get in the way of capitalizing on undervalued stocks--especially at a time when this sector offers so many compelling buys.