In Financial Services, Fund Skippers Bank on Regionals, Thrifts
No doubt banks rejoiced Tuesday after
Federal Reserve policymakers signaled that interest rate cuts are forthcoming. Now, if the Fed could only do something about problem loans and sagging equity markets that put a crimp on earnings.
Financial behemoths like
Chase and
Bank of America have already warned of earnings shortfalls. Fund managers say more problem loans and charge-offs are likely at big, diversified banks, while pure-play investment banks and asset managers will be hurt by soured capital markets.
Against that backdrop, where are fund managers finding their favorite picks in the financial-services landscape? While they think a rate reduction would likely help sentiment for financials on the whole, until credit problems get ironed out, it's the unflashy, low-risk outfits they like.
But those kinds of companies aren't so easy to find because, following the repeal of the Glass-Steagall Act, banks and insurers have stepped up their moves into volatile, high profit-margin businesses like brokerages and asset management. "It's a very incestuous kind of thing lately. Very few people are immune from anything in this environment," says Marc Halperin, a manager at
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Federated Global Financial Services.
One area that's attracted some interest is regional banks with little exposure to risky corporate loans. Regionals generally look cheap relative to their national counterparts. Money managers also like mortgage lenders, which should benefit from any impending reductions in interest rates and are considered to have high credit-quality portfolios (unless the economy really nosedives, people aren't likely to default on home mortgages). Property casualty insurance is another area that's considered to be relatively insulated from market turmoil, and should benefit from improved industry pricing.
The bad news, even in those favored groups, is that a lot of gains have already been made. For a couple of years in the past, financials had lagged behind as investors piled into sexy growth plays. But in 2000, the sector has posted a banner performance. The
Standard & Poor's Financial Index
was up 15.6% through the end of November, assuming reinvested dividends, compared with the
S&P 500's
loss of 9.5% through the same period.
"Many of the names at this level are a call on a hard or soft landing," says Meggan Walsh, a manager at
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(GFSAX)
AIM Global Financial Services. "If you believe in a soft landing, you can support the valuation. If you believe in a hard landing, you can't."
Financials remain relatively cheap next to the broader market, with many P/Es in the high single digits, compared with P/Es in the teens when the sector peaked a couple of years ago. But leading names in some of the relatively safer areas aren't as cheap as they once were. In the year to date,
Washington Mutual
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, a thrift, is up 86%, while savings and loan
Golden West
(GDW)
is up 82%. "Valuations reflect much of the upside," says one fund manager.
Some investors in financials are simply betting that the stocks will keep rising past the point of fair valuation. "Generally, industries and stocks start their move when they're very underpriced, and don't peak out until they're very overpriced.
Financials haven't reached the overprice typical of peaks," explains Craig Callahan, chief investment officer at
Meridian Investment Management
.
By his calculations -- using an equation based on one developed by
Benjamin Graham
-- banks as a group remain 10% underpriced. For that reason, Callahan has maintained weightings he established earlier in the year of around 20% to 25% in financials for separate accounts held at Meridian. Though some of those holdings have posted very solid gains, he's still hoping to squeeze out more upside.
Based on valuations, Callahan especially likes regional banks. Two favorites in his sector fund,
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Icon Financial, are
Downey Financial
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and
National Commerce Bancorp
(NCBC)
. (Callahan, a quant guru, doesn't focus much on the fundamental stories of the stocks he owns.)
Henry D'Auria, manager of
(EGFYX)
Enterprise Global Financials, is also overweighted in regional banks. "National banks today are trading at a higher multiple, despite having what we think is more downside," he explains. Besides being relatively cheap, regionals have low exposure to equity capital markets, a plus given the pounding equities have taken this year. D'Auria says he's steering clear of banks that have generated a lot of earnings from gains on venture capital or that have a significant underwriting business. Some of the companies
considered vulnerable to slowdowns in those areas are
Chase
(CMB)
, which is buying
J.P. Morgan
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,
Citigroup
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, which owns
Salomon Smith Barney
, and
FleetBoston Financial
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, which owns
Robertson Stephens
.
Among regional banks, one favorite is
Bank One
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. "We think that their credit card business is undervalued and that Jamie Dimon is the type of manager who will help shareholders realize full value for the company," says D'Auria. Plus, the stock trades at a "reasonable" multiple of about nine times earnings. He also likes
Huntington Bancshares
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and
Regions Financial
(RGBK)
, which just
announced it will buy boutique investment firm
Morgan Keegan
.
Adopting a similar strategy,
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FBR Financial Services manager David Ellison says he's buying companies without much credit risk. He likes residential mortgage lenders since, if the Fed cuts interest rates, they'd benefit from a drop in their borrowing costs. Ellison says mortgage lenders are "now sitting there with the potential to have the cost of
borrowing funds decline faster than their yield on assets." Among Ellison's holdings, Washington Mutual and
Astoria
(ASFC)
are thrifts with sizable lending businesses; other plays on the theme are federal lender
Freddie Mac
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and savings and loan
Golden West
(GDW)
.
Another group that's attracted a lot of attention -- enough to give a nice boost to the stocks' prices this year -- is property casualty insurance. For one thing, these stocks are relatively insulated from the problems emerging among bigger financial players. "They don't really have any exposure to nonperforming loans, they don't have exposure to syndicated lending, bridge financing, or asset management," explains Federated's Halperin, who has holdings in the area.
More importantly, pricing across the industry has started to firm up recently after about 15 years of cutthroat competition.
The bad news: After years of enduring investors' snubs, these plain-Jane stocks saw a resurgence in interest earlier this year, and as a result their prices have already gotten a boost. Weston Hicks, who covers property casualty insurance at J.P. Morgan, says many now trade within 10% to 20% of fair value. "A year ago, the list of stocks in this group trading at discounts to net asset value was very long, and expectations for a recovery in industry pricing were very low. Now, with many of the stocks up from 80% to 100% from their lows, valuations are nowhere near as attractive as they used to be."
