Our Outlook for Financial-Services Stocks

• The European debt crisis remains unresolved, leaving us wary of European banks. We prefer better-capitalized names in the U.S. and certain emerging markets.
• The low, flat yield curve is likely to pressure the earnings of retail brokerages and trust banks for some time, creating buying opportunities for patient investors.
• A mild hurricane season and increased capital in the insurance sector will have detrimental effects on industry pricing power.

As was the case last quarter, global economic uncertainties are continuing to weigh on the financial-services sector. U.S. unemployment remains elevated, the European sovereign debt crisis remains unsolved, and the high-flying Chinese economy looks increasingly more vulnerable to a hard landing. However, the aggregate Morningstar price-to-fair-value ratio for stocks in the financial-services sector actually rose during the third quarter, from 70% to 78%.

Although we still think macroeconomic headwinds will continue to affect the performance of companies in the financial sector for most of the coming year, several catalysts for higher stock prices could be on the horizon in 2012. Following yet another round of stress tests, it's likely that numerous U.S. banks could once again boost their dividends in the first half of the year. A successful resolution of the European crisis, including one involving sovereign debt restructuring and bank recapitalization, could also provide quite a boost to financial stocks with minimal direct exposure. On the other hand, a disorderly end to the situation would undoubtedly have severe negative repercussions for the entire market.

We believe stock selection is extremely important in the financial-services sector. Correct evaluations of balance sheet capital, asset quality, and management skill are a must, given the high leverage inherent to many financial-services business models. We continue to believe that competitively advantaged (and well-managed) 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
Our position on most European financials is unchanged--large holdings of questionable sovereign debt and low tangible capital levels are likely to result in shareholder dilution, or worse. 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.

Furthermore, while U.S. banks have put their mortgage-related errors behind them over the past few years, charging off loans and raising capital, European banks have taken few steps to deal with their problems. It therefore should not be surprising that we'd prefer to invest in the few well-capitalized banks on the European continent, and we recommend avoiding most of the rest in favor of better-capitalized U.S. and emerging-markets institutions.

Our outlook for retail brokerages also remains the same. In the near term, companies such as  TD Ameritrade (AMTD) and  Charles Schwab (SCHW) face uncertain trading volumes. Occasionally these firms benefit from volatility, but November produced lower retail trading activity than the previous month. However, interest rates remain the most important piece of the valuation puzzle for these firms, in our opinion. Low rates--which are likely to persist for some time--affect interest income received on margin loans, as well as other banking products, in the case of Schwab. Trust banks, like wide-moat  Northern Trust (NTRS), have also been adversely affected by low rates. 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. We think these companies are best suited for long-term investors who are willing to wait out a prolonged period of depressed earnings.

The fourth quarter is usually very quiet for most insurance companies given the seasonal dearth of natural catastrophes. This period allows many of the P&C insurers to post a quarter of earnings with low unusual losses and help rebuild their balance sheets after the hurricane losses that are often sustained during the volatile third quarter.

This year, heading into hurricane season, most predictions called for a higher-than-average level of storms. There were a few hurricanes that caused losses for the industry--the most notable hurricane was Irene, which caused primarily flood damage that is not covered by traditional insurance policies--but there was nowhere near the level of losses that some in the industry had been expecting. This is not to say the industry will have robust earnings for the year, as the first six months of 2011 had a much higher level of catastrophes than is usually experienced, and a calm fourth quarter combined with a lower-than-expected level of third-quarter hurricanes helps these companies rebuild their capital positions. Although this is a positive on the micro level for individual companies, robust capital levels are a negative for the industry as a whole. The industry pricing market continues to remain soft, a condition that is not likely to improve given the current abundance of capital. After declining for a number of years, most participants agree that prices are below their natural levels and a market hardening is necessary. Industry commentary has become increasingly positive on this front, and prices seem to be bottoming, but we still believe that it may take a major loss event in order to motivate insurers to re-evaluate their aggregate pricing levels and to drive a widespread market hardening.

Top Financial-Services Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Bank Bradesco		$22.00	Narrow	High	$13.20
Charles Schwab		$22.00	Narrow	Medium	$15.40
Berkshire Hathaway B		$89.00	Wide	Medium	$62.30
Data as of 12-18-11.

 Banco Bradesco (BBD)
Banco Bradesco is poised to benefit from favorable demographic and macroeconomic trends, namely Brazil's growing middle class. The Brazilian banking market is effectively an oligopoly, in which most players historically have achieved good returns, despite the volatility associated with a fast-growing economy. As the third-largest player, Banco Bradesco is well-positioned to benefit from GDP and credit growth within the country. We're also encouraged by the bank's conservatism, as evidenced by its solid capital levels, outperforming credit quality, and strong reserve positioning. Brazil's economy is somewhat dependent on China, and inflation and currency issues are always a concern, but we think Banco Bradesco offers an attractive risk/reward trade-off at 73% of our fair value estimate.

 Charles Schwab (SCHW)
We think consolidation in the retail brokerage industry during the last 10 years has decreased competitive pressures in that business, and the roughly 40% of Schwab's revenues related to asset management further contribute to the company's competitive advantage. We're also impressed with management's operating discipline over time and believe that Schwab is positioned to prosper even in a more competitive environment. Schwab is yet another financial firm suffering from the low-interest-rate environment, but earnings would rebound smartly if rates were to rise thanks to a return of money market fund fees as well as an increase in net interest margin. Trading at only 50% of our fair value estimate, we think Schwab is a reasonably priced growth stock with upside potential in a more favorable economic environment.

 Berkshire Hathaway (BRK.A) (BRK.B)
While Berkshire's size and the age of its management team virtually ensure that the company will never again achieve awe-inspiring performance, we think the firm maintains the ability to generate above-market returns, especially if purchased at the right price. Whether due to true structural advantages, such as GEICO's direct sales model and Berkshire's balance sheet strength, or management skill, including Ajit Jain's ability to price unusual tail risks, Berkshire Hathaway's numerous subsidiaries are mostly very attractive businesses. Obviously, Warren Buffett's capital allocation skills cannot be denied, and Berkshire recently announced a share repurchase authorization that could add value in the event that markets continue to decline. Along those lines, though, Berkshire's simple businesses depend on the health of the global economy, and the company's penchant for large bets creates the risk of a big mistake at some point, especially under a new management. We believe the company's collection of high-quality businesses is worth a serious look if the stock price falls much below its current level.

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