Bargains Hard to Find in Financials

• The financial services industry appears to be fairly valued. The overall industry trades at a price/fair value ratio of 1.01, which suggests bargains are limited. The cheapest sector is credit services, at a price/fair value ratio of 0.92, while the most overvalued sector is Asian banks, with a price/fair value ratio of 1.18.
• CCAR results were a surprise, and U.S. regulators continue to confound banks. One bank,  Zions Bancorp (ZION), did not pass the stress tests, while four others ( Citigroup (C), and the U.S. units of  HSBC (HSBC),  RBS (RBS), and  Banco Santander (SAN)) passed but did not win regulatory approval to increase capital returns to shareholders. A $4 billion error found by  Bank of America (BAC) also led to regulators asking the bank to suspend a share buyback and a planned dividend increase.
• European regulators consider whether to fine banks enough to raise capital. The U.S. Justice Department is reportedly seeking a $10 billion-plus fine from  BNP Paribas (BNP) to settle a criminal investigation into allegations that the bank illegally evaded U.S. sanctions, which raises the question of whether regulators are pushing for a high enough fine to force the bank to raise capital or change management.
• U.K budget bill affects annuity insurers. The introduction of a new budget bill in the U.K. in March has proven to have a negative impact on annuity sales.

Bargains continue to be challenging to find in the financial services industry, and we broadly see the space as fairly valued today. In today's market, we think careful stock-picking will be rewarded, and we highlight a few of our top picks below.

One of the most important events for U.S. bank investors in early 2014 was the release of the 2014 Comprehensive Capital Analysis and Review (CCAR) results. Several banks did not do well on the tests, and Bank of America later announced an embarrassing $4 billion error, and was forced to rescind a share buyback and a planned dividend increase. The CCAR results highlight an ongoing theme within banks that compliance, regulatory, and legal costs are highly elevated across the industry and will be for some time, and the uncertain nature of these costs over the next several years will be one of the biggest factors affecting large banks' returns on equity. Furthermore, regulators continue to resist requests from the industry to disclose more information around how they determine scenario outcomes, frustrating bank executives, while maintaining the integrity of the stress test process.

In addition, the U.S. Department of Justice continues to engage in discussions with BNP Paribas to settle its long-running criminal investigation for allegedly breaking economic sanctions on Cuba, Iran, and Sudan. The potential fine is now in the $10 billion-plus range, which would reduce BNP's March 31 CET1 ratio to 9.3% from 10.6%, but the bank could return to the 10% range within 18 months. That said, we wonder if prosecutors are pushing for a large enough fine to force a capital raise or changes in management, which would introduce an additional layer of uncertainty for banks that face similar investigations in the future. It's possible that BNP could be forced into a dividend cut, and the upcoming European stress tests in August could provide another opportunity for regulators to potentially punish the bank. We think the real impact of any settlement, whether it includes a fine or a temporary ban on processing payments through New York, is in whether its corporate clients want to continue to maintain a business relationship with the troubled bank.

Finally, the introduction of a new budget bill in the U.K. in March has had a negative impact on annuity sales, and competition with the U.K. banks could intensify further. The new bill also couldn't have come at a worse time for the insurers, as U.K. annuity sales have already been negatively affected by the Retail Distribution Review (RDR) in 2013, which requires more extensive disclosure on agent commissions.

At the heart of the issue for the insurers is the extension of retirement choices for the U.K.'s 12 million pensioners. Currently, defined contribution (DC) pensioners are required to go through annuity providers to purchase annuities for retirement savings. The new bill would allow pensioners the choice to cash out their DC benefits (by taking a lump sum) if their account values are less than GBP 30,000 and invest the money at their own discretion. We estimate that 25% of the U.K. pensioners fall under this "low lump sum" category.

Given the relatively large number of pensioners who could potentially benefit from the new bill, its passage would likely have a negative impact on the U.K. insurance industry, which generates a significant amount of new business from annual annuity sales. If U.K. pensioners do not believe annuities satisfy their retirement needs as a savings vehicle, the lost sales will be permanent, in our view. In that case, the industry could enhance the annuity benefits to make them more competitive for the buyers. We believe the U.K. insurance industry will continue to face challenges for some time as it deals with this latest setback.

Australian financials continue to trade at or close to record highs. The positive earnings outlook for the banks is based on historically low interest rates, a moderate rebound in economic activity, modest credit growth, tight cost control, and benign bad debts. Strong profit growth and increasing capital levels support solid increases in dividends. Financial stocks continue to attract investors seeking higher income due to attractive and sustainable dividend yields.

Top Financial Services Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Apollo Global Management		$43.00	Narrow	High	$25.80
OzForex		AUD 4.10	None	High	AUD 2.46
QBE Insurance		AUD 16.00	Narrow	Medium	AUD 11.20
Data as of 06-23-2014

 Apollo Global Management (APO)
Apollo is a global alternative asset manager with over $160 billion in assets under management deployed across private equity, credit, and real estate strategies. Notably, Apollo manages AUM for Athene, a fixed annuity provider, which provides Apollo with a $60 billion-plus source of permanent capital. We believe the market is overly focused on the short-term health of the IPO market and the near-term pace of realizations, and overlooking the strong growth prospects Apollo has within credit, thanks to regulators forcing banks to sell illiquid and risky assets to Apollo at a discount.

 Ozforex Group (OFX)
OzForex provides low-cost foreign exchange and online international payment services for consumer and business clients. The majority of income is generated by taking a spread on the exchange rates and, for smaller transactions, charging a transaction fee. OzForex's 120,000 active clients largely transact through one of its seven regionally branded websites, but the firm also offers a white-label product with profit-sharing agreements. Originating in Australia and New Zealand, it has expanded into Europe and North America. The market appears to be questioning OzForex's growth potential, with the stock trading substantially below our fair value estimate. With a company growing at a rapid pace, and investing in the future, short-term misses can be expected, and we retain our view that it can triple the size of its business in Australia in the next 10 years. The firm has even smaller market share in other countries, giving it ample room to grow.

 QBE Insurance Group (QBE)
QBE Insurance is an international property and casualty insurance company based in Australia, but it writes only about 24% of its annual gross earned premiums in its home country. Other regions include a large presence in North America (42% of premiums), Europe (26%), and Latin America and Asia Pacific (4% each). QBE offers a number of personal, commercial, and specialty lines including property (33%), auto insurance (14%), agriculture (13%), public/product liability (12%), workers compensation (7%), marine (7%), and financial and credit (5%). QBE Insurance provides attractive upside because of benefits from major restructuring and consolidation undertaken in 2013 and 2014. The extended period of global growth via acquisition has come at a cost. We are confident the new CEO will turn the business around, strengthen the balance sheet, and improve operational efficiency. We support management actions and expect underlying earnings to post a strong recovery in coming years on the back of disciplined underwriting and further improvement in productivity. We believe upside in profitability is not fully appreciated, and we look forward to evidence of a turnaround late in 2014.

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