Our Outlook for Financial Services Stocks
The good, the bad, and the ugly.
Quarter-End Insights
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The Good
Data-processing companies have been unfairly beaten up in the third quarter, in our view. We think most processors have some nice qualities like solid and fairly stable free cash flow, asset-light business models, clean balance sheets, and recurring revenue streams. But by Dec. 15, the segment was punished with the rest of the market as the price of the stocks in the sector went down, on average, about 26%, slightly more than the entire S&P 500. When the tide goes out all ships fall in proportion, it seems.
The Bad
Insurance--70% of the financial services stocks in Morningstar's coverage universe--continued on a downward spiral this quarter. One by one, insurance industry subsectors have experienced the domino effect initially caused by toxic housing-related derivatives and further compounded by frozen credit markets. Beginning in 2007, we observed the first signs of weakness with the mortgage insurance companies followed by bond insurers and, this year, title insurers. Life insurers have now caught the contagion as their investment portfolios have fallen prey to markdowns; shrinking equity and leaving balance sheets vulnerable to rating agency actions. And property and casualty (P&C) companies, further burdened by elevated catastrophic events, have followed suit, though not to the same extent as the life insurers.
The Ugly
Money management firms are on track for a horrific quarter, down over 50% by the middle of December. Money management fees are tied to the level of assets under management, so when the market falls, revenue for these companies falls proportionally. Magnifying this effect are record levels of fund outflows, as investors have retreated to safer ground. Most money management companies are scrambling to reduce their cost bases through layoffs, but cost reductions are unlikely to be sufficient to avoid margin compression.
Valuations by Industry
On a price/fair value basis the data processing industry currently has the most attractive valuations. Life insurers, on the other hand, are near fair value due to our reassessment of the industry.
| Financial Services Valuations | |||
 | | | |
| Segment | Price/Fair Value* | Three Months Prior | Change (%) |
| |||
| Data Processing | 0.62 | 0.81 | -23% |
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| Insurance (Gen & Prop) | 0.71 | 0.78 | -9% |
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| Insurance (Life) | 0.94 | 0.76 | 24% |
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| Insurance (Title) | 0.74 | 0.71 | 4% |
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| Money Management | 0.73 | 0.88 | -17% |
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| * Data as of 12-15-2008 *Market-Weighted Harmonic Mean |
We think the valuations on many data processing companies are attractive and that these firms will survive the downturn in relatively good shape. However, for those processors serving the financial sector, struggling customers will put a damper on growth in the near term. For instance, the core processors we cover saw growth slow across the board as banks deferred technology purchases, although none of them experienced a revenue decline. In other cases, secular trends still outweighed the decline in the economy. Small merchant credit card processor Heartland Payments , for instance, achieved 14% organic revenue growth in the third quarter, despite a 2% decline in same-store sales, as it continued to sign up new merchants. Other business services companies whose revenue is tied to the volume of credit applications, such as Equifax (EFX) and Fair Isaac (FIC), saw revenue declines of 2% and 10%, respectively. Results are unlikely to improve until the credit markets settle and we expect similar performance in the fourth quarter and into 2009.
Life insurers are of concern to us as the level of equity to investments threatens to further constrict capital if more write-downs occur. We undertook another review of the industry in November, which concluded with many of the larger life insurers receiving our extreme fair value uncertainty rating. We think there are more investment write-downs to come this quarter, which may cause some of the larger life insurers to have to raise additional capital, resulting in shareholder dilution. However, in our extended review of the industry we concluded that Aflac (AFL) and Torchmark (TMK) are in the best position to survive the carnage due to the quality of their respective investment portfolios as well as a greater percentage of equity to investments. These factors strike us as the most important metric as more conservative assets stand up better in troubled times and companies with more equity can take all but the most extreme write-downs in stride.
Compared with the life insurers, the P&C companies look much safer. Having to manage and invest to a shorter tail of insurance risk helps as the degree of equity to tangible assets is much greater than with the life insurers. We continue to like Allstate (ALL) but we also recommend well-managed, low-cost providers such as Mercury General (MCY) and Progressive (PGR). Insurance investment companies such as Alleghany and White Mountains (WTM) seem very attractive at recent bargain-basement prices. Both of these companies have long histories of creating shareholder value through patient, well-timed acquisitions and divestitures.
Most of the reinsurance world is still standing and we've been generally impressed with the performance and regulatory environment in Bermuda given how bad things might have been. We are expecting higher rates in reinsurance generally, given the hit to capital and other factors damping industry supply. But all firms will not behave the same. Some firms now have stronger incentives to try to gather premium inflow irrespective of price. Others with stronger balance sheets can pick and choose their spots more carefully. We see firms such as Berkshire Hathaway (BRK.B), Wesco Financial Corporation , Odyssey Re , RenaissanceRe (RNR), and IPC Holdings among the latter group, and currently Berkshire and Wesco are rated at 5 stars.
Money management stocks are tied to the direction of the market and we are loath to predict near-term market swings. Assets under management (AUM) have contracted at record levels as investors flee the heart-pounding collapse of the stock market. Worse yet, recent fraudulent events with funds may provoke even more selling in the near term as investors lose confidence and demand redemptions from asset managers. That said, there are a couple firms that may be worth a look. Federated Investors (FII) has actually been able to increase its AUM due to its focus on money market funds. Federated has increased its money market AUM nearly 70% in the past 12 months. Legg Mason has hundreds of millions of dollars of AUM diversified among equities, fixed income, and money markets, providing a measure of stability as investors switch from one asset class to another.
