The Morningstar US Financial Services Index significantly outperformed the Morningstar US Market Index over the previous year, returning 55.57% compared with 35.93% and slightly outperforming in the previous quarter, up 4.4% compared with the market’s 3.24%. The median North American financial sector stock trades at a 1% discount to its fair value estimate compared with about a 15% discount at the end of the third quarter of 2020. We currently rate less than 25% of the North American financial sector stocks that we cover as undervalued 5- or 4-star stocks with about 50% being rated fairly valued 3-star stocks and 25% rated overvalued 2- and 1-star stocks.
Exhibit 1: Financials Underperformed in the Third Quarter
Most of the primary drivers of earnings for financial sector stocks have continued to trend positively. The unemployment rate continues to move lower, and net loan charge-offs remain under control. However, long-term interest rates decreased in the third quarter, which contributed to the relative underperformance in financials to the overall market. Loan-loss provisions should tick up over the next several quarters, but banks are well capitalized.
Exhibit 2: Most Financials Are Fairly Valued to Overvalued
For property and casualty insurers, we believe earnings should trend upward in the next couple of years. Insurers should benefit from their strong pricing increases in 2020 and eventually higher interest rates. Hurricane Ida could lead to further pricing increases, though catastrophe-related losses will be high in the near term.
Exhibit 3: Charge-Offs Remain Low
Investment banks are having a record year and are firing on all cylinders. Equity underwriting, debt underwriting, and merger advisory revenue are benefiting from the strong stock market, currently low interest rates, and economic optimism. Special-purpose acquisition companies have also boosted investment banking revenue over the previous year and will help in years to come. We estimate that investment banks will earn upward of $17 billion of revenue related to the $200 billion of SPAC capital raised over the previous two years. Trading results are also well above historical averages, as there’s just enough uncertainty in the environment for a high volume of repositioning, speculation, and hedging.
Exhibit 4: SPAC Underwriting Surged Over the Previous Year
American International Group AIG Star Rating: ★★★★ Economic Moat Rating: None Fair Value Estimate: $65 Fair Value Uncertainty: Medium
American International Group announced upcoming changes to its management team and its intention to separate its property/casualty and life insurance operations. At the start of March 2021, Peter Zaffino took over as CEO, with former CEO Brian Duperreault moving to executive chairman. Arguably, Duperreault’s work as CEO remained unfinished, but Zaffino has been a key lieutenant in the company’s turnaround efforts, and we see this move as confirmation that AIG will maintain its positive course. From a strategic point of view, we also like AIG’s announced intention to separate its life insurance operations.
Berkshire Hathaway BRK.B Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $320 Fair Value Uncertainty: Medium
We continue to be impressed by Berkshire Hathaway's ability to generate high-single- to double-digit growth in book value per share. We believe it will take some time before the firm succumbs to the impediments created by its size and that the ultimate departure of CEO Warren Buffett (and Vice Chairman Charlie Munger) will have less of an impact on the business than many might think. Berkshire currently has a ton of cash on hand and a disciplined approach to share repurchases, which we think can be sustained at $5.5 billion quarterly, making it an ideal defensive name in a slowing economy or down market.
Wells Fargo WFC Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $55 Fair Value Uncertainty: Medium
We think Wells Fargo offers unique upside in the sector. Wells comes with a lot of baggage, which is one reason we believe the stock remains somewhat cheap while most of its peers trade at or above our fair value estimates. The company is still in turnaround mode, and we think the bank still has several years remaining of cutting out expenses, while reinvesting into the bank’s core franchises and attempting to reboot growth will remain an ongoing process. The bank is one of the most rate-sensitive names in our traditional U.S. bank coverage, which should give it a uniquely strong revenue tailwind if rates do start to rise. Higher rates, the lifting of the asset cap, and future expense cuts are all catalysts for Wells that could drive additional outperformance.