Our Outlook for the Financial-Services Sector
As the deleveraging continues, losses keep mounting.
Quarter-End Insights
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For almost half a decade, the financial sector was engaged in a rampant race to grow assets. Once-boring, slow-moving financials companies gobbled up almost any type of asset served by mortgage brokers, builders, and leveraged-buyout artists. And within the financials sector, few companies grew as fast as the nation's major investment banks. Take Lehman Brothers , the most recent victim of the current crisis. In less than five years, the firm's total assets exploded from $312 billion at the end of 2003 to $768 billion in the first quarter of 2008, an astounding 2.5-fold increase. What's most disturbing is that during that time, equity increased only 1.8 fold, amplifying the leverage of what was already a highly leveraged balance sheet.
As it turns out, financials also suffer ill effects if they engage in obsessive eating. To avoid permanent harm to their health, many now need a serious diet, or in the sector's lingo--deleveraging. A few things you can do to delever: sell assets, cut the dividend, hit the breaks on spending, and raise capital. Many financial institutions needed to take all these steps, and quickly. The investment banks have once again led the way, with the first to raise capital being Citigroup (C) (not a pure investment bank, but its need for capital came from this line of business) and Merrill Lynch . Bear Stearns, the most troubled among the group, shortly followed with an extreme solution: selling itself to a competitor for a pittance. Lehman didn't stay behind for long and recently announced that it will raise another $6 billion to boost capital. In addition, Lehman disclosed that in the second quarter of 2008 alone it sold $130 billion in assets, almost 30% of all the assets it had accumulated since 2003.
Nevertheless, we don't believe the industry's deleveraging process is over. Although we might have passed the peak in the recapitalization process, we don't think the industry is ready to resume asset growth. Assets of financial firms, excluding a few like J.P. Morgan (JPM), are likely to remain flat or decline further in the following quarters.
One thing that will certainly keep growing in the following quarters is loan losses. Until this point, the industry has been busy estimating what the final bill will be for its reckless behavior during the past five years. Non-performing loans mounted in recent quarters and write-offs of various securities reached unprecedented levels, but substantial charge-offs have yet to hit the books. This is about to change. Over the next few quarters, we expect many financial institutions--including Washington Mutual (WM), Wachovia , and National City --to report significantly higher net charge offs, in some cases higher than ever before. The question remains whether the capital, future earnings, and loan-loss reserves that are supposed to absorb all these losses will be high enough to leave a meaningful amount for investors. In our view, the answer in several cases is a resounding yes, but for some financials, more pain is in the cards.
Valuations by Industry
Even as the flow of negative news refuses to ebb, valuations in the sector remain attractive. The median price to fair value data below suggest that the median discount for the sector currently stands at 15%. Segments like insurance and regional banks offer an even larger discount.
| Financial Services Valuations by Industry | |||
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| Segment | Current Median Price/Fair Value | Three Months Prior | Change (%) |
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| Finance | 0.89 | 0.95 | -6 |
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| Insurance (Gen) | 0.87 | 0.87 | 0 |
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| Insurance (Life) | 0.80 | 0.81 | -1 |
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| Insurance (Prop) | 0.89 | 0.91 | -2 |
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| Insurance (Title) | 0.52 | 0.56 | -7 |
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| International Banks | 0.89 | 0.89 | 0 |
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| Money Mngt | 1.00 | 0.89 | 12 |
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| Regional Banks | 0.77 | 0.82 | -6 |
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| Reinsurance | 0.85 | 0.86 | -1 |
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| Savings and Loans | 0.96 | 1.00 | -4 |
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| Securities | 1.00 | 0.99 | 1 |
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| Super Regional Banks | 0.75 | 0.79 | -5 |
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| * Data as of 06-13-2008 |
Title insurers remain the most attractively priced group of stocks. Companies like LandAmerica Financial and First American (FAF) continue to trade at almost half of their fair value. The market is still fearful about the state of the real estate market, which we think creates a buying opportunity for long-term investors who believe that buying and selling activity will eventually pick up from current levels.
We also see opportunities in super-regional banks, as the market is still concerned that some of them will have to raise additional capital to absorb imminent loan losses. Although we don't disagree that loan losses are going to rise steeply, we argue that careful stock-picking in these groups can yield attractive long-term results. BB&T Corporation (BBT) and Synovus Financial (SNV) are two examples of super-regionals that trade at significant discounts to our fair value estimates.
Financials Stocks for Your Radar
| Stocks to Watch--Financials | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ |
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| Capital One |  | $103 | Narrow | High | 0.40 |
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| Discover Financial | | $35 | Narrow | High | 0.41 |
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| Land America | | $60 | None | High | 0.43 |
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| Legg Mason | | $96 | Wide | Medium | 0.53 |
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| Citigroup | | $34 | Wide | High | 0.57 |
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| Data as of 06-20-2008 |
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