Financial Services: Investment Services Competition Is Heating Up

• We assess the global financial-services sector as approximately fairly valued. It has recently traded at a market-cap-weighted price/fair value estimate ratio of 0.96--a 4% discount to what our analysts believe the sector is worth.
• While the economy remains relatively strong, increased competition among banks shown in rising funding costs are slowing net interest margin growth, and uncertainty regarding credit costs is increasing.
• There is a general easing of financial regulation in the United States, but signs of tightening in China, Australia, and Europe.
• Strategic moves in the United States' investment services industry heated up in the third quarter.

Americas Financials Update
By Brett Horn, Eric Compton, Greggory Warren, and Michael Wong

U.S. Asset and Wealth Management Firms
There were multiple interesting announcements in the third quarter with strategic implications for the asset and wealth management firms in the United States.  Fidelity (FIS) announced its line of "Zero" index funds with 0.00% net expense ratios that are available on Fidelity.com. Vanguard announced that it is expanding its no-transaction-fee platform for ETFs to include 1,800 ETFs, which is the largest offering among brokerage platforms. Meanwhile,  JPMorgan Chase (JPM) announced it is offering 100 free equity and ETF trades for the first year, with the potential for additional free trades every year based on the amount of a client's assets, for those signing up for its You Invest online brokerage platform. 

We initially see these announcements as tying into themes of financial institutions competing for market share by consolidating household assets that may be dispersed across multiple financial institutions and the increasingly diverse strategies firms are using to monetize clients. No financial services are truly free, and firms are trying various mixes of transaction, investment product, advisory, or other fees to appeal to customers and maximize profits. For a detailed look at how robo-advisors--new challengers in the investment services industry--generate revenue and why we've developed a more positive opinion on their evolving business model, please read our special report Robo-Advisor Upgrade! Installing a Program for Profitability, available on the Morningstar Blog, Morningstar corporate website, and PitchBook.

Looking more closely at the U.S.-based asset managers, we expect the following trends to have an impact on the industry in the near to medium term: 

1. A more limited regulatory environment in the U.S., with a heightened focus in global markets on fee transparency, fiduciary duty and investor-covered costs (such as investment research).
2. A continuation of the retail-advised distribution channel disruption, which has led to shrinking product platforms at major broker/dealers and advisory networks.
3. The ongoing migration from higher-fee active funds to lower-fee passive products.
4. A greater focus on relative and absolute investment performance and management fees.
5. Industry consolidation (both internally as funds merge within an organization and externally as asset manager look to add scale to their existing operations). 

On the consolidation front, our general take has been that consolidation is inevitable for the industry. Active asset managers, and even some passive managers, have a need to add scale to offset a lower fee and higher cost environment as the U.S. and other developed markets continue to experience a secular shift of investors capital into lower-cost options--primarily index funds and ETFs--at the expense of actively managed products. We expect fund companies that cater to retail customers to consolidate their funds not only internally, by merging some funds and eliminating underperforming offerings, but externally as well, with midsize to large asset managers pursuing deals that will increase the scale and/or product breadth of their operations.

We expect most of the U.S. firms we cover to consolidate internally where it makes sense, increasing the scale of individual funds under the direction of solid active managers that are more likely to provide them with the best chance to keep fee cuts to a minimum while still gaining access to third-party platforms. This can be a double-edged sword, though, as funds tend to underperform the larger they get, so managing that differential will be critical to long-term success. As for external consolidation, we view most of our U.S.-based asset manager coverage as buyers rather than sellers, and unlike past rounds of consolidation that involved buying up managers to either fill in product sets or expand distribution reach, we expect future deals to be done more for the purpose of increasing scale than anything else.

In these types of deals, we envision midtier asset managers (those with $250 billion-$750 billion in AUM) acquiring small to midsize firms (those with $25 billion-$250 billion in AUM), understanding that they could lose a fair amount of AUM as they consolidate the acquired company's funds into their own. Although there are plenty of firms out there that fall well below the threshold of a small firm, we don't expect much buying activity of these types of firms for scale. If anything, we could see deals of that size done to fill product holes or as product-enhancement moves.

