Skip to Content
Quarter-End Insights

Our Outlook for Financial-Services Stocks

The easy money has been made in financial-services stocks.

Mentioned: , , , , , , , , ,
  • An extended rally in financial-services stocks has drastically reduced the number of bargains in the sector.
  • Emergency liquidity provisions have lessened the chances of a funding crisis in Europe, but the sovereign debt crisis is not over. 
  • Hints of an economic recovery have improved the prospects for rate-sensitive names.

A bout of renewed optimism about the prospects for the global economy resulted in a dramatic rally in financial-services stocks in recent months. The aggregate Morningstar price/fair value ratio for stocks in the sector rose to 87% from 78% during the quarter. A few stocks remain undervalued, but with the European sovereign debt crisis still unresolved, the Chinese economy possibly slowing, and a long way to go before the U.S. economy returns to full steam, we think investors should remain cautious as they wade back into the sector. 

A major contributor to the rally was the establishment in late 2011 of the longer-term refinancing operation by the European Central Bank and the provision of EUR 1 trillion in funding so far to the continent's banks, which depend to a large extent on wholesale funding. This fact, along with these banks' relatively low tangible common equity levels and their holdings of peripheral European nations' sovereign debt, left us skeptical of the European financials throughout 2011. We think the emergency funds have lessened, if not eliminated, the chance of a funding crisis, but we think shareholders in some banks might still be vulnerable to dilution if other countries follow the same path as Greece.

Finally, hints of an economic recovery have boosted the stocks of rate-sensitive names. Not only lenders, which have lost net interest margin to a flattening yield curve, but firms such as the trust banks and retail brokerages fell victim to the low-rate environment. As the prospects for rate increases have grown as a result of economic growth and falling unemployment, these companies' stocks have risen.

Industry-Level Insights
The Federal Reserve's Comprehensive Capital Analysis and Review stress tests helped boost the prices of U.S. bank stocks during the past several weeks. Although several banks announced significant increases, it seems that few plan to push their payout ratios much above 30% of near-term earnings. We view this as a sign of continued conservatism on the part of both banks and regulators. Given the improvements in banks' capital positions during the past few years, and the prospects for increased earnings if the economy continues to improve, we think dividends are likely to continue rising during the next 24-36 months--an important consideration for yield-seeking investors. Among the largest banks,  J.P. Morgan Chase (JPM) and  Wells Fargo (WFC) announced large capital-return programs with numerous regional banks following suit shortly thereafter. Although  Bank of America (BAC) and  Citigroup (C) remain laggards on this front, the fact that neither bank was required to raise capital to meet stress-test demands is encouraging.  

Mobile payments remain at the forefront in the payment and card space, with
 eBay (EBAY) recently rolling out its PayPal Here point-of-sale system, allowing small businesses to accept payments via smartphone. We see this as further confirmation of our thesis that the payment world is changing, and that the moats of the card networks will be slowly eroded over time. We think the ability to store an infinite number of payment options on one device (the smartphone) will increase competition dramatically as consumers find it easier to switch among payment options.In markets like South Korea, consumers often carry dozens of different cards from various banks, retailers, and other providers. However, smartphones eliminate the need for holding physical cards, and they can consolidate numerous forms of payment among banks and retailers on one device. As smartphone adoption rates increase, we think the devices will make it easier for the U.S. and other markets to expand the number of consumer payment options.

Our Top Financial-Services Picks
Given the trends outlined above, we are still finding opportunities in banks with the potential to both grow and return capital, interest-rate-sensitive names, and companies shielded from potentially fast-moving changes in competitive dynamics within the payment space.

Top Financial-Services Sector Picks
  Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Wells Fargo $41.00 Narrow Medium $28.70
Western Union $29.00 Wide Medium $20.30
Lazard $42.00 Narrow High $25.20
First American Financial $25.00 Narrow High $15.00
Charles Schwab $23.00 Narrow High $13.80
Data as of 03-23-12.

 Wells Fargo (WFC) (
)
Wells Fargo is our favorite among the so called Big Four U.S. banks. In contrast to its money center peers, Wells Fargo is essentially a trillion-dollar regional bank, taking deposits and making loans. Decades of conservative management have resulted in exceptional performance in terms of margin, efficiency, and credit quality over the years, and we see little reason why this would change in the near future. In fact, Wells Fargo might still have room for improving its profitability as it continues to integrate former Wachovia operations. Although Wells Fargo will be subject to increased regulation in the future, we think its competitive advantages will soon result in returns exceeding the bank's cost of capital, and we think the bank could potentially increase its newly raised dividend by 50% during the next two years.

 Western Union (WU) (
)
Western Union's business model--using outside agents to collect and disburse cash--eliminates the need to maintain a retail footprint and requires very little capital. Although we acknowledge that rapid technological change is a factor in much of the payments industry, we think Western Union's established global network and massive scale ensure that competitors will not have an easy time replacing it as the industry leader in money transfers. Many of Western Union's customers reside in areas where economies are still largely cash-based, making the firm relatively immune to technological changes in the payment space, and immigrant populations in developed countries should continue to increase for the foreseeable future.  

 Lazard (LAZ) (
)
Lazard's advisory and asset management businesses are far more attractive than the more volatile trading businesses of many larger investment banks, and the firm's internationally recognized brand name adds to its competitive advantage. We like the relatively low leverage on the company's balance sheet as well as the countercyclical nature of Lazard's mergers and acquisitions and restructuring operations, which should lessen the pain of economic downturns. Furthermore, Lazard's relatively small size and the nature of its advisory businesses leave the firm less vulnerable to changes in public perception and the regulatory environment than larger peers such as  Goldman Sachs (GS)

 First American Financial (FAF) (
)
Although U.S. real estate markets continue to languish, First American Financial remains one of our best ideas. The title insurer has adapted its cost structure to the current depressed market environment and has remained profitable since 2008. Real estate will eventually recover, and First American is poised to benefit from margin expansion when that happens. Meanwhile, pricing is on the way up, and a shift in policy mix to higher-margin business will pave the way for profitability in the interim. In fact, it is possible that earnings could surprise on the upside in the second half as commercial business, the most profitable line in the title insurance industry, has been on the rise for the past year.

 Charles Schwab (SCHW)  
We think consolidation in the retail brokerage industry during the last 10 years has decreased competitive pressures in that business, and the roughly 40% of Schwab's revenues related to asset management further contribute to the company's competitive advantage. We're also impressed with management's operating discipline over time and believe that Schwab is positioned to prosper even in a more competitive environment. Schwab is yet another financial firm suffering from the low-interest-rate environment. However, a return of money market fund fees as well as an increase in net interest margin could drive rates higher, which would result in a nice earnings rebound. Trading at a decent discount to our fair value estimate, Schwab, in our opinion, is a reasonably priced growth stock with upside potential in a more favorable economic environment.

If you'd like to track and analyze the stocks mentioned above, click here to create a watch list. Then simply click "continue," name your watch list, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.

More Quarter-End Outlook Articles

Jim Sinegal does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.