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Quarter-End Insights

Our Outlook for Financial-Services Stocks

A further rally in financial stocks is unlikely without continued economic improvement.

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  • With a sector price/fair value estimate ratio of 90%, few opportunities exist in the risky financial-services sector, which has the highest uncertainty rating of all the sectors we cover.
  • High refinancing volumes are boosting mortgage-related businesses, but such support is likely to be relatively short-lived.
  • Macro concerns remain at the forefront, with troubles brewing in Europe and Canada, and low rates damaging profits in the United States.

Over the past few months, financial-services stocks continued to perform well, with the aggregate Morningstar price/fair value estimate ratio for stocks in the sector rising to 90% from 87% over the summer. As we pointed out last quarter, most bargains are accompanied by risk, and many will require a further macroeconomic rebound in order to demonstrate their full potential earnings power.

Industry-Level Insights

Dangers Still Lurk in Europe, but Banks Are Making Slow Progress
European bank share prices continued to rally in the fourth quarter as European politicians did the minimum amount necessary to preserve the stability of the eurozone. They cobbled together a back-door Greek bailout that kept the country from defaulting and announced a centralized bank regulator for 200 of Europe's largest banks.

However, we'd hesitate to buy shares of most European banks at current prices, given the significant danger we see lurking on the horizon. Much of Europe appears to be in recession, and any recovery in 2013 is likely to be tepid. As a result, we expect that European bank profits will remain subdued, at best, with thin net interest margins and ever-growing nonperforming loans.

We're unimpressed by the planned central regulator for European banks, as the current plans to do not include centralized deposit insurance and therefore don't help to weaken the link between the health of a sovereign and its banks. If turmoil in the eurozone increases and Portuguese banks begin to fail, for example, Lisbon will be called upon to bail them out and likely won't have the resources to do so.

Macroeconomic risk aside, we see reason to be hopeful. Some of Europe's most troubled banks have made significant progress toward turning themselves around.  KBC's (KBC) fourth-quarter capital raise, for example, took place at near tangible book value--something unmanageable in the middle of the year--and helped the bank repay a significant chunk of its government bailout. Separately,  UBS (UBS) announced a major restructuring and the closure of most of its fixed-income trading--the source of most of its losses--which we think puts the bank ahead of peers in preparing to operate under Basel III capital standards. For others, like  Barclays (BCS), many of these painful decisions are likely to be made in early 2013.

P&C Insurers Could See Better Pricing, While Life Insurers Are Playing Defense
Looking ahead, the first quarter, in general, tends to be relatively calm for property-casualty insurers. The period typically has a seasonal lack of high severity, major catastrophe events. That said, losses definitely can occur and are difficult to predict and tend to involve snow or ice caused by winter storms. Most losses tend to be related to winter storms.

In recent quarters the news has been getting increasingly optimistic on the top line for property and casualty insurers, a trend we expect to continue into the first quarter. In the past few quarters insurers have been positing mid-single-digit price increases. While not necessarily indicative of a hardening market, where prices can increase well into the double-digit levels, any positive news on the pricing front is undoubtedly welcome after many years of declines during the soft market period. The losses caused by Hurricane Sandy in the fourth quarter will be a negative for reported profitability in that period, but at the same time, they may motivate a more widespread change in the insurance pricing market, which would drive higher prices in upcoming quarters.

Persistent low interest rates continue to be a major challenge for the life insurance industry. We expect life insurance companies to lower their earnings outlook for 2013, as they are going to incur charges related to liability revaluation and are forced to invest premiums in low-yield securities. On top of that, the industry is facing the regulatory uncertainty surrounding the systemically important financial institutions (SIFI) classification. Against this backdrop, we think that life insurance companies will continue to focus on protecting their capital solvency.

There are several trends that are emerging in the life insurance industry. First, to lessen the overall capital burden, many life insurers are looking beyond traditional insurance and moving into alternative businesses, such as corporate pensions and asset management. Second, we believe life insurers will continue to de-risk the risk profile by selling off insurance assets and reducing exposure to annuities. Several European insurers have announced plans to unload their U.S. and Asia units, in part because they want to trim their balance sheet before the new solvency rules roll in. U.S. insurers have also significantly cut back on new annuity sales to reduce capital market exposure. Finally, we expect life insurers to increase allocation to high-yield bonds and other less-liquid investments to get a higher yield. Private lending to corporations can be another way for insurers to obtain a higher rate while holding less liquid securities.

Exchanges Also Looking for New Sources of Growth
Financial exchanges won't be sorry to put 2012 in the rearview mirror. The year was a difficult one for trading activity, and as the industry heads into 2013, we are cautiously optimistic for improvement. But given the swings that trading revenue can experience, exchanges that have good other sources of revenue will probably continue to look for ways to expand those in order to promote stability.  NASDAQ OMX Group's (NDAQ) plan to expand its corporate-solutions business (which includes products such as investor-relations tools) through an acquisition is part of this trend, as is  NYSE Euronext's (NYX) continuing effort to grow technology-related income.

