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Our Outlook for the Financial-Services Sector

Gloom replaces froth as the financial sector takes its lumps.

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It is difficult to imagine a more exciting third quarter than the one we've had in financial services. The ready money, cheap debt, and private equity buyouts that drove the sector last quarter dried up abruptly, and we were instead faced with a credit crisis. Financial stocks were punished, giving investors both bargains and bankruptcies. As we wrote in August, there was a virtual fire sale on financial-services stocks as the outlook for the sector blackened. And then on Tuesday, the Fed slashed its target rate by 50 basis points, in what was either a wise move or a capitulation to Wall Street (depending on your point of view). In any case, the dramatic rebound in stock prices served up enough euphoria to dispel some of the late-summer gloom.

Our outlook on the economy remains cautious, however. Despite the euphoria over the recent rate cut, we believe that there are still a number of significant issues that the market will have to work through. We will have to pay the piper for the happy-go-lucky lending practices of the past few years, and it will be another 18 months at least before we have dealt with all the fallout there. A rate cut may help delay or soften the inevitable, but there are still choppy waters ahead.

As always, we at Morningstar remain focused on the long term. And while we can't predict exactly what the market has in store, we can see through to the other end of the tunnel and understand the long-term earnings power of the businesses that we follow. We believe that gives us an edge, and we see a number of financial and real-estate stocks that patient investors can scoop out of the bargain bin today.

Valuations by Industry
Whereas we deemed the majority of our industry groups overvalued last quarter, third-quarter valuations have come down significantly. Now, the median price/fair value data below indicate that most of the financial-services industry groups are slightly undervalued.

 Financial Services Valuations by Industry
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Finance 3.23 0.97 36
Insurance (Gen) 3.45 0.90 20
Insurance (Life) 3.06 0.98 18
Insurance (Prop) 3.35 0.93 37
Insurance (Title) 4.67 0.65 3
International Banks 2.88 1.11 43
Money Mngt 2.32 1.08 20
Real Estate 3.60 0.98 7
Regional Banks 3.38 0.95 52
Reinsurance 3.64 0.87 14
REITs 2.74 1.05 73
Savings and Loans 3.08 1.04 12
Securities 3.22 0.96 27
Super Regional Banks 4.00 0.87 9
* Data as of 09-19-2007

Below, we'll take a look at the various industry groups in more depth and highlight our best values in each.

Banking
Banks continue to struggle with the turmoil in the housing market. While it is true the mortgage problems are affecting every single bank to some extent, most are handling the disruption with ease. However, we believe the worst is yet to come. With an estimated $1 trillion of adjustable rate mortgages resetting to higher interest rates over the next year, the amount of delinquencies, foreclosures, and loan losses are set to rise.

Investors in smaller banks can rest fairly easily. Most small to midsized banks do not keep the riskiest types of loans, such as subprime or negative amortization loans, on their balance sheets. Top lenders like  Countrywide (CFC),  Bank of America (BAC), and  Citigroup (C) have some meaningful exposure, either through the mortgages they hold in their portfolios, the mortgage-backed securities they own, or their funding of other subprime mortgage players.

With diversified revenue streams and strong capital bases, these mortgage problems are likely to be just a bump in the road for Citigroup and Bank of America. Countrywide, however, is much more exposed to a sustained housing problem. The near-total shutdown of the secondary mortgage market caused serious liquidity issues at Countrywide. But the firm has been busy shoring up its balance sheet. The mortgage lender recently secured a series of funding relationships to strengthen its liquidity position and announced it will lay off up to 20% of its workforce to reduce expenses. We believe Countrywide will ultimately be one of the survivors in the mortgage business and, in the long run, will thrive.

Other mortgage players like  Washington Mutual (WM),  National City (NCC), and  First Horizon (FHN) are following in Countrywide's footsteps, cutting their mortgage businesses back significantly. These players, along with most small and mid-sized banks, are bulking up their reserves for loan losses and securing their capital and liquidity positions, which we believe will properly prepare the banks to weather the mortgage storm safely. In the end, we believe the market is punishing the banking industry too much.

With  19 5-star banks as of Sept. 26, there is plenty of opportunity to get some great businesses at bargain-basement prices. Our top picks are those most associated with these problems--Countrywide, Citigroup, and Bank of America.

Insurance
The pricing environment in property-casualty (P&C) insurance continues to deteriorate, and our models forecast further declines in profitability ahead. We urge investors to keep P&C insurance firms on their radar screens and look for 5-star ratings ahead as pricing weakens further. However, two of our wide-moat insurers are currently on sale,  Marsh & McLennan (MMC) and  Progressive (PGR).

