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Quarter-End Insights

Our Outlook for the Financials Sector

We see a few good investments amid the maelstrom in financials.

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It's been a wild ride in financial markets in recent months. Mounting credit and investment losses have punctured confidence among borrowers and lenders, expressed most poignantly in the heightened stress in short-term credit relationships between financial services providers themselves.

We've chosen to sensitize our opinions on individual firms to a greater extent on macroeconomic conditions, and we have generally been lowering our cash-flow expectations for 2008 and 2009. But we have also tried to keep our eye on the ball and respect firms for their individual virtues as well as their warts. In turn, our fair value estimates remain rooted in a discounted cash-flow framework that reflects longer-term firm-specific expectations as well as near-term generalized weakness. At the end of the day, we still think there are some compelling bargains out there for patient investors.

The trials in the financial markets can easily appear intractably coupled with heightened stress on Main Street. Housing market weakness has intensified, along with the losses facing related financial sectors. The housing malaise has spread increasingly into the commercial real estate arena, while slowing economic growth has led a wider range of businesses and consumers to pose increased credit risk for financial institutions. In turn, heightened counterparty risk between financial institutions themselves has prompted extraordinary intervention by the Federal Reserve in recent weeks. These actions included rare but legally authorized lending for firms that are not depository institutions.

Monetary policy impacts the economy through the financial system. In recent months, the Federal Reserve has worked harder to liquefy relationships between wholesale financial-services providers and to stimulate the overall economy by lowering bank funding costs. Investors in financial-services firms may welcome these developments, but we note that they are arriving for a reason--the underlying weakness in financial markets to begin with. The central bank providing solutions for our current malaise is not itself entirely blameless for the problems it is solving. In turn, a growing consensus asserts that the Fed's liquidity tools have limits in addressing underlying asset price deterioration and may prove counterproductive given their impact on the value of the U.S. dollar and our inflation prospects. We think investors, and companies, are best cautioned not to rely on our monetary authority or the federal government for their future success.

Our overall outlook? In Rocky III, a TV announcer asks Rocky's opponent Clubber Lang (played by Mr. T), "what's your prediction for the fight, Clubber?" Clubber squints, looks mean, and simply growls, "Pain." We respect the weakness in the near-term outlook for financials firms. But we are still trying to look five to 10 years out and don't expect the recent trials to prove permanently intractable. We retain our basic faith in the productive potential of higher-performing firms within the financial-services sector. Our challenge (and yours) involves sorting out the long-term winners from marginal enterprises. The survivors and winners will thrive in the long run, while the losers are getting pummeled, and some won't survive.

Valuations by Industry
The rate of decline in stock prices for our financial sector coverage list slowed from the fourth quarter of 2007. We've been cutting our fair value estimates, on balance, but the median price/fair value ratio declined a bit further from the fourth quarter, reaching 88%. Some segments (for example, regional banks, title insurers, and life insurers) are still trading at significant discounts to fair value.

 Financial Services Valuations by Industry
Segment

Current Median Price/Fair Value

Three Months
Prior
Change
(%)
Finance 0.95 0.88 8
Insurance (Gen) 0.87 0.93 -6
Insurance (Life) 0.81 1.00 -19
Insurance (Prop) 0.91 0.94 -3
Insurance (Title) 0.56 0.56 0
International Banks 0.89 0.94 -5
Money Mngt 0.89 1.10 -19
Real Estate 0.78 0.65 20
Regional Banks 0.82 0.83 -1
Reinsurance 0.86 0.89 -3
REITs 0.93 1.02 -9
Savings and Loans 1.00 0.84 19
Securities 0.99 0.96 3
Super Regional Banks 0.79 0.71 11
* Data as of 03-14-2008

Banking--Who's Still Lending Out Umbrellas?
Last quarter, we noted that "financials were on sale" and that banks had been "taking a beating." Well, in the latest three months, any sale on financials turned into a fire sale, while some banks remained tied to the whipping post. Loan losses rose, credit quality declined, capital markets grew hotter and unforgiving, and macroeconomic determinants of bank operating results deteriorated significantly.