At this point, we're still in the early phases of the expected consolidation wave, with the deals that have been done so far--such as the merger between U.S.-based  Janus Capital Group (JHG) and U.K.-based  Henderson Group (JHG) (announced in October 2016)--being much more selective, with the firms involved looking to fill product set, distribution and geographic holes. That said, we should also point out  Invesco's (IVZ) acquisition of the ETF operations at Source and Guggenheim this past year, which, in our view, was done more for scale enhancement, with the company picking up $26 billion and $38 billion, respectively, with these deals, increasing its total ETF AUM by some 50% and allowing it to take some pricing action in parts of its ETF operations the past several months. 

And if the rumors are to be believed, Invesco's $5 billion bid for OppenheimerFunds (which was reported near the end of the third quarter) would also be all about scale, as the deal would increase Invesco's total AUM by 25%, as well as more than double its long-term open-end fund assets. This should allow the combined firms to offset some of the fee compression and expense pressures we see affecting the industry over the next five to 10 years. That said, it would also increase Invesco's exposure to active equities and the retail channel, the two areas of the market we expect to be pressured more by an increased focus on fees and investment performance. Given these pressures, we'd expect a scale-driven deal like this to be done at a slight discount to deals done over the past several years, but based on the reported price tag we view this deal with a fair amount of suspicion.

U.S. Insurers
The property and casualty insurance industry was buffeted by a flurry of natural catastrophes in 2017, with multiple hurricanes and wildfires hitting companies' bottom lines. Typically, industry pricing firms up after large catastrophes, and that appears to be the case again. However, the increases look modest, and lower than what we've seen in the past, as the industry remains well-capitalized. In our view, this adds up to an underwriting environment where moaty firms need to be careful in order to maintain excess returns, and the most well-managed franchises, in our view, have been cautious in terms of growth in recent quarters. We think Hurricane Florence is a manageable event for the industry, and by itself will not push the industry to outsize catastrophe losses for the year, but hurricane season is not yet over. Looking across the main areas of P&C insurance, we see some divergence. Personal lines, particularly auto, are currently enjoying strong pricing increases, which in most cases is more than offsetting a recent rise in claims and leading to strong profitability. The outlook in commercial lines is much more mixed, and it is questionable if pricing increases are keeping pace with claims increases. We remain most concerned about reinsurance lines, however, as we see catastrophe bonds as a growing source of capital, and believe structural overcapacity could leave pricing inadequate even if prices rise modestly in 2018.

U.S. Banks
The near-term outlook for bank performance is positive with tax cuts signed into law, solid expectations of more economic growth, regulatory relief already playing out, and a normalizing rate environment. Overall, bank stock market values today are much higher than they were a year ago. We think this is warranted to some degree, as we now believe returns for banking will continue to improve and will end up roughly in between precrisis return levels and the returns seen in the past 10 years since the crisis. However, this also means that bargains within the U.S. regional banks are few and far between. 

For U.S. banking in general, we believe four key themes will play out in 2018. First, we see higher loan growth in the later half of 2018 as uncertainty surrounding tax reform abates and companies are incentivized to invest given increased capital expenditure deductibility during the next five years. Second, we see more room for expense savings as banks continue to automate more functionality, embrace more technological change, and decrease or better optimize branch footprints. Over time, we think this trend favors the largest banks, which have the most scale and the most money to spend on new technology. Scale and technology should only increase in importance, and this should be a major factor in determining the winners and losers within banking over the next decade. Third, we believe regulatory spending likely peaked in 2017, and we expect the explicit regulatory spending burden to be flat to down in 2018, and the burden from holding excess capital on the balance sheet should only decline over the medium term. Finally, we see continued but measured federal-funds rate hikes in 2018. We also see increasing deposit betas offsetting the benefits of higher asset yields, as banks are forced to begin giving back more of each rate hike to their clients.

We think the U.S. Federal Reserve's cautious approach to raising interest rates is the correct one given the state of the economy. In our view, the Federal Reserve is walking a fine line as it attempts to normalize rates. Returning to a "normal" interest-rate environment would give the central bank more ability to fight a recession, and the combination of low unemployment rates and solid economic growth arguably shows the economy is ready for higher rates. However, tightening too quickly--before inflation data proves the need for higher rates--could cut short a long and fragile recovery. We continue to expect a slow and steady normalization, in line with the Fed's commentary.

