Our Outlook for Financial-Services Stocks
Financials are slowly beginning to recover from the credit bust.
Quarter-End Insights
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- Banks will continue to work through their credit-bust-induced hangover, with some recovering faster than others
- Property-casualty insurers will continue to struggle from excess capital while life insurers are exposed to financial market volatility
- Due to fickle investors' propensity to shift between asset classes, we prefer the most diversified asset managers.
Bank stocks, the bellwethers of the financial industry, face mixed prospects in the first quarter of 2011. The high-quality, narrow- and wide-moat names we typically favor, such as Wells Fargo (WFC), PNC Financial (PNC), BB&T (BBT), and J.P. Morgan Chase (JPM), have worked through many of their problems and are set to go on the offensive again, perhaps by acquiring troubled peers. However, valuations for these companies are, for the most part, becoming less attractive as the market finally begins to acknowledge the quality of these businesses. We think the best values can be found in recovering banks, like Bank of America (BAC). Although the bank is still working through its problems (particularly its penchant for acquiring the troubles of others), we believe Bank of America is further along the road to recovery than what others think. If we are correct, evidence of this should begin to show up in the company's results in the near future. Finally, some banks may never recover and may be forced to give up, like Wilmington Trust did when it agreed to be acquired by M&T Bank (MTB) following the last in a series of insurmountable quarterly losses. We think more companies, such as BankAtlantic , will find themselves on this route in 2011.
While 2010 was a good year for life insurance stocks, we don't think the prospects are nearly so bright in 2011. Life insurers continue to derive an increasing share of their profits from the sale of spread-based products, such as annuities and other retirement products, over the more traditional protection segment. The turnaround in financial-market performance produced capital gains in life insurer investment portfolios and helped repair their balance sheets, but with few competitive advantages to speak of, these companies remain susceptible to another downturn in the markets. Annuity sales are already returning to levels experienced prior to the financial crisis, and though we think some life insurers have learned that providing guarantees in an uncertain world is a risky business, others have not. Furthermore, considering the thin equity/assets ratios that most industry participants carry, these firms run the risk of not having sufficient capital in times of stress.
Property-casualty insurers also benefited from the financial market rebound in 2010, though to a somewhat lesser extent as short-term investment yields remain low. In contrast to life insurers, the problem in the sector is too much capital, which we think will keep a lid on price increases, especially in commercial lines. Rising levels of capital, and thus claims-paying ability, acts as a deterrent to price increases which the industry needs badly. We also think the significant volume of positive reserve development will soon run out, as reserve releases have already begun to trend lower in recent months.
On the bright side, property-casualty companies have been deploying capital into share repurchases in recent months--rather than aggressively chasing new business--which could eventually help with pricing as capital runs down. Furthermore, a continued deterioration in underwriting profitability could set the stage for a hardening pricing market, especially if positive reserve development reverses course, as we expect. We don't expect any of these positive developments to happen rapidly, but we will be looking for evidence as the year progresses. In title insurance, we expect the beginning of the new year to bring poor results because of temporary delays in foreclosure sales. However, we expect transaction volume and profits to rebound for these companies later in the year as late-stage delinquencies continue to work their way through the system toward foreclosure and eventual sale.
Like the insurers, asset managers also benefited from the equity market's recent performance. Although the equity markets continued to rally this year, it was not without bouts of volatility. This benefited the diversified asset managers more than it did the equity-heavy firms, even though it was not always reflected in their stock prices. Despite the gains made by equities, investors continue to pull funds out of U.S. stock funds, recording close to $70 billion in outflows through the first 11 months of the year. This would make 2010 the second-worst year for outflows from U.S. stock funds in the nearly 20 years of data Morningstar has on file (with 2008 being the worst year, recording more than $90 billion in outflows in response to the collapse of the credit and equity markets).
Even more troubling for equity-heavy active managers is the fact that more than $140 billion has flowed out of U.S. stock funds during the past four years, with almost all of it going into fixed-income strategies and exchange-traded funds. As long as investors remain risk-averse and ETFs continue their torrid pace of growth, equity-heavy active managers (especially those that have generated poor relative performance) will continue to face stiff headwinds.
On the other hand, we expect fixed-income inflows to continue in 2011 for BlackRock (BLK), Franklin Resources (BEN), Invesco (IVZ), and Eaton Vance . We expect firms with either passive equity offerings--BlackRock and Invesco--or solid relative fund performance that is backed by effective distribution networks--Franklin and T. Rowe Price (TROW)--to pick up equity business regardless of investor appetite. We continue to believe that firms with some relative stickiness in their asset base (whether through a diversified product offering or a niche that allows them to hold on to assets during longer periods of time) will outperform, especially if they are able to generate net new business. While Franklin Resources (diversified portfolio), T. Rowe Price (retirement focus), and Eaton Vance (tax-managed strategies) fit this bill, we believe robust ETF platforms and the cross-selling opportunities created by their recent acquisitions put BlackRock and Invesco in position to generate the strongest inflows. Although these will be tempered by merger-related outflows, we believe BlackRock is at the tail end of these outflows and that Invesco, though still early in the process, is unlikely to face the same level of outflows BlackRock had to deal with this year.
Our Top Financial Picks
Bank of America remains high on our list as a contrarian play. We think the near constant headlines about the name have obscured the massive institution's core earnings power, which remains on the rebound, for the most part. In insurance, we think First American Financial (FAF) is an attractive pick as the title insurer has raised prices, cut costs, and stands to profit from a potential rebound in transaction volumes. Finally, we like BlackRock in the asset management space; the company's diversified product offerings and institutional relationships lead to stability in both its client base and its bottom line.
| Top Financial-Services Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/Fair Value | |
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| Bank of America |  | $21 | Narrow | Very High | 0.62 |
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| First American Financial |  | $26 | Narrow | High | 0.58 |
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| BlackRock |  | $220 | Wide | Medium | 0.87 |
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| Data as of 12-16-10. |
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