Our Outlook for Financial-Services Stocks
The financial sector is fully valued despite global uncertainties.
Over the past few months, financial-services stocks continued to perform well, with the aggregate Morningstar price/fair value estimate ratio for stocks in the sector rising to 98% from 90% since our last update as improving macroeconomic indicators and receding fears contributed to renewed enthusiasm for the sector.
Rising Markets Bode Well for Investment Banks and Asset Managers
In 2013, we think that the investment banking revenue story will be about whether financial advisory and equity underwriting ramp up with an improved economic outlook, and if the strong debt underwriting activity in 2012, due to low interest rates and improved credit spreads, pulled forward demand from 2013. We believe the situation with trading revenue is similar to investment banking, with revenue growth dependent on whether an increase in risk appetite for equity trading from an improving economy offsets the potential reduction of a fixed-income tailwind. Strong principal investment and asset management revenue depend largely on a rise in asset prices, but with most stocks in Morningstar's coverage universe trading at approximately fair value, the market might not appreciate much.
The rise in equity markets thus far in 2013 should benefit the earnings of investment banks that have material asset and wealth management businesses, such as Morgan Stanley (MS). While equity markets have risen, aggregate equity trading volumes are nearly flat sequentially and down from the previous year. We're still expecting first half of 2013 financial advisory revenue to look relatively weak compared with the fourth quarter of 2012, as the fourth quarter benefited from seasonal effects and acceleration of some companies' merger plans due to potential 2013 tax law changes, but that merger-related financial advisory revenue and the earnings of financial advisory-focused investment banks like Lazard (LAZ) and Greenhill (GHL) are on an uptrend. Despite being positive on 2-star Raymond James Financial (RJF) and Evercore Partners' (EVR) medium-term earnings growth, we believe that their share prices have run up a bit too far ahead of fundamentals. We believe that Goldman Sachs (GS) and Morgan Stanley are approximately fairly valued at current prices, but that shareholders could be in for a bumpy ride depending on the resolution of acute European issues.
Our thesis with respect to the asset managers has pretty much played out as we have expected over the last four years, as a risk-aversion cycle--highlighted by investors gradually increasing their risk appetites during stable and expanding markets, while pulling back dramatically during market declines--has held sway over flows into and out of asset classes. With passively managed U.S. and international stock funds capturing almost all of the money flowing into equities, and fixed income reigning as the asset class of choice for risk-averse investors, it has been the more broadly diversified asset managers, especially those with solid equity and fixed-income franchises, exchange-traded fund (ETF) platforms, and the ability to offer exposure to international markets that have held the strongest hand in asset gathering.
While there was a marked increase in flows into equities during the first quarter of 2013, we think that a confluence of singular events--from a sell-off of equity funds in the fourth quarter of last year (to lock in capital gains before any potential increase in taxes) to the issuance of special dividends in the back half of 2012--left investors with a larger amount of capital to put to work at the start of the year, which also coincided with the typical portfolio rebalancing that takes place at the beginning of each calendar year (which has become an even more critical exercise given the amount of capital that has been thrown at fixed income funds during the last four years). As flows into equities have tapered off during February and March, and flows into fixed income have remained relatively strong this year, belief that this was the start of a "great rotation" out of "safer" investments (read: fixed income) into "riskier" assets (read: equities) has also lessened.
As can be expected, though, the combination of market gains and increased flows overall have led to a rally in the share prices of the asset managers in our coverage universe, with the group overall trading at a slight premium to our fair value estimates. We continue to be cautious on the equity-heavy names on our list--like Janus Capital Group (JNS) and GAMCO Investors (GBL)--which have not had the best track record when it comes to asset gathering, relying almost entirely on market gains to lift their AUM levels. And with political and economic uncertainty continuing to pose additional risks for equity markets that have run up dramatically (and in some cases reaching all-time highs), we still view the more broadly diversified asset managers, especially those that can offer a mix of active and passive strategies, strong equity and fixed-income franchises, and exposure to both domestic and international markets--namely, BlackRock (BLK), Invesco (IVZ,) and Franklin Resources (BEN)--as the better options for investors.
U.S. Banks Address Margin Pressure by Cutting Costs
With persistently low long-term interest rates, U.S. banks continue to be faced with net interest margin pressure as newly added assets come onto balance sheets at lower yields than maturing ones. At the same time, banks have had success growing their balance sheets, specifically loans funded largely by strong deposit growth. Last quarter, the industry grew loans at a 6.6% pace funded with 11.9% annualized deposit growth. Despite these growth statistics, the interest spread revenue at most U.S. banks remained the same or declined. As long as long-term rates remain low, we expect continued pressure on bank margins throughout 2013.
In response to tighter margins, U.S. banks are becoming more diligent in reducing their expense base in an effort to maintain capital generation capability. Generally, the larger expenses at banks are people and facilities. In order to address high costs, banks have been seeking ways to reduce them through lower headcounts and/or fewer branches. For example, JPMorgan Chase (JPM) recently announced its plans to cut 3,000 to 4,000 jobs in its consumer bank as it tries to improve profitability at its branches. Furthermore, U.S. banks have taken a hard look at the profitability of their branch networks. We are seeing banks consolidating locations as the expense of underperforming branches cannot justify their continued operation. We anticipate U.S. banks will continue seeking ways to reduce expenses during 2013 as a way to counteract lower spread revenue.