We highlighted Marsh last quarter and still believe it is an excellent value. Progressive is one of our favorite insurance companies and one of the few we have awarded a wide moat. My colleague Jim Ryan believes that Wall Street doesn't understand this auto insurer's full potential. "We do not believe the market is fairly accounting for the $2 cash dividend that will be paid in September and the 100 million share buyback over the next two years. Also, current results are skewed downward because of the changing business mix at Progressive. Although agency-generated policies-in-force are falling, direct auto and specialty are growing as Progressive takes a more aggressive approach to direct marketing and pursues different segments."

Mortgage insurers have been blitzed because of the turmoil in the mortgage market. However, we think the price declines are far scarier than the actual business results. Investors with a stronger stomach should look at mortgage insurers  MGIC Investment (MTG),  PMI Group (PMI), and  Radian Group (RDN). And those with a taste for less racy fare should consider  Old Republic (ORI). Old Republic is a firm that reeks of conservatism. It doesn't insure second mortgages at all. Insurance on second mortgages has been the main culprit of unpleasant results so far. Title insurance also holds some attractive values. Though it is a lower-quality firm than the ones we have highlighted above,  LandAmerica (LFG) currently trades at roughly half of our fair value estimate.

Capital Markets
The subprime mortgage meltdown--and the ensuing credit crunch--have led to significantly increased pessimism in the capital markets industry overall. With private equity activity grinding to a halt, most investment banks will almost certainly see fee growth slow from its recent scorching pace. Brokerage firms have benefited from volatility in the market, and trading volumes have risen healthily during the third quarter to-date. However, history has shown that retail trading volume tends to fall during bear markets, and we could very well be headed in that direction. Exchanges have been the biggest beneficiaries of all the volatility, with trading activity up strongly during the third quarter to-date, particularly at the  CME Group (CME).

In all, this quarter has been a great example of the cyclicality of these businesses: Once high-flying industries have seen their share prices fall significantly as the bad news mounts. We think excessive pessimism may lead to some fantastic buying opportunities among some beaten-down firms while the exchanges should survive the recent turmoil relatively unscathed.

Our two top picks in this industry have been significantly affected by the recent credit crisis.  E*Trade Financial (ETFC) announced it is jettisoning its wholesale mortgage operation. We believe the near-term waters will be choppy for the online broker, but we believe the long-term value of the franchise is intact. For more on E*Trade, click to see Pat Dorsey's video report.  Knight Capital (NITE) runs a hedge fund, Deephaven Capital Management, which accounts for some 20% of revenue. It was a rough summer for the fund, and Knight announced that it might have to return some of the lucrative performance-incentive fees generated by Deephaven. We believe the market has already priced in a substantial clawback in fees, and the shares are trading at a deep discount.

REITs
Like other financial stocks, real estate investment trusts (REITs) have taken a beating since June. According to the National Association of Real Estate Investment Trusts (NAREIT), equity REITs dropped 9% in the second quarter and have continued their descent through September. The reasons for the decline are multifaceted--the evaporation of an M&A premium embedded in REIT stock prices, worries that the U.S. economy will cool and curb demand for commercial property, and concerns that buyers of commercial real estate debt have disappeared.

While these are valid fears, they have not affected the majority of our REITs under coverage. Most REITs retain a good portion of earnings and aren't overly reliant on the debt markets for funding. Additionally, fundamentals in REIT-land continue to be solid, with most companies reporting higher net operating income and rental revenue in the second quarter.

We believe investors should use the weakness in REIT prices to buy quality names at bargain prices. To that end, we would recommend investors consider  Mack-Cali Realty (CLI),  Maguire Properties (MPG), and  Brandywine Realty (BDN) for their portfolios. These office landlords are trading below our Consider Buying prices, and we believe their regional focus and clout with tenants, leasing agents, and city authorities give them an edge over their national counterparts.

Financial-Services Stocks to Buy Now

 Stocks to Watch--Financial Services 
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

Countrywide $42 Narrow Average 0.43
Progressive $28 Wide Average 0.68
Old Republic $27 Narrow Average 0.68
E*Trade $24 Narrow Above Avg 0.50
Mack-Cali Realty $52 Narrow Below Avg 0.79
Data as of 09-25-2007.

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Rachel Barnard has a position in the following securities mentioned above: BAC, CME, CFC. Find out about Morningstar’s editorial policies.