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Quarter-End Insights

Our Outlook for Financial Services Stocks

Opportunities could be fleeting in a volatile market.

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  • Dividends and share repurchases are beginning again as the banking sector returns to health.
     
  • Consolidation activity is unlikely to slow down anytime soon.
     
  • Diversified asset managers should continue to benefit from volatile markets.

The first quarter of 2011 has been exciting for the financial-services sector. Several of our favorite narrow- and wide-moat banks received approval to boost dividends and begin share repurchase programs.

Deal drama is heating up, with  Deutsche Borse (DEU: DB1) set to merge with  NYSE Euronext (NYX), the London Stock Exchange (GBR: LSE) merging with  TMX Group (CAN: X), and  Charles Schwab (SCHW) making a bid for  OptionsXpress (OXPS).

Finally, crises of various types in Europe, the Middle East, and Asia have resulted in a rocky ride for investors over the first few months of the year. The combination of these factors has already altered the balance of risk and reward for financial-services investors in 2011, as have the lower margins of safety in the sector, resulting from two full years of increasing share prices.

Industry-Level Insights
One of the highlights of the first quarter for U.S. bank investors was the completion of the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) and the immediate announcement of dividend increases by companies given the green light following the latest round of supervisory evaluation. 

 J.P. Morgan  (JPM),  US Bancorp (USB),  Wells Fargo (WFC), and  State Street (STT) were among those that announced significant dividend increases, while other companies, like  Keycorp (KEY) and  SunTrust (STI), took the opportunity to pay back their TARP preferred stock. 

Exchanges that have yet to participate in the current merger wave may attempt to find a partner soon to increase their scale or diversify their revenue by asset class or geography. Additionally, a secondary wave of merger announcements may occur a year or more from now, as currently pending merger partners finish integrating their businesses and once again turn their focus outward. We think  CBOE Holdings (CBOE) and  Nasdaq OMX Group (NDAQ) could be prime acquisition targets--the former for its proprietary products like exclusively licensed index options, the latter for its U.S. and European exposures.

On the asset management front, we believe investors are still gun-shy with respect to equities thanks to the financial crisis. We have seen investors gradually increasing their risk appetite during stable and expanding markets, while pulling back dramatically during market declines. We think that this theme will continue to play out this year, which will primarily benefit the diversified asset managers in our coverage. Those with solid equity and fixed-income franchises are likely to make money no matter which way the risk pendulum swings.

Our Top Financial-Services Picks
 J.P. Morgan (JPM) continues to stand out as one of our top picks in financial services.  Banking is all about management, and Jamie Dimon is one of the best. In addition to the company's recently announced dividend, we like that J.P. Morgan plans to repurchase up to $15 billion of its undervalued shares. 

Similarly, title insurer  First American Financial (FAF) also announced a new $150 million stock repurchase plan--a good use of capital, in our view, given that the shares are trading at a deep discount to our valuation of the firm. Elsewhere in insurance, we believe  Allstate's (ALL) captive agents and cross-selling capabilities help to ward off competition from low-priced competitors. 

Our best idea in the credit card space remains  Discover Financial (DFS). We think Discover not only has a well-managed card-lending business, but also operates appealing debit and credit card networks that could attract more users and third-party issuers as its acceptance improves. We believe the market is underestimating Discover's ability to gain market share in the credit card space. 

Finally, we think  BlackRock's (BLK) diverse product offerings will benefit the company (and its shareholders) in a variety of market environments.

 Top Financial-Services Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

Consider Buying

J.P. Morgan Chase  $61.00 Narrow High 36.60
Discover Financial Services $30.00 Narrow High 18.00
First American Financial  $26.00 Narrow High 15.60
Allstate  $44.00 Narrow High 26.40
BlackRock $235.00 Wide Medium 164.50
Data as of 03-24-11.

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Jim Sinegal has a position in the following securities mentioned above: BLK. Find out about Morningstar’s editorial policies.