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Stock Strategist

Our Updated Take on Financial Stocks--Page 5

We still see opportunities amid the turmoil.

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Implications for Our Coverage of Financial Stocks
Considering the rather delicate situation facing many financial institutions, we've adjusted our process and methodology in covering financial stocks, which are at the epicenter of the current credit crunch. First off, we've gone through our coverage list and reassessed our economic moat and business risk ratings for the firms most impacted by the credit crunch and initial stages of asset deflation, especially those with concentrated exposure to riskier bond holdings and residential properties. If past economic profits now prove to be an illusion created by the credit/housing bubble, we're downgrading moat ratings as a result. We're also raising our risk ratings (and enlarging the margin of safety we require before recommending a stock) for those companies now facing a larger dispersion of outcomes depending on the magnitude and duration of the credit crunch and the ultimate degree of asset deflation. We've also shifted to an expected value methodology mindset rather than just a base case valuation as appropriate, especially in instances where we think that there is a material chance of insolvency or a dilutive equity offering. By weighing our base case valuation against a more negative potential outcome, some of our fair value estimates have been reduced.

To make our methodology change more clear, let's use  Washington Mutual (WM) as an example. Although we still think that this bank's sizable deposit base is highly valuable, our concerns about its riskier-than-average mortgage book have mounted along with the severity of the housing bust. Because we now think that this bank's past results were inflated by both the housing and credit bubble and that its future prospects will be highly dependent on whether the economy avoids serious asset deflation, we've reduced our moat rating from narrow to none and bumped our risk rating up to speculative from average. We think that these new ratings better reflect the fact that the firm's future cash flows have become much less predictable in the current environment and that this bank is unlikely to earn a premium to its cost of capital anytime soon. We've also employed an expected value framework to value the company. From the valuation section of our recent  Analyst Report: "We built in a 45% chance that the company would need a modest amount of additional capital and a 5% chance that it would need a great deal of additional capital, diluting current shareholders." As you can see, we're attempting to better quantify the risks derived from the housing bust explicitly into our fair value estimate.

Even after taking this more strict approach to valuation, we still see a tremendous amount of opportunities where we think the market has overreacted to the current environment. In fact, nearly 70 bank and insurance stocks in our coverage universe garner 5-star ratings as of this writing. In the end, if we face a benign macroeconomic environment, we would expect these undervalued stocks to rally more quickly and substantially. If, however, incoming data continue to deteriorate, we would expect to further downgrade some of our fair value estimates. Lastly, in the big middle, we would expect our 5-star rated stocks to perform quite well within a reasonable timeframe.

Matthew Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.