Our Outlook for Financial Services Stocks
Opportunities could be fleeting in a volatile market.
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.
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.
|Top Financial-Services Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
|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|
|Data as of 03-24-11.|
If you'd like to track and analyze the stocks mentioned above, click here to create a watch list. Then simply click "continue," name your watch list, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.
Other Outlook Articles
Jim Sinegal has a position in the following securities mentioned above: BLK. Find out about Morningstar’s editorial policies.