In June, the Federal Open Market Committee raised its target for the federal-funds rate to 1.75%-2%. Current expectations are for the target rate to be 2.25%-2.50% by the end of 2018. We think the advantages of a sticky retail deposit base are likely to shine through as rates rise.  Comerica (CMA),  Zions Bancorp (ZION), and  Cullen/Frost
(CFR) have the highest percentage of noninterest-bearing deposits, all above 40%.  Regions (RF) and  M&T (MTB) are also well-positioned, as they have had some of the lowest deposit betas in the second quarter of 2018. Unfortunately, we are not finding any screaming bargains among the regionals today, but still think  Wells Fargo (WFC) and  Capital One (COF) look attractive at today's prices.

Asian Financials Update
By Iris Tan, Jay Lee, and Michael Wu

China Banks
As for the Chinese banks, there are five industry trends worthy of attention in 2018. First, bank lending rates will continue to climb because of tighter credit availability and the squeeze-out effects of tighter shadow bank controls. The average lending rate has increased 64 basis points to 6.08% as of mid-2018 from the trough in end-2016, though we believe further increases will be limited given the slowing economy and modest easing in market liquidity. 

Second, deposit costs face greater pressures in 2018 as June M2 growth further slowed to a record low level of 8.0% over the past three decades, versus the average of 12.8% during 2011-17. This was also exacerbated by mounting threats from deposit substitutes including money market funds and savings-type insurance products, while banks' wealth management products become less attractive as they no longer carry implicit guarantees and yield lower returns as their investment in shadow credits are banned. 

Third, bank loans will maintain their steady growth at around 13% in 2018 on strong credit demands to partially make up for the unfilled financing gap left by ongoing shadow banking curbs. Contrary to market belief, we do not think the banks are able to shift a majority of their off-balance-sheet shadow banking exposure into their books, given stringent regulations including requirements on capital, provisioning, and loan quotas for specific industries. Fourth, there is a higher level of credit costs uncertainty due to stricter rules in bad debt recognition in 2018 and rising internal and external economic uncertainties. 

Finally, fee income growth will temporarily be dragged lower by ongoing regulations in wealth management products. Despite the tweak toward softening as shown through explanatory notes being announced recently, the tone of tightening regulations remained intact. We expect wealth management products will shrink in scale as both supply and demand for shadow bank credits are subject to strict controls. 

Chinese banks' H-shares under our coverage are trading at a price/fair value of about 0.82. The current valuation level implies 0.5-0.8 times 2018 price/book value for the Chinese banks we cover with  China Merchants Bank (03968) the exception. This is the lowest level over the past three years due to the market's renewed credit quality concerns amid rising refinancing risks for the corporate sector and elevated trade war fears. As financial deleveraging has become one of the government's top priorities, we believe this trend will continue in the near term, while the marginal impact on banks will gradually mitigate. We are more optimistic than the general market about large banks, including  Agricultural Bank of China (01288) and  Industrial And Commercial Bank Of China (01398). We believe large banks will steer through the challenges better than peers thanks to their strong funding cost advantage, prudent operations, and limited exposure to shadow bank credits. Tighter regulations and ongoing reform should benefit both the industries and wider economy in the long run, as it marks an important step by the government to derisk the financial sector and a push for more rational pricing for credits.

Hong Kong Banks
A pullback in Hong Kong equities resulted in some value emerging for Hong Kong banks. However, none is trading at significant discount to our respective fair value estimates and our 2- and 3-star ratings are largely unchanged. Net interest margin improvements and loan growth remain the key in the second half of fiscal 2018. There is no change to our view that net interest margins will rise steadily in the medium term as stronger economic conditions underpin the normalization of interest rates globally. The Hong Kong Interbank Offer Rates, or Hibor, edged higher in the first half as liquidity exited Hong Kong. The latter saw the Hong Kong Monetary Authority intervening in the foreign currency market to maintain the Hong Kong dollar peg. The higher Hibor should underpin rising net interest margins but partially offset by competition. As noted previously, the Hong Kong banks saw pressure on lending spreads for both corporate and commercial loans in the first half. In our view, competition could ease as rising interbank rates increase funding costs across the industry, particularly banks without a large deposit franchise. We believe narrow-moat  BOC Hong Kong (02388) and  Hang Seng Bank (00011) will fare better than peers given their large Hong Kong dollar deposit base, as funding costs for their low-cost, sticky current and savings account deposits should rise at a slower pace.

