Our Outlook for Financial-Services Stocks
We prefer companies with little direct exposure to questionable sovereigns.
Quarter-End Insights
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- The ongoing European debt crisis could drive financial-services stocks lower in the short run, creating buying opportunities.
- Investors should focus on competitively advantaged companies with strong balance sheets and the potential to grow.
- A mild hurricane season will probably allow insurers to rebuild capital.
After a short-lived period of enthusiasm for financial stocks in late 2010 and early 2011, the second quarter saw the return of bargains in the financial sector as macroeconomic and regulatory uncertainties reduced our sector price-to-fair-value ratio to 85%.
The third quarter did little to assuage investors' fears, as an untenable debt situation in Europe continues to threaten many of the continent's financial institutions. Additionally, the U.S. economy remains listless, with the European situation increasing the possibility of a double-dip recession.
As a result, the aggregate Morningstar price-to-fair-value ratio of financial-services stocks now stands at only 70%, a level we think is indicative of a growing number of attractive stocks within the sector.
On the other hand, investors should not expect to get rich quickly by investing in financial stocks. The major factors contributing to depressed prices--a pan-European debt crisis, continued deleveraging in developed economies, and an uncertain regulatory environment--are unlikely to be resolved soon. The effects of higher capital levels on profitability are yet to be determined, and several U.S. and European institutions are facing multibillion-dollar lawsuits over their mortgage-related behavior during the boom years. We therefore see few catalysts that are likely to drive financial stocks higher in the near term. Instead, buying opportunities are likely to present themselves in the remainder of 2011.
Along those lines, stock selection may be more important in financial services than in any other sector. Much as in 2008, inadequate balance sheet capital and questionable asset quality could mean that many companies' stocks are not as cheap as they might appear, particularly names with significant European exposure. For firms with capital to deploy, the potential to grow will prove valuable, as many companies will struggle to expand their balance sheets and top lines as customers pay down debt and regulators continue to crack down on sources of fee income. Companies with the ability to win market share from troubled peers and those with a presence in developing markets could be great investments at the right price.
As always, we believe competitively advantaged narrow- and wide-moat firms are best positioned to deal with near-term headwinds and thrive at the expense of troubled peers.
Industry-Level Insights
The same capital and asset quality issues that U.S. banks dealt with in late 2008 and early 2009 are now manifesting themselves in Europe. With respect to asset quality, Greece was the subject of many investors' concerns last quarter. Today our focus has turned to Italy, whose sovereign debt balance also exceeds the country's GDP. Seven of the major European banks we cover, in addition to the two large Italian banks, hold Italian sovereign debt worth more than 10% of their equity, and four non-Italian banks have made substantial amounts of loans within the country.
Compounding the problem, in our view, are the low capital levels prevailing in Europe. Capital is not an issue from a regulatory perspective--all major public European banks now report core Tier 1 capital levels above 8%--but lofty regulatory capital levels in Europe are obscuring highly variable and generally inadequate bases of common tangible equity. Even after adjusting for divergent derivative accounting, many European banks appear to be overleveraged relative to U.S. banks. We think that leverage in excess of 20:1 or 25:1 leaves banks with too slim an equity cushion to absorb losses, and we see this as especially true in Europe, where bank balance sheet disclosures are generally meager. Only a few European banks meet or exceed the 4%- 5% tangible common equity/adjusted assets level we see as a bare minimum for investments, while virtually all of the U.S. banks we cover do. It should not be surprising that we'd prefer to invest in the few well-capitalized banks on the continent.
The third quarter tends to be the most volatile for insurance carriers' earnings due to the seasonal presence of hurricanes. Thus far, with hurricane season nearly over, it seems as though the insurance industry has largely avoided the large-scale losses that had been feared. The biggest scare was hurricane Irene, but most of the losses from this event have been caused by floods, which are not covered under most private insurance policies. Although we still expect that a number of companies will report a significant drop-off in earnings compared with a year ago, the quarter is not likely to be as bad as was originally predicted.
The lack of material storms is both a positive and negative for insurance stocks. The obvious positive is that the companies will be better able to rebuild capital positions, especially after a higher-than-average level of losses incurred during the first half of the year due to tornadoes in the United States and losses overseas, including the Japanese earthquake and tsunami. This ability to rebuild industry capital cuts two ways, however, as it may further postpone an eventual hardening of the pricing market, a cycle that is largely driven by industry capital levels.
After years of rate decreases, the commentary surrounding the pricing environment has been increasingly positive with many market participants indicating that the market might be bottoming. We believe that a turn toward a hardening market will require a catalyst, such as a large loss event, in order to motivate a change in behavior. We will be paying close attention to guidance and information surrounding the trend in insurance pricing when insurance companies release their third-quarter earnings reports.