The poet Robert Frost once called a bank "a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain." It has been raining relentlessly lately, but the Federal Reserve has been giving out some important umbrellas. You may or may not like what the Fed has been doing as a matter of public policy, but as investors and analysts, we have to respect the stabilizing impact recent actions have had for banks--at least in the short run.

But another source of relevant public policy has provided a sobering note. In a speech in early March, U.S. Treasury Secretary Henry Paulsen urged banks to revisit their dividend policies, suggesting that they should cut their dividends if necessary to conserve capital. That isn't just idle advice or spurious opinion. It comes from one of the most powerful levers in the financial system in the event of any systemic crisis, and it seems likely to find its way into bank dividend policy in the months ahead.

We recently placed our coverage for all the large money-center banks, the center of much of the systemic risk attention lately, under review. Relative to other financial-services firms, we still think depository institutions enjoy some funding stability. We do note, however, that only about half of the total deposits in U.S. banks and thrifts are insured by the FDIC. Timely data aren't available, but a lot of hot money may be flying around lately, looking for safer nests.

The market has severely and broadly penalized bank stocks amid deteriorating capital market conditions. But we think this leaves us with some good values, for example, in the regional and "super-regional" banks.  Synovus Financial (SNV) operates in a stressful region for real estate assets (the Southeast) right now. But the firm still stands out for financial strength. High-quality risk management systems are more important than simple leverage ratios in determining financial strength, particularly for Synovus, a holding company for a network of locally responsive community banks. My colleague Jaime Peters respects the care they exercise in extending individual loans and managing their overall loan portfolio. A local focus and old-schoolish "block and tackle" operating characteristics provide long-run competitive advantages for Synovus, which we rate as a 5-star buy.

Three other regional banking institutions appear to offer good value right now.

  •  Zions Bancorporation  (ZION) operates in the Southwest U.S., where the economy has been doing relatively well. While my colleague Ryan Lentell has reduced his earnings expectations for Zions in 2008 and 2009, citing overall economic conditions, he still sees Zions as a compelling value. Lentell likes Zions for some of the same reasons Black respects Synovus. In particular, Zions has developed careful risk-management systems for a network of locally responsive banks.
     
  • Among the regional banks,  U.S. Bancorp (USB) looks like another winner. It produces relatively high margins, reflecting the cost and pricing advantages from a wide economic moat. Shareholder-friendly corporate governance practices help reinforce our confidence in longer-term bottom-line returns, and Lentell rates U.S. Bancorp highly in this area.
     
  • A third regional banking firm that looks stable and offers compelling long-term value is  M&T Bank Corporation (MTB). Morningstar analyst Jim Sinegal thinks highly of management's stewardship after taking a close look at its corporate governance practices. He views M&T's careful but steady growth emphasizing traditional banking services as having stood the firm in good stead over the last year. He thinks they have a trustworthy foundation for long-run success.

Speaking of regional banks, but looking to a different region, my colleague Erin Davis thinks the  National Bank of Greece (NBG) is worth keeping on the radar. This organization was actually the central bank of Greece until 1927, and remained under fairly strict government control for decades. But it has been granted freer rein in recent years and has improved its efficiency while expanding into new markets. Davis thinks the firm has been growing responsibly and likes how it remained resilient amid recent turmoil in financial markets. The stock has been trading near what she considers 5-star (consider buying) territory.

Another region offering some stable banking franchises amid macroeconomic weakness is Canada. Morningstar's Chris Blumas thinks  Royal Bank of Canada (RY) is a good one to watch these days. Royal Bank is Canada's largest bank, with a deeply entrenched branch network. Blumas likes how the firm has been true to its growth objectives and capital allocation plans in recent quarters, a sign of its financial strength. Royal Bank has been trading near Blumas' 5-star price in recent weeks.

