Our Outlook for Financial Services Stocks

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The companies in the financial services sector are all tied to the financial system in one way or another, and they continue to experience the effects of the ongoing credit crisis. However, recent results have varied widely across different industry segments, with some segments facing major problems and others coasting through with hardly a scratch.

Insurers comprise the largest part of our financial services team coverage. Within this industry, performance has varied widely. Financial guarantors and mortgage insurers are at the center of the asset-backed and housing market storm and we believe that the uncertainty surrounding these stocks remains extreme. Even the traditionally stodgy title insurance business has experienced a rough patch, as tight credit markets have led to steep drop-offs in real estate transactions.

For life and property and casualty companies, conditions have been much more sedate, although the insurance cycle has continued on a downward trend. There are reasons to suspect the next upturn in pricing may come sooner than later, however, given recent trends in overall inflation and the hit to industry capital in the credit market crisis. On the claims front, Hurricanes Gustav and Ike have rolled through, and while loss estimates have yet to be pinned down with precision, the damage doesn't appear to be enough to result in large fair value decreases. But hurricane season is not yet over (and here we refer to hurricanes both natural and financial), so we will need to continue to track events.

We like the money-management business as it is something of a heads I win, tails you lose business. Their fund investors might not like it, but money managers still earn a fee regardless of performance. That said, money managers are somewhat unique in that a market decline, by itself, can affect their business by reducing assets under management. And, in case you haven't noticed, the equity market has declined quite a bit lately. Compound this with the tendency of investors to run away from underperformers and individual funds can experience dramatic volatility. That is why the money managers we like best are those diversified by asset class, investing style, and geographic markets. With managers operating under various mandates, outflows in one area are generally offset by inflows elsewhere. Still, with investors growing more jittery, big moves from individual funds and asset categories are possible, and we'll be keeping a close eye.

Investors looking to play the financial crisis with the least amount of risk would do well to keep an eye on bank technology companies like  Fiserv (FISV) and  Jack Henry (JKHY), both of which are currently in 4-star territory. Despite the fact that their bank customers are struggling, these companies haven't felt much of an effect. Their customer relationships are incredibly sticky and the vast majority of their revenue is recurring under long-term contracts. While the weak banking environment has led banks to defer software license purchases, the result has been only a mild downtick in revenue growth, as license sales make up only a small portion of revenues (5% and 11%, respectively, for Fiserv and Jack Henry).

Valuations by Industry
As the market has moved, we've seen some significant shifts in our industry valuations. While we think the sector as a whole looks undervalued, those opportunities are not evenly spread out.

Insurance companies look somewhat undervalued, with the weak near term weighing on market prices. We don't see a lot of opportunities in money mangers at the present time, but with the uncertain markets, pockets of overreaction could arise. Data processors look undervalued at this point, and for those looking for a relatively safe harbor in these uncertain times, data processors are probably worth a look. Profit margins for the bigger players are typically healthy and stable and limited capital needs tend to lead to unlevered balance sheets.

Financial Services Stocks for Your Radar
We see some attractively priced stocks in the space. In particular, we think the following names are worth putting on your radar screen.

Stocks to Watch--Financial Services
Company	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Mkt Cap ($ Bil)
Allstate		$63	Narrow	Medium	25
Fair Isaac		$35	Narrow	Medium	1
Marsh & McLennan		$40	Wide	Medium	17
Renaissance Re		$83	Wide	High	3
Western Union		$32	Wide	Low	18
Data as of 09-18-2008.

 Allstate (ALL)
Allstate has been the victim of a series of weather-related catastrophic losses in 2008, but we still think the company will persevere. Property and casualty companies are prone to the occasional setbacks from Mother Nature but the best companies make it through difficult times intact. Over the past 10 years, Allstate has averaged a 95% combined ratio (expenses divided by earned premium) which ranks it among the best over a cycle that includes Hurricane Katrina. Since 1997, return on equity has averaged just under 15%. Allstate has earned its stripes through a well-thought-out strategy that chases marketing opportunity, not price. With a reach into 17 million households the company has steered its exclusive agent force toward selling bundled products that add value to the consumer. We expect that 2008 will be a challenge to earnings, but that has also created an opportunity to buy into this first-class insurer.

 Fair Isaac (FIC)
Fair Isaac's FICO business has endured a tough stretch as the credit markets have tightened and the number of credit applications has dwindled. Further, a new scoring system developed by the credit bureau has emerged as the first real competition FICO has faced. Still, we think the market is missing the light at the end of the tunnel. The company's previous CEO wasted the company's ample free cash flow through value-destroying acquisitions and the company's current CEO has reversed this course, shutting down unprofitable units and focusing on cutting costs. While the FICO business may lose some share in areas such as marketing, where the need for score reliability is not so great, we think the odds of FICO being replaced as the industry standard are slim, and the FICO business should remain a highly profitable cash cow.

 Marsh & McLennan (MMC)
Marsh & McLennan's economies of scale and scope, long-standing valuable relationships in attractive international markets, and the ability to attract and retain topnotch insurance brokerage talent led to an outstanding historical financial record. The firm's longstanding wide moat was tested by a regulatory crisis in 2004 and 2005, and recent market conditions have been challenging for other reasons, but we believe Marsh & McLennan's underlying potential remains intact. Soft insurance pricing and uncertainty about the structure of brokerage compensation have been weighing on Marsh & McLennan's commission revenue. The insurance industry has long been subject to cycles of hardening and softening markets, however, and there are reasons to expect the next upturn in pricing to come sooner than later.

 Renaissance Re (RNR)
Reinsurance is a difficult area to build and defend a wide moat. In recent years the industry has witnessed significant new entry, increased government risk assumption, and competition from new capital market instruments. But we think Ren Re's continuing ability to differentiate itself enables it to remain a wide-moat reinsurer. Nobody underwrites catastrophe risk better than Ren Re, and its volatile but high margins also reflect customer appreciation for its value-added risk management services and claims handling. Ren Re attracts premium pricing for its financial strength, consulting service quality, and post-loss services. The firm's combined ratio (a measure of underwriting losses and expenses as a share of earned premium revenue) has averaged 69% since 1994. This is an extraordinary result on the surface, considering that many insurance firms survive just by breaking even on their underwriting and making money on the float. Ren Re's growth has been slowing in recent years along with a softening market, but we think the firm's caution is evidence of underwriting discipline rather than any longer-term trend toward losing significant market share.

 Western Union (WU)
Western Union is the clear leader in an industry where size confers significant advantages. The money transfer business is scalable because the incremental costs of processing additional transactions are minimal. This gives Western Union a marked cost advantage over its rivals. Also, the company's network of 335,000 agents creates a network effect, as each additional agent makes using Western Union incrementally more convenient for customers. Finally, the Western Union brand is the most recognized in the industry, and Western Union's size allows it to invest more heavily to maintain this advantage. With the company recently announcing that it intends to roll back the commissions it will pay its agents, we think Western Union is just starting to flex its muscles. While the stock has moved up recently, we still think it's attractively priced and that the market is too focused on near-term headaches, such as the weakness in U.S.-to-Mexico money transfers, as opposed to the long-term opportunity in countries such as India and China.

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