Finally, we note that our coverage of title insurance stocks has now shrunk to two companies. LandAmerica has filed for bankruptcy protection and Fidelity National Financial (FNF) has offered to purchase the main title underwriting subsidiaries Commonwealth Title and Lawyers Title as well as smaller United Capital Title. If this deal goes through Fidelity will control close to 50% of the title insurance market and will be able to significantly combine operations resulting in large cost savings. We don't think the title insurance market is on the verge of any return to glory in the near term, but Fidelity is positioned to rule this cash-rich industry when it does.
Financial Services Stocks for Your Radar
Despite all the gloom and doom we think the following companies deserve consideration as long-term investment opportunities.
| Stocks to Watch--Financial Services | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Mkt Cap($Bil) |
| |||||
| Fiserv (FISV) |  | $61 | Wide | Medium | 6 |
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| Equifax (EFX) | | $39 | Wide | Medium | 3 |
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| Berkshire Hathaway (BRK.B) | | $4,800 | Wide | Medium | 154 |
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| Marsh & McLennan (MMC) | | $38 | Wide | Medium | 12 |
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| Mercury General (MCY) |  | $56 | Narrow | Medium | 2 |
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| Data as of 12-16-2008. |
Fiserv (FISV)
Fiserv faces a number of head winds in the near term, but we think its shares are very attractively priced for the long haul. A struggling bank customer base, lower interest rates (which reduce float income), and a drop-off in the company's HELOC business, combined to keep revenue flat on an organic basis in the third quarter and we don't expect this to change soon. However, these factors are at the margin and with 85% of the company's revenue generated under long-term contracts, we think Fiserv will hold up well through tough times. The company should generate close to $600 million in free cash flow in 2008 and the long-term trend toward increased technology needs for banks remains intact in our opinion, which should allow this industry leader to ultimately return to the mid- to high-single-digit organic growth rates it has historically enjoyed.
Equifax (EFX)
Credit bureau company Equifax enjoys a wide moat. Its database of credit information on 300 million consumers would be almost impossible to replicate and limited competition allows the company to maintain fat profit margins. The turmoil in the financial markets has led to a drop in demand for credit information and we think a loose credit environment is unlikely to return anytime soon. But international growth has helped to offset this decline, and adoption of consumer credit scores in emerging markets could provide opportunities for long-term growth. In the meantime, while domestic revenue may continue to fall a bit in the near term, Equifax should remain highly profitable. Despite the difficulties it has faced, through the first nine months of 2008, the company produced $236 million in free cash flow.
Berkshire Hathaway (BRK.B)
Berkshire Hathaway has long had a lot of fans here at Morningstar. Berkshire's core competitive advantages flow from its financial strength and conservative capital position, attributes that have become only more valuable with the developing financial crisis. After some recent and, we believe, unwarranted concern about its equity derivative positions, Berkshire's share price has fallen to create an attractive buying opportunity. Berkshire built up an extraordinarily liquid balance sheet in recent years, while many other financial firms pursued a quest for yield they now painfully regret. Berkshire has recently been deploying its cash hoard in selective investment opportunities at attractive prices. We're anticipating some hardening in the reinsurance markets in coming years, after several years of weaker rates, and higher-quality reinsurers like those in the Berkshire stable are likely to benefit most.
Marsh & McLennan (MMC)
Marsh & McLennan's economies of scale and scope, long-standing valuable relationships in attractive international markets, and ability to attract and retain topnotch insurance brokerage talent led to an outstanding historical financial record. The firm's moat was tested by a regulatory crisis in 2004 and 2005, and recent market conditions have been challenging for other reasons. We believe MMC's underlying recovery remains on track, however. The firm's performance several years out is likely to be well ahead of what its share price would suggest today. Soft insurance pricing and uncertainty about the structure of brokerage compensation have been weighing on MMC's commission revenue. But the insurance industry has long been subject to cycles of hardening and softening markets, and the next upturn in pricing is likely to come sooner than later. We think the industry and its regulators are making progress on rationalizing brokerage compensation practices, which will likely allow greater returns for valuable intermediaries. We don't expect economic weakness to weigh on MMC's consulting businesses forever, either. Down the road, we see MMC as an improving firm in improving markets.
Mercury General (MCY)
Mercury's underwriting performance this year has suffered from downward pricing pressure and increased catastrophe claims. And the adoption of SFAS 159 has taken a toll on the income statement as the investment portfolio has suffered from write-downs. But we think these are temporary issues. P&C pricing is now on the rise as companies raise premiums to increase capital. Almost 95% of the $276 million third-quarter write-down is from mark-to-market of municipal bonds--70% of Mercury's investment portfolio. Mercury benefits from being a low-cost provider in an industry that has government-backed mandates for purchase (almost all states require the purchase of at least minimum liability auto insurance coverage). The California-based insurer is in the midst of a national expansion, which presents opportunity for growth. Debt/capital is under 10% and Mercury pays a $2.32 per share annual dividend, which yields over 5% at today's price. We think the growth opportunities, outsized dividend, and pristine balance sheet make Mercury a compelling buy at the right price.
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