Investment Banks--A Different Breed
We've taken a broad, bigger-picture rating action for the investment banks. With the demise/merger of  Bear Stearns (BSC), we recently changed our risk ratings for all of these firms to speculative. The range of potential outcomes arising from currently stormy capital market conditions appears much broader for these firms than for depository banks, even as the Federal Reserve has now broadened the range of institutions it deems worthy of serving with its discount window facilities. The investment banks remain heavily reliant on increasingly unstable private short-term financing, and we'll be keeping our ratings at speculative until we see greater stability in market conditions. The prices for most of these firms (e.g.,  Goldman Sachs (GS),  Morgan Stanley (MS),  Lehman Brothers (LEH), and  Merrill Lynch (MER)) have fallen sharply, and courageous investors with money to lose may be rewarded handsomely down the road.

REITs--A First-Quarter Zigzag
Like other financial stocks, shares of real estate investment trusts (REITs) experienced quite a bit of volatility in the first quarter. However, equity REITs finished relatively flat for the period as investors wrestled with divisive issues. On one hand, demand for debt backed by commercial real estate remained anemically low, and asset values, depressed by the higher cost of financing, were dropping. But on the other hand, property fundamentals were hanging in there, and quarterly results continued to be solid. As a result, REITs zigzagged throughout the first quarter as investors pondered the future of the commercial real estate market.

For our part, we expect commercial real estate not to go the way of its residential counterpart. Development has simply been much lower, keeping the supply-and-demand equation in check. Most REITs are well positioned to weather a tougher environment, with long-term leases locking in tenants and conservative balance sheets bolstered by long-term financing.

Still, we would be surprised to see shares of REITs take off in the near term given worries about the economy and its effect on companies' demand for new space. Despite this, we see a number of great values in our stock universe.  Vornado (VNO) is a 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.  Brookfield Properties (BPO) is another REIT we like, thanks to its collection of office space in markets with high barriers to entry. Most of its net operating income is from top real estate markets such as New York, Los Angeles, Washington, D.C., and Toronto.

Insurance: The Lay of the Land
Specialty firms like mortgage and title insurers have rested squarely in the crosshairs of the housing meltdown. We have reduced our cash-flow expectations for a growing number of these firms in light of housing market conditions. In turn, the outlook for financial guarantors such as  Ambac (ABK) and  MBIA (MBI) remains especially clouded. Earlier this year, we simply stopped rating the financial guarantors as their exposure spiked with the deterioration in structured finance markets. Material uncertainty has arisen over credit rating agency actions and regulatory intervention in the financial information marketplace.

Among property/casualty insurers, still-softening markets have generally been weighing on revenue growth and our profitability expectations. But all markets are not behaving equally, and auto insurance rates--which may be a leading indicator for rates more generally--are showing signs of tightening. One of our longtime favorites in the insurance sector is  Progressive (PGR), a cost-effective provider of auto insurance. We believe it has a wide economic moat, and Morningstar analyst Jim Ryan thinks it's a 5-star stock at its current price.

Softening insurance markets have continued to weigh on insurance brokers' revenue and margins, along with lingering regulatory uncertainty about industry compensation practices. We don't expect either factor to prove permanent, and we see  Arthur J. Gallagher (AJG),  Marsh & McLennan (MMC), and  Willis Group (WSH) as good long-term buys. Added headwinds have recently arrived in the form of slowing economic activity, as brokerage results are not immune to recessions. We may be reducing our revenue and margin expectations for 2008 and 2009 among the brokers, but we don't expect any recession to prove permanent either.

Financials Stocks for Your Radar

 Stocks to Watch--Financials
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/E

Synovus $21 Narrow Average 12x
Legg Mason $107 Wide Average 11x
Royal Bank Canada $58 Wide Average 11x
Data as of 03-19-08.

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