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Quarter-End Insights

Financial Services: Bargains Still Hard to Find

In today's market, we think careful stock-picking will be rewarded. Plus, we look at the impact of rising interest rates on banks and of ETFs on the traditional asset management industry.

  • The financial services sector appears to be fairly valued overall at a price/fair value ratio of 0.99.
  • Rising rates will not translate one-for-one to higher earnings for banks, and the timing of an increase is not as meaningful to our fair value estimates as our belief that rates will eventually rise.
  • While it has been easy so far for most of the traditional asset managers we cover to ignore the growth of ETFs, we think that will change as actively managed exchange-traded products take off.


The financial services sector appears to be fairly valued. The overall industry trades at a price/fair value ratio of 0.99, which suggests bargains are limited. The cheapest subsector is Latin American banks at a price/fair value ratio of 0.81, while the most overvalued subsector is saving and cooperative banks, with a price/fair value ratio of 1.13.

Many investors rightly see interest rates as a key driver of bank earnings and wonder whether they should buy bank shares now in anticipation of rising rates. But this question is more complex than it initially appears. First, rising rates will not translate one-for-one to higher earnings for banks: Bank earnings--and valuations--are driven more by net interest margins, which are more stable over time, than by rates themselves. Second, while we expect interest rates to normalize in the medium term, the timing of an increase is not as meaningful to our fair value estimates as our belief that rates will eventually increase.

While exchange-traded funds have for many years been viewed as disrupters of the traditional asset management business, we would argue that has yet to be the case. In our view, the biggest disrupter to active management over the past decade has been the poor relative investment performance of the group as a whole, which has only spurred on the secular trend toward passive investing. With close to $2 trillion in ETF assets domestically and the market for plain-vanilla index-based ETFs already in the hands of a few top fund providers, there has been an increased focus in the ETF industry on products that blur the lines between passive and active management. While it has been easy so far for most of the traditional asset managers we cover to ignore the growth of ETFs, as it has had relatively little impact on their economic moats, we think that will change as we move forward--especially if actively managed nontransparent exchange-traded products take off.

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 three top picks:  Apollo Global Management (APO),  Santander Brasil (BSBR), and  Lloyds (LYG).

Interest Rates and Banks
Net interest margins, not interest rates themselves, are a key driver of bank earnings and our fair value estimates. Net interest margins tend to be more stable than rates over time, although margins can become--and currently are--depressed as short-term rates approach zero.

Management actions can significantly affect the magnitude of the impact of rising rates on bank earnings. For example, hedging and increasing exposure to loan types that are less rate-sensitive, such as credit cards, can reduce the impact of rate fluctuations, while increasing deposit funding and focusing on more sensitive loan categories, such as commercial and industrial lending, can increase sensitivity.

Banks can build moats by developing and maintaining a strong base of deposit funding--deposit funding is significantly lower-cost than wholesale funding, and high switching costs mean that deposits are sticky and insulated from price competition. Banks with the strongest deposit bases have funding costs that are 50-150 basis points lower than those with the least deposits, and the benefits of moaty funding will strengthen as interest rates rise.

We expect rising interest rates to be a tailwind to banks across the board and to be disproportionately favorable to banks with strong, moaty funding, such as  Cullen/Frost (CFR),  BNY Mellon (BK),  Northern Trust (NTRS), and  State Street (STT), and banks with highly liquid balance sheets, like  JPMorgan Chase (JPM). Markets are indicating that interest rates may rise more slowly than signaled by the Federal Open Market Committee, and history shows that rate stagnation remains possible. We think that banks with the largest streams of fee income, such as  Fifth Third (FITB) and  PNC Financial (PNC), which hold large payment processing businesses, and diversified European banks, such as  UBS (UBS), will have the most resilient earnings projections--and fair value estimates--if rates fail to rise as expected.