The strong system loan growth continued in the first half and remains a key positive. However, loan growth may be more restrained in the second half of fiscal 2018 on rising trade tensions. July loan growth was lower though year-to-July system loan growth remains at 5%, or 8.8% on an annualized basis. Demand for offshore loans was one key driver as Chinese corporates expanded regionally. A decline in the Chinese economy at a controlled pace and reasonable strength in global economic conditions will sustain moderate loan growth for the remainder of fiscal 2018. 

Japan Banks
We maintain our preference for  Mitsubishi UFJ Financial Group (8306) among the three megabanks as Mitsubishi is trading at the largest discount to fair value at 20%. After a sharp appreciation of the bank's share price close to our fair value estimate in early 2018, its share price declined in line with global equity markets in the first half. The decline accelerated post the bank's fourth-quarter fiscal 2018 result, which we attribute to a smaller-than-expected buyback and dividend, as well as a fairly soft profit guidance. Our forecasts conservatively factored in slightly higher than guidance credit cost. 

Credit cost was benign for the Japanese banks in the first-quarter result, largely in line with last year. We expect credit cost to remain low this year but assumed higher provisioning thereafter as Mitsubishi has a larger exposure to international loans, which we deem slightly riskier. However, we believe the risk is priced into the current share price.  Mizuho Financial Group (8411) and  Sumitomo Mitsui Financial Group (8316) both have lower levels of international exposure, with Mizuho in particular having a conservative loan portfolio concentrated in high-quality domestic corporates.

We do not expect a significant increase in nonperforming assets in the medium term and credit cost should remain low for the remainder of 2018. Interest rates are expected to remain low in Japan as inflation growth remains weak. While the low interest rate should result in a lower level of credit cost, net interest margin will continue to be pressured. This is further compounded by weak loan demand domestically and we expect net interest income to remain largely steady.

Singapore Banks
The Singapore banks' share prices softened in line with the wider market in the first half. We see better value in  Oversea-Chinese Banking Corp. (O39), trading at a 19% discount to our fair value, relative to 8% and 14% for peers  United Overseas Bank (U11) and  DBS Group (D05) respectively. While we reiterate our view that DBS Group will benefit the most from a rising interest rate environment, given its larger than peer Singapore deposit market base and a larger proportion of lower-cost current and savings deposits, the upside is currently priced in. 

All three banks reported solid second-quarter results, reflecting the still favorable operating environment. Higher net interest income was driven by both improving net interest margins and stronger loan growth, while favorable capital markets saw rising demand for investment products and wealth management, underpinning increases in fee and commission income. Credit costs remained low, which also benefited from the write-down of their oil and gas nonperforming assets last year. With rising trade tensions, the three banks provided a more cautious outlook for the remainder of fiscal 2018. Domestically in Singapore, more restrictive measures on the residential property sector will likely result in slower mortgage growth. Overall, we expect loan growth of midsingle digits for the three banks. 

Australian Financials Update
By David Ellis
Solid operating conditions for the Australian major banks are being completely overshadowed by the negative sentiment and damaging revelations raised to date at the Royal Commission into misconduct in the banking, superannuation, and financial-services industry. The commission is due to release an interim report by the end of September with the final report due in February 2019. We expect the interim report to focus on residential lending standards, vertical integration of wealth businesses, grandfathered commissions in the wealth industry, a review of mortgage broker commissions, and potentially the retail superannuation sector. Recommendations covering the insurance sector will likely be included in the final report. 

Despite an outlook for tighter regulatory and compliance requirements, the biggest risk for the major banks is the potential for a credit squeeze triggering an economic downturn as borrower demand softens at the same time as stricter lending criteria bites. But the Australian banks continue to be well-supported by strong economic fundamentals as global and domestic economic conditions improve. Australian GDP for the June quarter came in at a respectable 3.4% year-on-year growth rate, with strong employment growth, record high export volumes and values, continued positive net immigration, solid credit growth of around 4.5%. and record high infrastructure investment. House prices have retraced slightly, and we expect further modest house prices weakness in the year ahead.

