With a sector price/fair value estimate ratio of 103% and a number of macro headwinds still blowing, financial-services bargains are few and far between. Interest rates remain a key factor for companies in several industries. Capital concerns have diminished in Europe, but uncertainty remains.
At 103%, Morningstar's aggregate price/fair value estimate ratio for financial-services stocks reflects the increasing bullishness of market participants, in stark contrast to the fears driving down valuations only two years ago. Indeed, the sector's price/fair value ratio has increased from 70% to 103% over that time. In our view, investors would be wise to pick their spots carefully when adding to positions in financial-services firms at this time.
The property-casualty industry remains awash with capital, which continues to keep pricing in check in most segments of the market. A generally benign first-half catastrophe season, coupled with new capital entering the industry, primarily through the reinsurance sector, has weighed on the ability of most industry participants to raise prices to levels consistent with a hardening market. We expect to see continued minor price gains driven by lower returns from investment portfolios in the near term, but until economic conditions improve or a significant catastrophic event, or series of events, occurs, price increases will likely taper off.
Personal line carriers have increased prices modestly, mainly because of the demand from consumers who must continue to carry automobile and homeowners insurance. However, price increases in this segment have been contained because of the extremely competitive nature of the industry as well as purchasing shifts brought on by online providers. We expect this trend to continue. Commercial lines carriers, however, are more sensitive to economic conditions. Many of their clients have chosen to cut back or self-insure in order to keep profits and margins up. Furthermore, because of the longer-tail nature of many commercial lines, interest rates tend to have a greater impact on returns. Nevertheless, pricing has improved a bit more than in personal lines as the industry attempts to make up for increased losses in certain lines of insurance, most notably workers’ compensation and other economically sensitive lines.
Overall, we expect the P&C insurers to continue to show modest pricing improvement but still fall far short of performance we would expect at the beginning of a hardening market. Still, P&C insurers are on track for solid performance this year, provided there are no surprises like Hurricane Sandy in late October of last year. At present, we think the sector is about fully valued with relatively few opportunities for investment. Over the past year, P&C insurance stocks have had a good run, but we think the market has caught up to the sector.
Low interest rates continue to be a headwind for the life insurance industry, but the pressure seems to have eased up a bit, as long-term interest rates have moved up in the past six months. Recent price increases and reserve revaluation have allowed insurers to maintain a reasonable level of capital solvency. With that said, protecting capital is still front and center for most insurers, especially when regulators are considering non-bank systemically important financial institutions (SIFIs) classification for some of the largest insurers by assets. We believe life insurers will continue to derisk, either by selling noncore assets or moving into alternative businesses, such as corporate pensions and asset management that require less capital. Several European insurers have announced plans to unload their U.S. and Asia units. At the same time, U.S. insurers have rolled back on new annuity sales to reduce capital market exposure. We also see increased activities on insurers acquiring pension assets in emerging markets. 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.
Third-quarter investment-banking revenue should be decent, with a pickup heading into 2014. Underwriting volumes have been fairly healthy year to date. Announced merger and acquisition volumes have also received a boost in the third quarter; however, the bulk of the fees related to those deals may not materialize until the beginning of next year when the deals close. The rise in equity markets should benefit the earnings of investment banks that have material asset management, wealth management, and principal investment businesses, such as Morgan Stanley (MS).
Partially offsetting decent underwriting and asset management revenue, trading revenue looks like it will come in on the softer side in the second half. Third-quarter equity volumes are lower than in the earlier half of the year. While we believe much of the fixed-income inventory markdown pain from rising interest rates occurred in the second quarter, rates have continued to rise in the third quarter, and fixed-income trading volumes have lightened. We still expect the story of the investment banks in the next year or two to come down to whether growth in revenue lines tied to a recovering economy, such as equity underwriting and M&A advisory, are offset by a pullback in debt underwriting and fixed-income trading.
After a rocky second quarter, European banks continued their steady climb in the third quarter as the evidence of a modest economic recovery in Europe accumulated. We'd hesitate to buy shares of most European banks at current prices, as we think that the tentative recovery is already fully priced into shares. That said, we think that the positive is likely to outweigh the negative in the back half of the year, and we expect a modest climb in bank earnings. We've already seen positive signs, such as the uptick in Lloyds Banking Group's (LYG) core net interest margin in the second half, and evidence of increased client activity at private banks.