In general, we think these businesses do have the potential to help stabilize exchanges' revenue trends, but we also think that a healthier trading environment would do the sector significant good. Operating efficiently in lean times will continue to be a focus for exchanges, and although targeted merger-and-acquisition activity is certainly possible, we think that large-scale, cross-border deals are less likely.

Refinancing Volumes Remain a Key Factor in the Mortgage Market
Sale volumes in the U.S. residential housing market have yet to meaningfully recover. However, the mortgage business has not vanished in the post-bubble environment thanks to refinancing activity. In response to record low rates and government assistance, refinance volumes have picked up sharply over the past year. This has led to a much more favorable environment for the title insurers and mortgage processors, as well as increased origination business for banks.

Although refinance volume has been a boon to financial firms in recent quarters, it could prove to be a double-edged sword. A return to normal sales volumes, especially if accompanied by an improving economy and higher interest rates, could merely offset declining refinancing volumes in a rebounding housing market.

At banks, cost-cutting will remain in focus as management teams attempt to deal with continued top-line weakness and low interest rates.  Citigroup (C) recently announced yet another round of planned expense reductions, and we think other banks could follow as management teams attempt to regain a modicum of economic profitability. As credit quality has stabilized, reserve releases are likely to taper off as well, leaving few avenues for banks to boost their bottom lines.

Canadian Banks Continue to Demonstrate Resilience
Despite a flatter yield curve and concerns about the impact surrounding a housing bubble, Canadian banks continue to post strong earnings. Although loan growth has not been as strong as in past years, it is still very respectable, averaging upper single digits.

Strong earnings are primarily led by their largest segment, personal and commercial banking, though many of these banks experienced lower net income from this segment due to the lower rate environment and slightly higher loan loss provisions. However, all of the banks showed stronger results from their wealth management and capital markets segments, which made up the difference for lower Canadian banking income.

Over the course of the quarter, some of the banks (i.e.,  Toronto-Dominion Bank (TD),  Royal Bank of Canada (RY), and  Bank of Nova Scotia (BNS)) have looked to reinvest some of their cash by making acquisitions to enhance market share, build fee-based businesses, or expand geographically to help diversify their revenue streams. Canadian bank investors closely watch for any common dividend increases from these companies. This quarter, only one of the six major banks raised its common dividend,  National Bank of Canada (NA). Nevertheless, common dividend yields remain high, ranging from 3.8% to 4.8%. In terms of future dividend increases, we expect the banks to review the potential of dividend hikes following their first-quarter 2013 results.

Over the long term, we think the Canadian banks will continue to generate significant capital. However, we are cautious about the housing market, which appears significantly overpriced. At this point, the debt-service capabilities of the Canadian consumer appear manageable. However, if the Bank of Canada decides to raise rates, we worry about the impact upon the highly leveraged consumer and subsequent effects upon the banks.

Our Top Financial-Services Picks
Given the trends outlined above, we are finding only scattered opportunities in the sector. We believe there is some value left in a few names, but the economy may need to give these companies a boost if investors are to make much money in them over the next 12 months.

Top Financial-Services Sector Picks
Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
City National $64.00 Narrow Medium $44.80
Julius Baer Gruppe CHF 42 Wide High CHF 25.20
Old Republic $15.00 Narrow High $9.00
Data as of 12-14-12.

City National (CYN)
City National is one of our favorite lenders among U.S. regional banks. Its focus on wealthy business owners and its low-cost structure garner the bank a narrow economic moat. With a solid balance sheet, City National is well positioned to take advantage of the dislocation in its markets and grow internally by gaining share from troubled lenders or acquiring failed or distressed banks.

 Julius Baer Gruppe AG (BAER)
We're optimistic about Baer's acquisition of Merrill Lynch's non-U.S. wealth management operations, which we think will help the bank to build scale in fast-growing markets and lessen its dependence on Swiss offshore banking. While Julius Baer may not enjoy the same worldwide name recognition as some of its Swiss competitors, we see that as an advantage--the private bank's brand has been relatively untarnished by scandals or heavy losses during the financial crisis. While the bank faces currency risk because its expenses are predominantly denominated in Swiss francs (which eventually could appreciate against dollars and euros), we think the risk is balanced by its quality business and its current discount to our fair value estimate.

 Old Republic International (ORI)
At its heart, Old Republic is a well-run commercial property-casualty insurer, and although some of its forays into other areas in the past have not worked out as well as intended, the strength of the primary business line has kept the ship afloat. The stock has been battered ever since one of its primary operating subsidiaries, mortgage insurance, suffered skyrocketing claims from residential mortgage foreclosures and was placed into run-off. Though its troubles are not yet over, we think management is focused on the difficulties at hand, and that it is capable of guiding the business profitably through these uncertain times.

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