During 2012, the mortgage-refinancing boom has helped boost fee income at most banks. While this has countered the impact of lower asset yields, we think the refinancing boom is starting to reach an end. With mortgage rates at all-time lows for much of 2012, we have seen three to four quarters of elevated mortgage banking fees. However, we also think that any homeowner with a mortgage has likely already refinanced at these low rates. Thus, we question whether the refinancing boom, which has benefited bank income statements in 2012 through higher non-interest revenue, has momentum remaining.
Despite the income statement pressures facing U.S. banks, recent results of Federal Reserve stress tests required by the Dodd-Frank Act of 2010 bear out that U.S. banks are generally better capitalized and able to withstand serious economic shock. In addition, nearly all of those banks were permitted to return more capital through dividend increases or share repurchases.
On the mergers and acquisitions front, we doubt that there will be much activity by the larger U.S. banks in our coverage. Despite the lower returns on equity of most potential targets, the price expectation of sellers still varies significantly from what buyers are willing to pay for those companies. For example, U.S. Bancorp (USB) has publicly stated that until target bank prices are more attractive, the company will focus on acquisitions for its ancillary businesses like payment firms or trust companies. However, we believe smaller banks will continue to team up in order to gain larger scale.
Life Insurers Focused on Capital Management
Persistent low interest rates continue to be a major headwind for the life insurance industry. We expect the industry earnings to remain pressured by modest investment returns and liability revaluation in a low interest rate environment.
Against this backdrop, capital adequacy remains a central focus for the life insurers. The decline in interest rates has had a negative impact on the company’s economic capital, which has fallen from its peak in 2010 to a new low at 2012 year-end. In response to that, life insurers are looking beyond traditional insurance and moving into alternative businesses, including corporate pensions and asset management, in an effort to lessen the overall capital burden. To free up capital, we expect life insurers to retreat from markets and dispose of noncore assets that do not meet the company’s return target. Several European insurance carriers have announced plans to unload their U.S. and Asia units, partly because they want to trim their balance sheets before the more stringent solvency rules become effective.
Additionally, U.S. annuity sellers have significantly cut back on new annuity sales to reduce market sensitivity to capital. Also, we expect life insurers to increase allocations to risky assets, including high-yield bonds and illiquid investments to obtain higher returns. Private lending to corporations can be another way for insurers to obtain a higher rate while holding less liquid securities.
On the regulatory front, several large-cap U.S. insurers are facing the uncertainty of being deemed as non-bank systemically important financial institutions, or SIFIs. The final rulings are still under debate. However, if an insurer were to be deemed a nonbank SIFI, the company’s capital plan could be subject to the supervision and review of the Fed, and the Fed could potentially limit a company’s ability to return capital to the shareholders. Because of that, we expect life insurers to remain intensely focusing on protecting their capital solvency.
Housing Will Continue to Boost Specialty Insurers
Gradually improving residential real estate markets have boosted the share price of firms in the mortgage insurance business. The two leading monoline mortgage insurers we cover, Radian (RDN) and MGIC (MTG), have seen their shares skyrocket and both are up more than 60% since the beginning of the year, but we think caution should be exercised when considering an investment in either of these stocks. Both firms have large inventories of claims from defaulted mortgages that could still go into foreclosure if the economy reverses course. While their prospects are better due to the ability to write more new insurance, we think it advisable to look more at the possible costs of claim payments than at possible revenue gains.
Title insurers, on the other hand, have had a relatively flat quarter as their stocks had a huge run-up starting in summer of last year that leveled off at the beginning of this year. Most likely, the market became concerned over rising mortgage rates that signal a possible end to the refinance business that was responsible for about 70% of their residential orders over the past two years. However, we think any significant pull back in these stocks could be a buying opportunity as residential refinance orders are at the bottom of the totem pole in terms of profitability and the eventual rise in resale business, both residential and commercial, will aid in margin expansion. What’s more, title insurers have become very good at adjusting their expense ratios to accommodate lower order levels and although first-quarter earnings will probably be down on a year-over-year basis, we think the summer could bring good tidings to the title insurance industry.
Our Top Financial-Services Picks
Given the trends outlined above, we are finding only scattered opportunities in the sector. We believe there is some value left in a few names, but the economy may need to give these companies a boost if investors are to make much money in them over the next 12 months.
|Top Financial-Services Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
| Consider |
|American International Group||$51.00||None||High||$30.60|
|Data as of 03-26-13.|
Capital One (COF)
While Capital One is still one of the top credit card issuers in the world, growth is likely to come from other loan categories stemming from its branches in high-density markets like Washington, D.C., and New York City. Furthermore, Capital One is aggressively moving into the online space, which could be very profitable if the company is able to use its new deposits to fund high-yielding loans. We think Capital One will be able to get past its recent issues and that the stock is a bargain at current prices.
We think FirstMerit Corporation's focus on middle-market commercial lending and recent acquisition of Citizens Republic Bancorp will give the company the scale to compete with larger Midwestern regional banks. Not only does FirstMerit have a record as a strong underwriter of loans, as demonstrated by its low nonperforming loans and loan losses, it also has enviable access to low-cost deposit funding. Finally, the stock now boasts a dividend yield of just under 4%.
American International Group (AIG)
We do not believe that American International Group has a moat, but we do think the market is underestimating the firm’s potential earnings power. New management brought in during the bailout has restructured the company, selling off noncore assets and reigning in excessive risk-taking activities. While we don’t expect the global multiline insurer to earn its cost of capital in the near term, we think the franchise value has improved and if management executes on its strategy, shareholders could be rewarded over the long term.(
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Jim Sinegal has a position in the following securities mentioned above: BLK, AIG. Find out about Morningstar’s editorial policies.