Still, we see reason to be cautious. In late August, Germany admitted that Greece will need a third bailout, and Spain's unemployment rate may remain around 25% as late as 2018 according to International Monetary Fund predictions. France is likely to overshoot its deficit target, and the government trimmed its 2014 GDP growth projections to less than 1%. Against this backdrop, developed-world central banks have begun pulling back on quantitative easing, and interest rates have begun to rise--good news for net interest margins, but likely bad news for still-tepid loan demand in Europe. We also think that investors should be cautious about long-term capital requirements. European banks are increasingly meeting the 2019 Basel III requirements, and some already meet the proposed 3% supplementary (unweighted) leverage ratio. Still, the capital levels of European banks notably lag those of U.S. banks. Moreover, in September, Sir John Vickers, author of the U.K.'s post-crisis regulatory reforms, said that he believes that banks' core Tier 1 capital requirement should eventually be 20%, double the current 10% initially recommended. This is a level that would have seemed unimaginable in 2007, but one that is well supported by the academic literature. Mathematically, if capital levels were to double, returns on equity would halve.
In the U.S., the story on bank profitability hinges on the movement of interest rates. While there has been anticipation of rising mortgage rates with the expected tapering by the Federal Reserve in its $85 billion per month bond-buying program, the end of quantitative easing was recently postponed once again. Furthermore, the LIBOR (London Inter-Bank Offer Rate) rate, which is the basis for most commercial loan pricing, has continued to decline throughout 2013. For commercial lenders that price off of LIBOR, yields have continued to decline. As a result, we do not anticipate any significant increases in interest income for those banks reliant on spread income as loan growth is also expected to be underwhelming. For mortgage lenders, the rise in interest rates has brought the refinancing boom to a trickle. While banks have been hopeful for continued mortgage activity through the home purchase market, it is apparent that mortgage banking revenue will continue decline for the remainder of 2013 as overall home loan originations decline sharply, driven by a dramatic decline in refinancing as long-term rates have risen.
With little cause for top-line optimism, U.S. banks continue to be diligent in addressing their expense base in an effort to maintain capital generation capability, especially in their mortgage businesses. Many of the large banks have already announced layoffs in their mortgage businesses including Wells Fargo (WFC), which has already cut 3,000 jobs in the mortgage business since July, and Bank of America (BAC), which recently announced that 2,100 employees have been notified that they were being let go because of the decline in refinancing. We anticipate that the theme of careful expense management will continue as long as yields remain relatively low and rate spreads remain squeezed.
We think that the positives should outweigh the negatives for investment banks in the second half of the year. Underwriting volumes have been fairly healthy year to date. The rise in equity markets should benefit the earnings of investment banks that have material asset management, wealth management, and principal investment businesses, such as Morgan Stanley. That said, financial advisory volumes remain relatively weak, and rising interest rates could catch investment banks by surprise and lead to fixed-income trading inventory markdowns. We still expect the story of the investment banks in the next year or two to come down to whether growth in revenue lines tied to a recovering economy, such as equity underwriting and M&A advisory, are offset by a pullback in debt underwriting and fixed-income trading.
With flows into fixed-income funds falling into net redemption mode in response to the Fed's comments about potentially tapering their asset repurchase program as early as the end of 2013, investors have been looking for places to put capital in the face of a rising interest-rate environment. While there has been plenty of movement within taxable bond funds, as investors have moved away from longer duration and constrained core products into more unconstrained strategies (which, in our view, has kept category outflows being much worse than they currently are), there has been no respite for municipal bond funds. Aside from concerns over the impact that the removal of quantitative easing will have on fixed-income securities overall, municipal bond fund flows have been hindered by the Detroit bankruptcy filing and the ripple effect it has had on not only the surrounding counties in Michigan but on other cash-strapped municipalities. With investors continuing to be concerned about where interest rates are going in the near to medium term, we don't expect to see a meaningful improvement in fixed-income flows.
While the strong rally in the domestic stock markets this year has been a big positive for flows into strategies dedicated to U.S. equities, including sector equity funds, the majority of the inflows continue to be directed at index funds and exchange-traded funds. Even though flows for actively managed U.S. equity funds remains in negative territory this year, the outflows are at levels not seen since 2009 (with flows during 2010-12 affected by a lack of market-beating performance by most domestic fund managers). International equity fund flows have also been solid this year, as most global markets have been up this year as well, with actively managed international stock funds actually picking up the majority of the inflows that have been coming into the category. This has left asset managers with a strong lineup of domestic and international stock funds in the best position, as they've benefited from the impact that rising markets have had not only on investment performance but on their equity flows.
