Our Outlook for Financial-Services Stocks

• With a sector price/fair value estimate ratio of 87%, opportunities in financial-services stocks are becoming scarce.
• Some U.S. banks remain on the mend, while others continue to struggle. Fast-growing Latin American banks are hitting a speed bump, while Canadian institutions continue to post healthy profits despite macro headwinds. European banks' issues are yet to be resolved.
• Diversified asset managers are best positioned to thrive in a volatile environment.

Over the past few months, financial-services stocks made up the ground lost in the second quarter, with the aggregate Morningstar price/fair value estimate ratio for stocks in the sector rising to 87% from 78% over the summer. While a few bargains remain, low prices are for the most part accompanied by higher risk and/or near-term challenges such as low interest rates and lackluster capital markets.

Industry-Level Insights

Europe Has Not Passed the Last of Its Tests
In September, bank equities soared on news that the European Central Bank announced plans to buy unlimited quantities of sovereign bonds from troubled euro-area countries that apply for aid. While we think this greatly reduces the near-term risk of a euro breakup, we don't think the program is the panacea that the markets seem to believe it to be. While the program limits the near-term risk of a major sovereign default, it does less to alleviate the risk of long-term recessions in peripheral Europe. We think the success of the program depends in large part on the creation of a sustained virtuous circle in which the bond yields for the troubled countries are brought down to affordable levels by the mere presence of the program without the countries ever having to apply for aid. If the markets begin to test this virtuous circle, as they often do, counties needing aid will almost certainly be subjected to strict austerity programs that could mean many years of recession or low growth. For banks, this will mean higher credit losses and more difficulty meeting Basel III standards through retained earnings; we think capital raises remain a distinct possibility over the next several years.

High-Quality U.S. Banks Will Perform Best in a Tough Operating Environment
U.S. banks are continuing to show signs of recovery on the capital and credit fronts, though low interest rates, slack credit demand, and new regulations are likely to weigh on performance for some time. Late in the second quarter, deal activity among our coverage rebounded, with  M&T Bank (MTB) announcing plans to acquire  Hudson City Bancorp  and  Morgan Stanley (MS) and  Citigroup (C) finally agreeing on a valuation of their Morgan Stanley Smith Barney venture. Notably, the buyers seem to have gotten the better deal in both cases. Hudson City investors will receive less than tangible book value for their shares, while Citigroup's remaining stake in the MSSB joint venture will be transferred at a valuation of $13.5 billion, far less than the roughly $22 billion Citigroup had previously ascribed to the venture. We expect this trend to continue as many banks struggle to regain an acceptable level of profitability, and we believe the stocks of skilled acquirers like  PNC Financial (PNC) at reasonable valuations are generally preferable to those of weakened takeout targets.

Strong Capital and Reserve Positions Bolster Latin American Banks
We anticipate a relatively quiet--if somewhat dismal--quarter for our Latin American banks. Across the board, we expect loan growth, while positive, will remain subdued, especially in Brazil. Moreover, we think that with an even lower benchmark rate (the Selic target rate is currently at 7.5%, compared with 11.0% in December 2011), interest revenue growth will be challenging as net interest margins will remain under pressure. In addition, we expect to see credit quality remain soft. Early delinquencies have been contained but are not meaningfully decreasing, which points to stable levels of dud loans. Of our Brazilian banks,  Banco Bradesco (BBD) has the lowest nonperforming loan ratio (just over 4%) combined with the highest reserve coverage (around 180% of nonperforming loans), so we anticipate less volatility on its bottom line due to credit risk.  Itau Unibanco (ITUB) and  Banco Santander Brasil (BSBR) both have somewhat higher nonperforming loan ratios (hovering close to 5%). However, their reserve coverage is adequate at about 150%. Thus, while these two are slightly more exposed to credit risk, we think that like Bradesco, the main headwind will be revenue generation and not provisions for loan losses. As with its Brazilian peers,  Banco Santander Chile (BSAC) will not see stellar revenue growth, in our opinion. However, credit risk (nonperforming loans are less than 3.0% of the total portfolio) is much less, and we would be surprised to see a hike in provisions for loan losses. Thus, we think that Chile's largest lender will maintain a return on equity around 20%. Lastly, Banco Santander Mexico will make its trading debut on Sept. 26 in what will very likely be Mexico's largest share offering to date. The bank's American depositary receipts will trade under the ticker BSMX, and we plan to provide full coverage of the company shortly after its initial public offering.