Insurance companies such as  Principal Financial Group (PFG),  Torchmark (TMK), and  Aflac (AFL) should also benefit from higher interest rates, and we project earnings per share to increase anywhere from 30% to 50% over the next five years. Similarly,  Charles Schwab (SCHW),  TD Ameritrade , and  Federated Investors (FII) will benefit from sharply improved earnings over the next few years as they will no longer have to provide fee waivers on money market funds. Schwab and TD Ameritrade will also earn higher interest rates on margin loans.

The Global ETF Industry
The global exchange-traded fund market is too big to ignore. With just over $1.7 trillion in assets under management domestically at the end of 2013, accounting for close to 10% of U.S. investment company assets, and with more than $2.4 trillion in AUM worldwide, the ETF industry commands a lot more attention these days. The U.S. industry remains on pace to pass the $2 trillion AUM mark this year, with global ETF levels approaching $3 trillion overall.

The secular trend toward passive investing has fueled the growth of ETFs. The U.S. ETF industry has benefited from the trend toward passive investing that took root more than two decades ago, greatly aided by the inability of a large percentage of active equity managers to outperform the market over that time and the ability of ETFs to offer market returns for a substantially lower fee.

The bulk of ETF assets and growth has been concentrated in equities, with equity-based ETFs currently accounting for 79% of domestic ETF assets and picking up more than two thirds of the inflows into ETF products. We expect equity ETFs to grow organically at a high-single-digit rate in each of the next five years, below our forecast 11.5% compound annual growth rate for the U.S. ETF market overall.

In the near to medium term, domestic ETF growth should be driven by the increased use of ETFs in the retail-advised market and by self-directed and institutional investors; the expansion of ETFs as core holdings for both retail and institutional investors; the expansion of the fixed-income market for ETFs; and the launch of new products.

A first-mover advantage has kept the largest ETF providers in the driver's seat. The top three ETF providers continue to dominate the U.S. and global ETF markets.  BlackRock (BLK) with iShares, State Street with SSgA, and Vanguard have effectively maintained a triumvirate, controlling 82% of the U.S. market and 70% of the global market. We do not expect things to change much in the near to medium term.

ETF strategies have begun to blur the lines between active and passive management. The rapid growth of ETF managed portfolios and strategic beta products have highlighted the demand for hybrid investment vehicles that can meet different investor needs. While actively managed ETFs have not really taken off, recent Securities and Exchange Commission rulings on nontransparent ETFs could open the door to more active ETFs.

Few of the asset managers we cover have benefited from the growth of ETFs. Only BlackRock, the owner of iShares, and  Invesco (IVZ), which owns PowerShares, have truly benefited. While most have filed for permission to offer ETFs, only a few have either launched or partnered up on an ETF product. BlackRock remains our top pick among the asset managers we cover and is the best way for investors to benefit from the growth of the ETF industry in the near to medium term.

Top Financial Services Sector Picks

Star Rating Fair Value
Fair Value
Apollo Global Management $40.00 Narrow High $24.00
Lloyds $6.40 Narrow High $3.84
Santander Brasil $7.50 Narrow High $4.50
Data as of 12-23-2014

 Apollo Global Management (APO)
Apollo is a global alternative asset manager with more than $160 billion in assets under management deployed across private equity, credit, and real estate strategies. Notably, it 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 is overlooking the strong growth prospects Apollo has in credit, thanks to regulators forcing banks to sell illiquid and risky assets to the firm at a discount. 

 Lloyds Banking Group (LYG)
We think Lloyds has finally turned the corner and for 2014 will not only report its first annual profit in five years, but will outearn its 10% cost of equity. We expect results to continue to improve: We anticipate that the bank will declare a dividend for 2014 (its first since 2008), net interest margins will continue to improve as noncore operations run down, and shareholders will finally see the benefit of Lloyds' strong competitive position in the United Kingdom's profitable retail banking market.

 Santander Brasil (BSBR)
We think Santander Brasil is undervalued because investors are overly focused on headline profitability metrics that do not capture the true earnings power of the company. In our view, Santander Brasil holds a strong competitive position in the highly concentrated Brazilian banking market with a narrow economic moat. We expect that the negative accounting impact from goodwill and excess capital will fade, and over the long term, investors will come to realize the bank's true earnings power.

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