Skip to Content
Quarter-End Insights

Our Outlook for Financial-Services Stocks

Investors should continue to pick their spots carefully in the financial-services space.

Mentioned: , , , , , , ,
  • Most European banks remain thinly capitalized, compounding the risks associated with the ongoing sovereign debt crisis on the continent.  
  • J.P. Morgan Chase's announcement of a large trading loss reinforced our view that large money center banks are riskier than regionals. However, these firms are also cheaper.
  • Slow improvement in the U.S. economy could be overshadowed by growing problems in Europe and China, leading to volatile markets. This should continue to benefit diversified asset managers. 

 

The brief rally in financial-services stocks that began in the fourth quarter of 2011 lost steam, with the aggregate Morningstar price/fair value ratio for stocks in the sector falling back to 78% from 87% during the second quarter. Although stocks in the sector are getting cheaper, investors may wish to keep some powder dry in the event that troubles--especially those emanating from the eurozone--continue to escalate. The global financial system is still quite interconnected, and with many European banks still holding large quantities of sovereign debt supported by relatively little tangible common equity, we don't think banks are out of the woods yet.

Industry-Level Insights
While European banks' regulatory capital levels are generally adequate, tangible common equity ratios at the continent's banks still lag behind peers. By this measure, numerous European banks are still leveraged in excess of 20:1, a level that we find worrisome, especially at companies with large holdings of peripheral European debt and those that have extensive investment banking operations. We don't think the sovereign crisis will be over until European banks or the troubled nations themselves are recapitalized.

Highlighting the risks inherent to large financial institutions was  J.P. Morgan Chase's (JPM) announcement of a $2 billion (and counting) trading loss related to a massive hedging position gone awry. Although we don't think the loss will have much of an effect on J.P. Morgan's long-term earnings power, the trades highlight two key issues facing large money center banks around the world. The first of these issues is the difficulty of managing complex financial firms. The fact that a derivatives trade of this magnitude escaped the attention of an extremely competent management team does not inspire confidence in the average institution. Second, the trades--ostensibly hedges gone awry--illustrate the difficulty in defining "proprietary trading" for the purposes of the Volcker Rule. We expect this controversy to resurface as the rule progresses toward completion.

Activity in the capital markets through the first half of the year continued to verify our thesis that markets will remain volatile for quite some time in the aftermath of the global financial crisis. We believe this volatility has affected investor behavior, causing investors to rapidly alter their risk tolerances and asset class preferences in response to short-term news and investment performance. We therefore continue to favor broadly diversified asset management firms, especially those that offer a mix of active and passive strategies, strong equity and fixed-income franchises, and exposures to both domestic and international markets.

As we survey the landscape for financial exchanges, our expectations remain modest for volume growth. One company that may buck the trend, however, is  IntercontinentalExchange (ICE), where futures trading activity recently has been trending well. We expect the aftermath of the mishandled  Facebook (FB) IPO will continue to attract attention to  Nasdaq OMX (NDAQ), which is receiving criticism for its performance on the offering's debut. Our longer-term view remains that Nasdaq can survive the controversy with proper attention by management, though competition for trading volume will remain tight, spurred by challengers such as BATS Global Markets.

Our Top Financial-Services Picks
Given the trends outlined above, we are finding opportunities in large, well-managed U.S. banks, diversified asset managers, and economically sensitive names. However, we'd caution that the reminder of 2012 has the potential to take financial-services investors on a wild ride.

Top Financial-Services Sector Picks
Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Wells Fargo $41.00 Narrow Medium $28.70
BlackRock $220.00 Wide Medium $154.00
Lazard $37.00 Narrow High $22.20
Charles Schwab $23.00 Narrow High $13.80
Data as of 06-22-12.

 Wells Fargo (WFC)
Wells Fargo is our favorite among the so-called Big Four U.S. banks. In contrast to its money center peers, Wells Fargo is essentially a trillion-dollar regional bank, taking deposits and making loans. Decades of conservative management have resulted in exceptional performance in terms of margin, efficiency, and credit quality over the years, and we see little reason why this would change in the near future. In fact, Wells Fargo might still have room for improving its profitability as it continues to integrate former Wachovia operations. Although Wells Fargo will be subject to increased regulation in the future, we think its competitive advantages will soon result in returns exceeding the bank's cost of capital, and the bank could potentially increase its newly raised dividend by 50% during the next two years. Furthermore, Wells Fargo has a much smaller investment banking operation than other large banks and few legacy issues stemming from the financial crisis, reducing risk compared with peers.

 BlackRock (BLK)
BlackRock's scale, institutional relationships, and diverse product offerings (including equities and fixed income, and active and passive strategies) should allow the firm to generate returns above its cost of capital in most market environments, no matter what asset class is in favor. The company is already massive, with well over $3 trillion in assets under management, but still has growth potential as it expands its retail business. At a 20% discount to our $220 fair value estimate and a low-teens multiple of our 2012 earnings estimate, the stock is attractive, in our opinion.

 Lazard (LAZ)
Lazard's advisory and asset management businesses are far more attractive than the more volatile trading businesses of many larger investment banks, and the firm's internationally recognized brand name adds to its competitive advantage. We like the relatively low leverage on the company's balance sheet as well as the countercyclical nature of Lazard's mergers and acquisitions and restructuring operations, which should lessen the pain of economic downturns. Furthermore, Lazard's relatively small size and the nature of its advisory businesses leave the firm less vulnerable to changes in public perception and the regulatory environment than larger peers. Finally, a potential catalyst for stock price appreciation at Lazard may have recently arrived in the form of an activist investor--Nelson Peltz of Trian Partners.

 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. However, a return of money market fund fees as well as an increase in net interest margin could drive rates higher, which would result in a nice earnings rebound. Trading at a decent discount to our fair value estimate, Schwab, in our opinion, is a reasonably priced growth stock with upside potential in a more favorable economic environment.

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.

More Quarter-End Outlook Articles

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