Canadian Banks Continue to Post Strong Earnings Despite Apparent Headwinds
Despite a flatter yield curve and concerns about the impact surrounding a housing bubble, Canadian banks continue to post strong earnings. While loan growth has not been as strong as in past years, it is still very respectable, averaging upper single digits. With strong earnings primarily led by their personal and commercial banking businesses, many of these banks have looked to reinvest some of their cash to enhance market share, build fee-based businesses, or expand geographically to help diversify their revenue streams. Canadian bank investors closely watch for any common dividend increases from these companies. This last quarter, four of the six major banks raised their common dividend, including  Bank of Montreal (BMO), which had not raised its dividend in five years. For the Canadian banks, common dividend yields currently range from 3.5% to 5.2%. While  National Bank of Canada (NA) may raise its dividend next quarter, we do not expect increases from most of the banks in the short term. We expect the banks to review the potential of dividend increases following their first-quarter 2013 results. Over the long term, we think the Canadian banks will continue to generate significant capital. However, we are cautious about the housing market, which appears significantly overpriced. At this point, the debt-service capabilities of the Canadian consumer appear manageable. However, if the Bank of Canada decides to raise rates, we worry about the impact upon the highly leveraged consumer and subsequent effects upon the banks.

Diversified Asset Managers Can Weather an Uncertain Environment
While the global equity markets have regained their footing during the third quarter, we don't believe this signals an end to market volatility. With the European situation still changing day to day, most developed economies around the globe struggling to maintain any kind of positive momentum, and growth in emerging and developing markets like China and Brazil stumbling as a result, we don't see much that will change what has been a macro-driven market for investors. We continue to believe that this ongoing volatility has affected investors' behavior, causing them to rapidly alter their risk tolerances and asset class preferences in response to short-term news and investment performance. As such, we continue to favor the more broadly diversified asset management firms, especially those that offer a mix of active and passive strategies, strong equity and fixed-income franchises, and exposure to both domestic and international markets. We think  BlackRock (BLK),  Franklin Resources (BEN), and  Invesco (IVZ) fit the bill, though their valuations have risen recently along with the market.

Exchange Volume Could Rebound After a Slow Summer
The summer months were generally not very strong at the financial exchanges we cover, as the appetite for trading activity that took hold in August 2011 did not repeat itself this year. Going into the fall months, we continue to hold relatively tempered expectations for transaction activity--it would be natural to expect a rebound from the summer months, but we are not betting that the environment is going to stage a dramatic turnaround. We think themes such as organic growth, expense control, global reach, and the potential of nontrading businesses will continue to play an important role in the storylines of these companies, and we think  Nasdaq OMX Group (NDAQ) is most attractive from a valuation standpoint.

Our Top Financial-Services Picks
Given the trends outlined above, we are finding only scattered opportunities in the sector. However, we'd repeat our second-quarter caution that the remainder 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
City National		$64.00	Narrow	Medium	$44.80
Western Union		$29.00	Wide	Medium	$20.30
Lazard		$37.00	Narrow	High	$22.20
Charles Schwab		$23.00	Narrow	High	$13.80
Data as of 09-18-12.

City National
City National is one of our favorite lenders among U.S. regional banks. Its focus on wealthy business owners and its low-cost structure garner the bank a narrow economic moat. With its low-cost structure and solid balance sheet, City National is well positioned to take advantage of the dislocation in its markets and grow internally by gaining share from troubled lenders or acquiring failed or distressed banks.

Western Union (WU)
Western Union's business model--using outside agents to collect and disburse cash--eliminates the need to maintain a retail footprint and requires very little capital. Though rapid technological change is a factor in much of the payment industry, we think Western Union's established global network and massive scale ensure that competitors will not have an easy time replacing the firm as the industry leader in money transfers. Western Union's business is well accepted in numerous locations, trusted and secure, and heavily used by its customers--characteristics that will take time for competitors to acquire. In fact, Western Union is still expanding its presence in markets like Asia, even as alternative payment methods arise, and immigrant populations in developed countries should continue to grow for the foreseeable future.

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 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 past 10 years has decreased competitive pressures in that business, and the roughly 40% of Schwab's revenue related to asset management contribute to the company's competitive advantage. We're also impressed by management's operating discipline over time and believe 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.

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