That said, we continue to be cautious on the equity-heavy names on our list, especially those that are more domestic-centric and have struggled to generate positive flows, with Janus Capital Group (JNS) standing out from the rest. A confluence of poor investment performance, fund manager changes, and investor fatigue with the firm's lack of a turnaround in its investment offerings have led to an acceleration in outflows at Janus this year, and it doesn't look like things will turn around anytime soon. As for the group overall, we remain concerned that gains in assets under management that have been driven by rising equity markets are likely to diminish once things return to more normalized levels. On top of that, we expect the rotation out of fixed-income products (which is expected to occur as interest rates rise) to affect the AUM levels of bond offerings at most managers, and have modeled this into the valuation models of the asset managers in our coverage universe. Even so, we continue to have more faith in the more broadly diversified asset managers in this environment, especially those that can offer a mix of active and passive strategies, strong equity and fixed-income franchises, and exposure to both domestic and international markets--namely, BlackRock (BLK), Invesco (IVZ), and Franklin Resources (BEN).
Peeking toward the end of the year, we are anticipating the completion of IntercontinentalExchange's (ICE) acquisition of NYSE Euronext (NYX) sometime this fall. Since its unveiling in December 2012, the transaction has attracted attention in part because of its once-unthinkable nature. But upon further review the fact that the parent of the venerable Big Board is being taken over by a relative upstart is yet another indication of the continuing evolution of exchanges. We continue to regard the deal as mostly about ICE's interest in NYSE's European Liffe derivatives business and though we think well of ICE management, we still suspect the combined company will find it challenging to drive significant improvements in NYSE's U.S. cash equities business.
During the third quarter, investors were again reminded of the exposure of financial exchanges to potential system failures, as an outage in the trading of Nasdaq-listed stocks sparked a round of negative headlines about NASDAQ OMX Group's (NDAQ) handling of the situation. Looking ahead, we expect the level of scrutiny of technology problems to remain high from parties such as regulators. Nasdaq, meanwhile, is not lacking in important projects, as it is digesting two recent deals--it bought certain corporate-services businesses from Thomson Reuters (TRI) and later added the eSpeed U.S. Treasuries trading system. In sum, we believe that Nasdaq management can overcome its technology stumble, but given that the market operator's 2012 problems with Facebook's (FB) initial public offering are still fresh it is possible that Nasdaq may face some turbulence in the near term, for instance from management teams choosing among listing venues.
Among other exchange groups, CME Group (CME) saw exchange volume trends improve later in the summer after a sequential swoon during July. We expect the company will also continue building on its early progress in the OTC interest rate swap clearing business, where activity has been trending higher through the early part of September.
Consolidation remains a theme in exchange land. Even as Nasdaq and London Stock Exchange Group (LSE) have recently completed deals and the NYSE-ICE transaction is nearing the finish line, investors also recently saw closely held exchange operators BATS Global Markets (BATS) and Direct Edge Holdings announce their own merger plans. In our view, the imperatives for consolidation in the exchange industry remain standing, though the regulatory environment can be more dicey depending on the transaction.
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 investors may not want to get too aggressive with some financial stocks that are surprisingly near all-time highs.
Top Financial-Services Sector Picks Data as of 09-20-13
Morningstar Rating: 4 Stars Fair Value Estimate: $5.90Economic Moat: NarrowFair Value Uncertainty: HighConsider Buying: $3.54 Much like Bank of America, Lloyds is making a comeback after a near-death experience resulting from an ill-conceived acquisition, and the bank is beginning to escape the yoke of government ownership. We recently upgraded the company's moat rating to narrow as the company's core business is once again driving results--Lloyds' U.K. Retail division regularly posts pretax returns on risk-weighted assets of over 3.0% thanks to a base of low-cost deposits and the expense-lowering benefits of the company's domestic scale.
Franklin Resources (BEN)
Morningstar Rating: 4 Stars Fair Value Estimate: $58.00Economic Moat: WideFair Value Uncertainty: MediumConsider Buying: $40.60 While its greater reliance on retail investors and dependence on a relative handful of high-profile funds make it somewhat riskier than past pick BlackRock, Franklin often trades at a substantial discount to the industry behemoth. And though BlackRock's institutional clients may be less fickle, these large, sophisticated investors may also be able to exert more pressure on pricing than Franklin's broader base of clientele.
Berkshire Hathaway (BRK.B)
Morningstar Rating: 4 Stars Fair Value Estimate: $143.00Economic Moat: WideFair Value Uncertainty: MediumConsider Buying: $100.10 Berkshire Hathaway has money to spend, as evidenced by its recent agreement to acquire NV Energy. While the company's cash hoard is down from its peak, the firm is still poised to take advantage of market volatility, and Warren Buffett's willingness to repurchase shares could set an effective floor on the company's share price. While we don't think Berkshire can possibly replicate its past performance, a bet on Buffett and company to outpace an index fund is not unreasonable, in our view, especially when the stock is purchased at a discount to fair value.
Jim Sinegal does not own shares in any of the securities mentioned above.
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