Our Outlook for the Financials Sector
Financials are on sale.
It is an exciting time in the normally boring world of the financial sector. Unfortunately, it is exciting because, to some, the world is about to come to an end--or at least that is how the financial sector is trading recently. For a while, it looked like the major credit crunch of August was going to ease. The Fed cut rates in late September, headlines died down somewhat, and pressure on the stock market eased. But October brought the headlines back and billions of dollars of charges along with it.
Banks, some REITs, and insurance companies--anything remotely related to the housing sector--have gotten pounded in the market. And we haven't even gotten to the worst part of this credit cycle. Currently most of the headlines surrounding these problems relate to anticipated future losses or mark-to-market losses rather than actual cash losses, which are likely to show up in 2008 and beyond. We believe it will be more than 18 months before the markets work through this turmoil.
It is exactly at these times, when headlines have driven down the market, that being a long-term investor is most rewarding. We at Morningstar are looking 10 years out. Without any signs of permanent disruption (people still need to live somewhere and will still need to finance home purchases), we believe the financial markets will show their resilience. While cheap money is likely to be a thing of the past (at least in the near term), we believe most companies will eventually return to normal operating procedures. So, our challenge (and yours) is to sort the long-term winners from the ones that cannot survive a two-year hiccup in the markets.
Valuations by Industry
The recent stock market declines are evident in our valuations--while most of the sector was within 5% of fair value last quarter, fourth-quarter valuations have plummeted. The median price/fair value data below indicate the sector is trading at just 92% of fair value, with some segments (super regional banks and title insurance) trading at significant discounts.
|Financial Services Valuations by Industry
| Three Months
|Savings and Loans
|Super Regional Banks
|* Data as of 11-15-2007
Below, we'll take a look at the various industry groups in more depth and highlight our best values in each.
Across the board, banks have taken a beating. For the first time in years, banks are seeing loan losses increase, rather than decline, and the larger banks are having problems with their subprime mortgage paper and collateralized debt obligations. With some estimates of the potential cost of subprime mortgage fallout reaching hundreds of billions of dollars, the market is running scared.
Actual losses on mortgages are still near historical lows at most banks. However, late payments and delinquencies are up, while housing prices are falling in parts of the country--this is a recipe for higher loan losses ahead. Our banking analysts realized some time ago that the record low loan loss rates were only temporary. Now the question is, "How bad will it get?" In general, we have increased our commercial-based loan losses (which have yet to show signs of deterioration) back to historical averages and increased our consumer loan losses to reflect the unprecedented pain the housing market is likely to feel. In 2006 and the beginning of 2007, underwriting standards were deplorable, and banks are going to have to pay for that. But not everyone was eager to jump on the easy-credit bandwagon, and many of those who did will be able to weather this storm.
In late November, 42 bank and thrift stocks were rated 5 stars. With such a bounty of bargains, investors must decide which bargain is the best. US Bancorp (USB) and Synovus Financial (SNV) are two companies that have largely avoided the headline problems. Each company has a strong capital position and is well-reserved for elevated losses. While neither will completely avoid the problems (US Bancorp has operations in Las Vegas, and Synovus has operations in hard-hit parts of Florida), both are easily able to absorb the losses. We believe another long-term winner will be Capital One (COF). It exited its subprime mortgage business in August, and through acquisition, it has diversified away from its credit card concentration. Trading at just 43% of our fair value estimate, Capital One is definitely one bargain-basement purchase.
With similar problems as the banks, several types of insurance (mortgage, title, and financial guarantors) are having problems because of the weakening mortgage market. With housing prices dropping a record 4.5% in the third quarter of 2007 compared with the third quarter of 2006 (according to S&P), those in first loss positions, like the mortgage insurers, are suffering. Losses have already spiked and are expected to continue to escalate. Consequently, the market has driven down the price of every player in the group. PMI , Radian (RDN), and MGIC (MTG) are all deep in 5-star territory. With some questioning the survival of these firms, we take comfort in PMI's substantial capital resources and would recommend it to the more risk-tolerant investor. But our top recommendation would be 5-star Old Republic (ORI), which offers a mix of property and casualty (P&C), mortgage insurance, and title insurance. This deeply conservative company's underwriting abilities clearly underscore its narrow moat. With a crack management team, this is a rare opportunity to buy a quality insurer for a marked-down price. The management of each of these companies is taking the chance to buy fistloads of the stocks, and we would not be averse to joining them.
There are some bargains among P&C insurers as well. With the pricing environment continuing to erode, we believe P&C insurers are likely to see profitability deteriorate. The two stocks we highlighted last quarter, wide-moat Progressive (PGR) and Marsh & McLennan (MMC), continue to trade in 5-star territory. Progressive's strong underwriting and ability to break down risk allow it to provide low-cost insurance to lower-risk drivers. Meanwhile, Marsh & McLennan's ability to find innovative ways to manage risk has created a global insurance brokerage powerhouse able to meet all of its clients' needs.
Capital markets have continued to deteriorate over the past quarter. Liquidity for some supposed "AAA" securities has disappeared causing a chain reaction of mark-to-market write-downs at a series of investment banks. While some of the investment banks have fared better than others, all are under pressure. Merrill Lynch had to revise its losses upward from $5.5 billion in mid-October to $7.9 billion in late October. On the flip side, Goldman Sachs (GS) was short subprime mortgages and reported strong earnings. While we think the disruption in the complex CDO and residential-mortgage-backed securities markets are likely to continue into 2008, we believe the major investment banks will survive these problems and are ripe for risk-tolerant bargain-hunters.
With the credit crunch spawning fears of a broader slowdown, other market-sensitive firms have also been waylaid recently. Asset managers, whose fortunes typically hinge on the trajectory of the market, have taken it on the chin amid stocks' pullback. That has pushed some names even further into bargain territory, with Legg Mason --which has been pummeled due to lingering concerns over the performance of some of its most-prominent strategies--topping our buy list. Although we believe asset managers will continue to be under pressure in the near term, the market seems to be discounting these temporary woes into perpetuity.
Shares of real estate investment trusts (REITs) finished flat for the third quarter, although they have since resumed their downward spiral. Since the beginning of 2007, REITs have fallen on a number of wide-ranging concerns. The blowup in the credit markets stifled leveraged buyout activity, prompting investors to take profits from sectors such as office and apartment that saw companies taken out at large premiums. Talk of a recession also weighed heavily on REITs, which depend on job growth to fuel demand for new space. Finally, the higher cost of debt led market participants to conclude that investment returns and property prices would both come down.
Owing to REITs' business models, we think these worries are largely overblown. Even if building values drop, few REITs are active sellers of properties and prefer to hold assets for long periods of time. REITs with cash on hand can use the pullback to make opportunistic acquisitions. We also believe that demand for commercial real estate remains strong, with the economy showing robust job growth and billions of institutional capital earmarked for real estate. As a result, we expect net operating income to tick higher as fundamentals hold tight.
Across our coverage universe, we believe REITs are fairly valued given their outsized returns since 2000, but we continue to see value in select names. Corporate Office (OFC) is a midsize office REIT that owns properties in the greater Washington, D.C., area--one of the top markets in the nation. Vornado (VNO) is also another high-quality REIT with one of the top management teams in the industry. Chairman and CEO Steven Roth has amassed an impressive track record for buying out-of-favor assets and repositioning them for higher rents.
Financials Stocks for Your Radar
|Stocks to Watch--Financials
|Fair Value Estimate
|First American Corp
|MGIC Investment Corp
|Vornado Realty Trust
|Data as of 12-07-07.
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Other Sector Outlook Articles
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