Financial Services: Value in Banking and Asset Management Firms

The Morningstar Global Financial Services Index (Exhibit 1) has fallen 15% in 2018 through Dec. 20, underperforming the broader market because of moderating expectations for higher interest rates, which primarily affects banks and companies that earn interest on securities portfolios, and the general decrease in asset prices, which primarily affects companies that have fee-based assets, like asset managers and wealth management firms.

Exhibit 1: Lower rate expectations and asset prices are to blame

Given where most of the negative sentiment has been directed in the financial sector, we unsurprisingly see the most value in the bank and asset management industries (Exhibit 2). The median price/fair value estimate among our bank coverage is 0.80, while the median for asset managers is 0.73. More than half of the banks and asset managers we cover currently have a 4- or 5-star rating.

Exhibit 2: Currently, the bank and asset management industries look most attractive

While expectations for higher interest rates have been moderating, central banks are still likely to pursue neutral to tightening stances over the next year (Exhibit 3). CME Group's FedWatch tool displays around a 50% probability that the target fed-funds rate will be over 2.5% compared with its current range of 2.25% to 2.50%. The Governing Council of the European Central Bank expects to keep ECB interest rates at current levels through at least the summer of 2019 and will stop net purchases under its asset purchase program, quantitative easing, in December 2018.

Exhibit 3: We expect near-term monetary policy to remain neutral or modestly tighten

Global asset prices are generally off their 2018 highs (Exhibit 4), pressuring asset managers. That said, with our assessment that the median price/fair value estimate among the stocks that we cover is 0.86, we think that asset managers should be able to count on appreciation in their assets under management and that some concerns, such as large pricing cuts among active equity managers, are overblown.

Exhibit 4: Global asset prices are generally off their 2018 highs

Top Picks

American International Group AIG

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: $76

Fair Value Uncertainty: Medium

5-Star Price: $53.20

We believe AIG CEO Brian Duperreault's background is a good fit for solving AIG's main operational issue: commercial property-casualty insurance underwriting. He was a primary architect behind peer Chubb's strong franchise that has generated industry-leading underwriting margins. He has pledged that the company will generate an underwriting profit in 2019. Given that we see no structural issues in its core operations, we believe AIG is gradually trending toward peer results. The current market price equates to about 0.6 times book value, a level that implies a long period of very poor returns, which is more of a worst-case scenario.

Capital One Financial COF

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $127

Fair Value Uncertainty: Medium

5-Star Price: $88.90

Investors seem to be concentrating on interest rates and fears about economic growth and applying it across all banks regardless of interest-rate sensitivity and growth prospects. Though economic growth would weigh on Capital One, investors should take comfort that the company’s open-source software strategy should help the company win market share. Capital One’s Walmart victory is important. To us, it signals that businesses are looking at a bank’s technological competency when deciding financial institutions with which to partner. We believe Capital One is years ahead of its competitors.

Credit Suisse Group CS

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $23

Fair Value Uncertainty: High

5-Star Price: $13.80

Narrow-moat Credit Suisse is one of the few European banks that we believe can generate a midcycle level of profitability in excess of its cost of capital. It has a strong presence in the lucrative ultra-high-net-worth investor market. We believe that the high-touch service and complex needs of ultra-high-net-worth individuals support high switching costs. Exhibit Sources: Morningstar, US Treasury, ECB, BoJ. Data as of Dec. 20, 2018.