Uncertainties Will Weigh on Financials in the Near Term

• Macroeconomic and regulatory uncertainties could result in lower valuations and buying opportunities in the coming quarters.
   
• Troubles in Europe will have little direct effect on U.S. banks, but the opposite may be true for highly leveraged European institutions.
   
• The insurance pricing cycle could be turning, but the market is not unaware of this fact. 

Last quarter, we mourned the "lower margins of safety" available in the financial services sector, as exuberance over a mounting economic recovery, a resurgence in M&A, and the resumption of dividends by some of the largest banks bolstered climbing stock prices. Sentiments change quickly, though, and rising uncertainty among investors contributed to a rapidly changing tide in the second quarter. The aggregate Morningstar price-to-fair value ratio of financial services stocks now stands at only 85%, the lowest level in almost a year. 

Regulation has been one of the biggest burdens on financial services stocks in the second quarter. The important one-year anniversary of the Dodd-Frank Act will occur in July, but many of the act's most relevant provisions have been delayed as regulators struggle to implement rules on time amid vigorous debate. For example, some of the major derivatives-related provisions originally scheduled for midyear are being pushed back to the end of 2011. Similarly, the Basel III observation and implementation process will last for years, not months. As we have often seen in other industries--health care, tobacco, and for-profit education, to name a few--many investors are loath to purchase stocks threatened by political, regulatory, or legal attacks. We think this is one of the factors that is most heavily weighing on the financial services sector at the moment, and one that is unlikely to be lifted anytime soon. 

If regulatory uncertainty was not enough, macroeconomic fears are building again as the global recovery slows. A "Goldilocks" economy is no longer considered a possibility, with many investors pondering only extreme inflationary and deflationary scenarios. Admittedly, the U.S. economy has not given financial services investors much to be excited about in recent months.  Unemployment is high, housing remains in the dumps, credit growth is anemic, and the stock market is roughly flat year-to-date. With the possible exception of the volatile and unpredictable stock market, we think slow improvements in these macroeconomic factors are the best U.S. investors can hope for, to the detriment of those looking for short-term catalysts. 

European financials are subject to even more uncertainty, with fears of a sovereign debt crisis once again coming to a head. While European financial stocks could be more volatile than their U.S. counterparts during the quarter, we don't expect fears of a financial debacle to completely abate until the most troubled European nations are more obviously in the clear. 

On the bright side, all of these fears and uncertainties have the potential to benefit investors with a long time horizon, as we believe competitively advantaged narrow- and wide-moat firms are best positioned to deal with near-term headwinds and thrive at the expense of no-moat peers in an increasingly difficult environment. 

Industry-Level Insights
Among the banks, worries about Greece's fate have weighed on the market for the past several weeks. Rumors of U.S. banking exposure to Greek debt--through direct holdings--vary greatly, with some estimates putting it as high as $40 billion.  Citigroup (C) and  Wells Fargo (WFC) do not disclose their direct exposure in their annual reports, but  J.P. Morgan (JPM) reported "PIIGS" exposure of less than $15 billion at Dec. 31, 2010, with no one country representing a majority.  Bank of America (BAC) reported total exposure to Greece was $477 million as of the same date, with just $103 million of sovereign exposure. Some of the European banks are a different story, however. In addition to the obviously exposed banks like  National Bank of Greece , European banks like  Dexia (DEXB) and  Commerzbank (CBK) could be quite vulnerable in the event of a Greek restructuring.

Fears are somewhat less rampant in the insurance sector, where investors are optimistic over potential improvements in pricing power. We agree that the combination of heavy stock repurchases by carriers during the last few quarters and relatively large catastrophe losses so far this year should work down industry capital levels and lead to better pricing. However, we believe much of this improvement is already priced into stocks in the property and casualty sector, like  HCC Insurance Holdings  and  W.R. Berkley (WRB). In our opinion, the best investment opportunities in P&C insurance typically come at points when industry profitability is low, which is not the case at the moment.

Our thesis with respect to the asset managers has played out much as we expected. Investors' preferences have vacillated over the past few months, gradually increasing their risk appetites during stable and expanding markets, while pulling back dramatically during market declines. We think that this theme will continue to play out over the next few quarters, which will primarily benefit the diversified asset managers in our coverage universe. These franchises, like  Invesco (IVZ) and  BlackRock (BLK), are likely to make money no matter which way the risk pendulum swings.

Our Top Financial-Services Picks
In a welcome development for value investors, Wells Fargo--one of the nation's best banking franchises--went on sale during the quarter, trading at less than 70% of our $42 fair value estimate. The bank's enviable deposit base and wide net interest margins give it plenty of room to withstand potentially higher capital requirements, while also winning business from weakened competitors on both coasts.

Internationally, we favor  Banco Santander Brasil (BSBR). While most investors in Brazilian financial services are focused on the potential for rapid growth in the country, we favor Banco Santander's conservative approach, and we like its massive capital base. We believe the Brazilian bank has benefited in numerous ways from a close relationship with  Banco Santander (STD) in Spain, learning how quickly a hot economy can turn cold from the latter company's experienced Spanish bankers.

Among insurance names, we view  Allstate's (ALL) stock--punished due to a string of relatively unprofitable quarters that were driven in part by freak occurrences such as hailstorms in Arizona--as attractive. A more valid concern is that Allstate's captive agent network potentially looks obsolete given the growth in online policy shopping. However, while this might affect growth, we believe that a sufficient number of policyholders, especially those with multiple policy needs, value the high-touch service an agent provides. This should keep Allstate's business model viable in the long run.

In the credit card arena, management at  Discover Financial (DFS) continues to impress us. While competitors like  Capital One (COF) chase big deals--spending $9 billion on ING Direct, for instance--Discover has taken a more measured approach, paying only $56 million for a mortgage origination platform and announcing a $1 billion buyback of its own undervalued shares. We'd keep an eye on the shares of the company in the event of further market declines.

Finally, we believe  Invesco (IVZ) is poised to start reaping the benefits of the Van Kampen acquisition. One year into the integration, management has been working hard to deepen its relationship with clients and consultants across all assets classes, distribution channels, and geographic markets. We expect the firm to soon be a far more formidable competitor domestically, with the size and scale necessary to secure placement on a wide array of platforms.

Top Financial-Services Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Wells Fargo		$42.00	Narrow	Medium	29.40
Discover Financial Services		$30.00	Narrow	High	18.00
Banco Santander Brasil		$17.00	Narrow	High	10.20
Allstate		$44.00	Narrow	High	26.40
Invesco		$32.00	Narrow	Medium	22.40
Data as of 03-24-11.

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