Our outlook for financial-services stocks

Volatility could return to the financial sector in the second half of 2013.

Jim Sinegal 28 June, 2013 | 2:17AM
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With a price/fair value estimate ratio of 96% and market volatility on the upswing, caution may be warranted in the financial-services sector.
Investment banks and asset managers are levered to market performance and are good stocks to watch in the event of a pullback.
Banks will need to continue cutting expenses in order to grow earnings.

At 96%, Morningstar's aggregate price/fair value estimate ratio for financial-services stocks shows the sector continues to hover just under fair value. We expect a still-shaky macroeconomic environment around the world to result in volatility through the second half of the year. The European debt crisis remains somewhat unsolved, civil unrest is rising around the world, and central banks in the U.S. and Japan are taking the next steps in their unprecedented economic experiments. Despite this, some financial stocks are setting record highs. In our view, investors would thus be well-served to pick their spots when adding to positions in financial-services firms.

Industry-level insights

Investment bank and asset manager results will follow the markets
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 for the 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 MS.

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.

While there was a marked increase in flows into equities in the United States during the first quarter of 2013, flows have since tapered off, with most of the money that is still being invested in the asset class going into passively managed funds. It should also be noted that investors have not thrown in the towel on fixed income, with flows into taxable-bond funds during the second quarter of 2013 set to match the US$68 billion quarterly run rate that has been in place since the start of 2009.

Although the equity markets have stumbled somewhat during the month of June, the gains seen in the S&P 500 Index since the start of the year have driven the share prices of the asset managers up to the point where most of the names in our coverage universe are trading at or around our fair value estimates. Opportunities can arise quickly in down markets, though, as investors tend to punish the entire group, ignoring the impact that asset class diversification will have on assets-under-management (AUM) levels.

That said, we continue to be cautious on the equity-heavy names on our list including Janus Capital Group JNS and GAMCO Investors GBL, which have not had the best track record in asset gathering, relying almost entirely on market gains to increase their AUM levels. Our main focus remains on the more broadly diversified asset managers, 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.

Refinancing slowing, but borrowing growing at U.S. banks
While longer-term mortgage rates rose toward the end of the second quarter, we don't think the increase will be significant enough to counteract the persistent pressure on net interest margin experienced by U.S. banks over the last year. Banks have continued to face net interest margin pressure, albeit at a slower rate, as newly added assets come onto balance sheets at low yields. Nevertheless, banks have had modest success growing their balance sheets. Historically, banks have had their strongest loan and deposit growth during the second quarter. We expect the same pattern to hold for this quarter as well. Nevertheless, we also expect the interest spread revenue at most U.S. banks to remain the same or decline as a result of low loan yields. Looking ahead, we do not expect significant expansion of bank margins throughout 2013.

In response to tighter margins, U.S. banks continue to be diligent in addressing their expense base in an effort to maintain capital-generation capability. We anticipate U.S. banks will continue seeking ways to reduce expenses during 2013 as a way to counteract lower spread revenue. U.S. banks have taken a hard look at all areas of the company but specifically at the profitability of their branch networks. Banks are consolidating locations as the expense of underperforming branches that cannot justify their continued operation.

The mortgage-refinancing boom that has helped boost fee income at most banks over the last four quarters appears to be slowing. With mortgage rates at all-time lows for much of 2012, we have seen three to four quarters of elevated mortgage banking fees. However as the Federal Reserve ponders a reduction of mortgage bond purchases, we think increases in long-term mortgage rates will persist as the Federal Reserve exits the market. As a result, we think mortgage refinancing volumes will fall at many banks for the month of June. Thus, we question whether the refinancing boom, which has benefited bank income statements in 2012 through higher non-interest revenue, has momentum remaining.

On the mergers-and-acquisitions front, there has been little activity by the larger U.S. banks in our coverage. However, we continue to see numerous announced deals between small and micro-cap banks. Despite the lower returns on equity of most potential targets for the regional banks, the price expectation of sellers still varies significantly from what the buyers are willing to pay for those companies. We think that companies are generally sensitive about their capital positions and any impact an acquisition would have upon future Federal Reserve stress tests and capital return plans. Therefore, we would be surprised to see an announcement by one of the regional banks for a significantly sized bank acquisition.

Merger mania continues at exchanges, integration now in focus
As we look ahead to the second half of 2013, we expect financial exchanges to continue to adapt to changes in the industry environment. The aftershocks of merger activity will continue to be felt. We expect that NASDAQ OMX's NDAQ priorities will include integrating the recent acquisition of a group of investor-relations, public-relations and multimedia-solutions businesses from Thomson Reuters as well as the soon-to-be-completed purchase of the eSpeed U.S. Treasuries trading platform. The transactions are expected to shift Nasdaq's business mix further away from equities trading.

NYSE Euronext's NYX acquisition by IntercontinentalExchange ICE is on deck to be completed, likely before the end of the year. As the deal progresses, we expect to learn more about the combined companies' plans to wrest value from their derivatives operations--which are key to the deal--and how they intend to improve NYSE's equities business.

CME Group CME has recently been benefiting from improved volume dynamics that, if they persist, could help rev up the exchange's earnings power. We think competition in the options business will remain tight in areas such as options available for trading on multiple venues, but in our view an exchange such as CBOE Holdings CBOE should continue to benefit from exclusive products in areas such as indexes and futures.

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
Star Rating Fair Value
Fair Value
Capital One $75.00 Narrow High $45.00
Franklin Resources $185.00 Wide Medium $129.50
Berkshire Hathaway $130.00 Wide Medium $91.00
Data as of 6-24-13

Capital One  COF
While Capital One is still one of the top credit card issuers in the world, growth is likely to come from other loan categories stemming from its branches in high-density markets such as Washington, D.C., and New York City. Furthermore, Capital One is aggressively moving into the online space, which could be very profitable if the company is able to use its new deposits to fund high-yielding loans. We think Capital One will be able to get past its recent issues and that the stock is a bargain at current prices.

Franklin Resources  BEN
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
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 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.

More quarter-end outlook reports

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Jim Sinegal

Jim Sinegal  Jim Sinegal is a senior equity analyst for Morningstar.

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