Despite solid fundamentals, the sector is suffering from elevated uncertainty, particularly around pricing risk, credit risk, and operating risk. In response to mounting regulatory pressure, the banks are investing to improve reporting and risk management systems at a cost to underlying profitability. There is a risk the Royal Commission recommendations could be tougher than expected, and combined with weakening house prices, slowing credit growth, increasing trade tensions and further economic slowdown in China, bank share prices could face further short-term pressure. Major bank share prices are all down from 12-month highs with  Australia and New Zealand Banking Group (ANZ) down 9%,  Commonwealth Bank of Australia (CBA) down 15%, National Australia Bank (NAB) down 15% and  Westpac Banking (WBC) down 18%. 

At current prices, Westpac Bank and National Australia Bank are most undervalued, trading 20% and 14%, respectively, below our valuations. Commonwealth Bank and ANZ Bank are trading 13% and 5%, respectively, below our valuations. We are comfortable with our modest earnings forecasts, with EPS expected to grow an average of 2.4% per year to fiscal 2022, and near-term catalysts to drive share prices materially higher are difficult to find.

It was comforting to see three of the four major banks (ANZ Bank, Commonwealth Bank and Westpac Bank) increase variable home loan rates (14-16 basis points) in late August/early September without too much regulatory, political, and media heat. Short-term wholesale funding costs increased several months ago and remain elevated, exerting pressure on net interest margins. We are surprised with National Australia Bank’s decision to hold interest rates steady as pressure on margins is meaningful. Major bank pricing power remains undiminished, despite intense negative scrutiny from the Royal Commission, politicians, and media. 

As always, there are plenty of risks to earnings and stock prices for the major banks, not the least being unfavorable Royal Commission outcomes, a tougher regulatory environment, slowing economic conditions in Australia, the long-running fear of an economic correction in China, and, of course, major banks' exposure to expensive housing. Global tightening of liquidity could raise Australian bank wholesale funding costs further. In these circumstances, bank net interest margins could contract if borrowing rates are not increased for Australian corporate, commercial, and housing loans. 

Political and regulatory risks are increasing, with a range of issues unfolding. A potential change of government could have an impact on the Australian housing market and the major bank oligopoly. All eyes are on the next election scheduled by May 2019 and a likely change of government. Current government opposition Australian Labor Party policies on negative gearing residential property, capital gains tax discounts, and tax treatment of trusts are all indirectly negative to bank earnings. Potential changes to bank compliance requirements, regulatory framework, and the current 0.06% bank levy are all creating uncertainty. 

Despite the political and regulatory risks, we expect improved productivity and benign credit quality to support future fully franked dividends delivering attractive dividend yields in the 6%-7% range. We forecast average annual dividend growth of just 1.4% to fiscal 2022, with average payouts forecast to decline to 72% in fiscal 2022 from 76% in fiscal 2017. Major bank forward price/earnings ratios have contracted to an average around 11 times from 13 times a year ago and are below longer-term averages around 12 times. Returns on equity are expected to average above 14% during the next five years, with Commonwealth Bank to stand out at around 15.5%. Political uncertainty is not helping business confidence, while weak wages growth is a drag on consumption and the Reserve Bank of Australia inflation target. The most damaging negative risk to bank earnings is the potential for an exogenous shock triggering a global downturn that drags the Australian economy into recession, but this is not our base case.

European Financials Update
By Johann Scholtz and Henry Heathfield

European Banks
The European banks that we cover are starting to offer value; on average they are now trading at 0.85 times our fair value estimate. A 9.5 times average forward P/E is hardly demanding and a 4.3% dividend yield is attractive to dividend investors.

European banks' share prices have declined by 11% over the past year and 5% over the past three months, reflecting concerns first around banks with emerging market exposure and the impact on global trade of the escalating tariff war. Therefore, banks with a strong global and emerging-market presence have been under the most pressure. Developments in Italy have taken a back seat for the time being, but to our mind populist policies from the coalition government could be a risk, not only to Italian banks but also the whole eurozone.  Danske Bank (DANSKE) and  ING (INGA) (ING) have been punished severely by the market as regulators dished out heavy fines for failure on their part to pick up on money laundering.