For retail-focused brokerage shops, the economic uncertainty that has been hanging over the stock market can bring short-term benefits, but the longer-term effects are mixed to negative. In the near term, companies such as TD Ameritrade , Charles Schwab (SCHW), and E*Trade Financial can be expected to profit from the pop in volumes--and, more to the point, trading-fee revenue--that characterizes broad market volatility. The sustainability of these gains, however, is questionable if the market's gyrations eventually inhibit the behavior of longer-term investors. Low interest rates are also no friend of these businesses, reducing the earnings power of their balance sheet assets. We expect increased economic activity and a more typical yield curve to eventually result in higher earnings power, but almost assuredly not for the next 12 months.
Publicly traded exchanges such as CBOE Holdings (CBOE) will also benefit from increased trading activity, but the exchange sector is confronting deeper strategic questions, such as whether the consolidation wave that already has seen several once-independent markets pair up will continue for much longer. Investors in the sector have grown used to the merger-speculation game, but if this cools, they will likely pay much more attention to potential organic growth issues. In our view, an end to mergers might actually benefit companies like Nasdaq OMX (NDAQ), which has historically done an excellent job buying back its own shares at low prices.
Finally, our thesis with respect to the asset managers continues to play out much as we've forecasted over the last couple of years, as investors once again fled equities in droves when the global markets turned south during the third quarter (and even took flight from taxable bonds in the aftermath of the political wrangling over the U.S. debt ceiling that ultimately led S&P to download our nation's debt rating). We believe this theme of investors gradually increasing their risk appetites during stable and expanding markets, while pulling back dramatically during market declines, will likely continue in the near term. This will primarily benefit the diversified asset managers in our coverage universe, with franchises like Invesco (IVZ) and BlackRock (BLK) expected to make money no matter which way the risk pendulum swings.
| Top Financial-Services Sector Picks | |||||
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| Star Rating | Fair Value Estimate ($) | Economic Moat | Fair Value Uncertainty | Consider | |
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| City National |  | 64 | Narrow | Medium | 44.80 |
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| HSBC |  | 61 | Wide | High | 36.60 |
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| Standard Chartered | | 1,800 GBX | Narrow | High | 1,080 GBX |
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| First American Financial | | 26 | Narrow | High | 15.60 |
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| Invesco | | 29 | Narrow | Medium | 20.30 |
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| Data as of 09-22-11. |
As stock prices have continued to fall in the banking sector, opportunities are beginning to present themselves among high-quality regional banks, like City National . This California bank's impressive deposit base allows it to fund its balance sheet at a considerably lower cost than its competitors. Unlike the country's largest banks, City National is relatively insulated from the detrimental effects of increased regulation, and this conservative, business-focused bank has little to fear from mortgage-related issues. We think City National will continue to win market share from the large number of troubled banks in California. In fact, the bank has already picked up some bargain assets from the FDIC.
Bank investors looking for growth have few options in the Western world, as the United States and Europe continue to recover from the global financial crisis. Emerging markets, on the other hand, offer a much longer runway for credit expansion. This is no secret to most investors; however, some of these stocks are once again beginning to look appealing from a valuation standpoint. In addition to Banco Santander Brasil (BSBR), which we highlighted last quarter, we also believe the stocks of HSBC (HBC) and Standard Chartered (STAN) are now attractive. Unlike many of their European peers, HSBC and Standard Chartered are adequately capitalized, in our view, and neither has worrisome exposure to the most troubled nations in Europe. Instead, HSBC and Standard Chartered are plays on the rise of Asia and other fast-growing markets around the world.
Although U.S. real estate markets continue to languish, First American Financial (FAF) is one of our best ideas. The title insurer has adapted its cost structure to the current depressed market environment and has remained profitable since 2008. Real estate will eventually recover, and First American is poised to benefit from margin expansion when that happens. Meanwhile, pricing is on the way up, and a shift in policy mix to higher-margin business will pave the way for profitability in the interim. In fact, it is possible that earnings could surprise on the upside in the second half as commercial business, the most profitable line in the title insurance industry, has been on the rise for the past year.
Finally, despite having a product portfolio that is fairly diverse by asset class, distribution channel, and geography, and a stronger ability than most to generate organic growth, we feel the market continues to misprice shares of Invesco (IVZ), which we believe should be trading more in-line with more diversified asset managers like BlackRock and Franklin Resources (BEN), as opposed to equity-heavy firms like Janus Capital Group . The company is more than one year into its integration of Van Kampen, with Invesco's management working hard to deepen its relationship with clients and consultants across all assets classes, distribution channels, and geographic markets. We expect the acquisition, which has come off without a hitch, to make Invesco a much more formidable competitor domestically, with the size and scale it will need to secure placement on a wide array of distribution platforms.
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