We prefer to look through the shorter-term cyclical issues that concern the market and focus on long-term secular drivers. Our main concern is the low midcycle level of profitability we foresee for the European banks. Return on equity ratios in double digits have become the exception and the bulk of the banks in Europe will not generate returns ahead of their cost of capital consistently. While we concede that net interest margins stand to benefit from a future normalization of monetary policy, we do caution that investors should not expect a return to margins as they were before the 2008 financial crisis, because most banks now have much lower risk appetite hence lower credit spreads have become the norm. Loan loss provisions are close to all-time lows and they will increase going forward. The new accounting standard dealing with impairments of financial instruments, IFRS9, has yet to be tested during a downturn in the credit cycle, and it adds to the high level of uncertainty as to what constitutes a midcycle level of impairments for European banks. Banks have been successful in driving down their cost/income ratios until now but the visibility of future efficiency gains are less clear to us.

We do not believe that the average European bank will be able to increase its revenue in line with nominal GDP consistently. Credit penetration in most of Europe is high already and competition from technology and telecommunication firms are expected to increase. We do note that the initial impact of the opening up of the European payment landscape under the PSDII directive has been less pronounced than anticipated. Banks with strong wealth management franchises, especially in the high net worth space, have greater earnings visibility to us, although competition is increasing.

European Insurance
European insurance as it pertains to our coverage remains slightly undervalued in quarter three 2018, trading at 0.96 times price/fair value.

Corporate action has been fast and furious this year and  AXA (CS) (AXAHY) has finally completed its acquisition of XL on Sept. 12. This accelerates AXA's growth into the specialty and corporate property and casualty insurance. We remain reticent about the future direction of AXA as proposed by this buyout. Admittedly, we thought any corporate action would focus on bolstering up its slightly ailing asset management division. Clearly, in our view, AXA is positioning itself as a  Zurich (ZURN). We remain concerned about these U.S. corporate accounts and lines. Zurich has had problems here. However, the sale of its European Variable Annuities book will reduce the overall business portfolio. And we maintain the stock still looks cheap at 0.7 times book value and that any reserve strengthening should not be as severe as the discount the market is pricing.

 Prudential PLC (PRU) (PUK) is the second large European listed insurer going through significant corporate activity with the proposed divestment of its United Kingdom, European, and asset management operations. We still think this plan for separation highlights a number of key trends occurring in the European life insurance space. First, the lines between life insurance savings and asset management have been substantially blurred with the rise of unit-linked products. Second, we see a bifurcation occurring within the market. Premium operators like Prudential rely on good quality advice to retain and attract policyholders, as well as reputation on service, payments, and investment returns. Whereas lower down the spectrum of individual wealth, scale is becoming the name of the game, attracting assets onto platform and focusing on retention through digital experience, service, guidance and advice, as well as the requisite reputation on service, payments, and investment returns. This is what we see the likes of  Aegon (AGN) (AEG) and  Aviva (AV.) (AVVIY) focusing on. However, we do believe these latter operators are using platforms to increase and improve control environments and service that accompanies this. We think Prudential is fairly valued, having dropped in value from GBX 1,780 at time of initiation to just below our current fair value estimate that has included purely time-value-of-money adjustments.

The rough timeline for this demerger is completion by end of 2019 and while there have also been talks in the market for smaller life operators such as Aegon following a U.S. and European separation suit, we think for Aegon the strategy does not make sense.

Outside of this corporate activity, but still largely on our radar, is  Assicurazioni Generali (G). Hit substantially by the Italian political uncertainty we maintain our EUR 17.30 fair value estimate. In our view, the League already has had its wings partially clipped, with court rulings threatening EUR 50 million in asset seizures, with the Italian legal system having a reputation for a bark worse than their bite. Our European Insurance opinion is that this political uncertainty will right itself and Italy will drag itself out of the trenches. However, the 0.9 times book value of current share price at EUR 15.1 offers a less appetizing discount and inherently higher risk than our other European insurance picks with our EUR 17.3 fair value estimate at 1.0 times book value.

Top Picks
 American International Group (AIG)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $76
Fair Value Uncertainty: Medium
5-Star Price: $53.20

In May 2017, American International Group announced that Brian Duperreault would become CEO. We believe his background is a good fit in terms of solving AIG's main operational issue—improving commercial property-casualty insurance underwriting. However, the market remains unimpressed with his tenure, with the company's stock down about 10% since AIG announced his appointment. While the company has not shown a lot of tangible progress in improving underwriting results so far, we appreciate that it will take some time to solve its issues.

The company, in our view, does not need to see a dramatic improvement to stop destroying shareholder value; it only needs to move from a negative outlier to merely subpar. We estimate that, all else equal, AIG would only need to improve its commercial P&C combined ratio to 97% (a level that would still be worse than its peer group range) to be able to generate a 10% adjusted ROE. Given that we see no structural issues in its core operations, we believe that the company gradually trending toward peer results is a realistic assumption. Using peer price/book multiples, we estimate that there could be over 50% upside from the current trading level if AIG were to reach this mark.

 Credit Suisse Group (CSGN)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $23
Fair Value Uncertainty: High
5-Star Price: $13.80

The profitability of Credit Suisse's core businesses comfortably exceeds its cost of capital; we estimate a midcycle return on equity of 13% compared with our cost of capital estimate of 10%. A few issues have concealed the company's true profitability. As part of the process of derisking the business away from volatile sales and trading, Credit Suisse has run down a massive noncore book of EUR 126 billion-EUR 45 billion over the past four years, incurring cumulative before-tax losses of EUR 16 billion in the process. To add insult to injury, Credit Suisse has incurred legal expenses of CHF 7 billion over the past four years. 

Credit Suisse has often been criticized that it was behind  UBS Group (UBS) (UBSG) in adapting its strategy to the new requirements for Swiss private banks. The market has hounded Credit Suisse to reduce its exposure to risky sales and trading and replicate UBS' business mix, where wealth management dominates. However, there are many more similarities between Credit Suisse and UBS than there are differences. We believe that losses booked out of the noncore portfolio have led investors to overestimate the importance of sales and trading to Credit Suisse. Sales and trading contributed 27% to Credit Suisse's revenue in 2017, compared with 23% of UBS' revenue generated by sales and trading.

 BlackRock (BLK) 
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $570
Fair Value Uncertainty: Medium
5-Star Price: $399

While there are a handful of U.S.-based asset managers trading at steep discounts to our fair value estimates, wide-moat BlackRock remains our top pick among the group. With $6.3 trillion in total assets under management at the end of June, BlackRock is the largest asset manager in the world. The company is at its core a passive investor. Through its iShares exchange-traded fund platform and institutional index fund offerings, BlackRock sources close to two thirds of its managed assets (and nearly half its annual revenue) from passive products.

In an environment where investors and the advisors that serve them are expected to seek out providers of passive products, as well as active asset managers that have greater scale, established brands, solid long-term performance, and reasonable fees, BlackRock is well-positioned. The biggest differentiators for the firm are its scale, ability to offer both passive and active products, greater focus on institutional investors, strong brands, and reasonable fees. We believe that the iShares ETF platform as well as technology that provides risk management and product/portfolio construction tools directly to end users, which makes them stickier in the long run, should allow BlackRock to generate higher and more stable levels of organic growth than its publicly traded peers the next five years.

The market tends to reward organic growth and operating profits in the U.S.-based asset managers, and BlackRock scores well on both measures. Unlike many of its peers, the firm is currently generating solid organic growth with its operations, with its iShares platform, which is the leading domestic and global provider of ETFs, riding a secular trend toward passively managed products that began more than two decades ago. This helped the company maintain average annual organic growth of 4%-5% the past several years despite the increased size and scale of its operations. 

As we expect the headwinds for the asset managers to be stiffer as we move forward (even incorporating a major equity market decline midway through our five-year forecast), we envision BlackRock generating 3%-5% average annual organic AUM growth, with slightly better levels of revenue growth but relatively flattish margins (of around 40% on average) during 2018-22 (well above the industry average of 30%).