We entered this year very bullish on the financial sector. And to date, the group has produced: Financials were the best-performing sector in the first quarter of 2012. In light of the sharp bounce, the question arises: Is it too late to buy financials?
Our answer is no. We believe the most recent quarter is the beginning of a multi-year period of strong relative and absolute returns for the sector.
While financials will continue to have headline risk, and although the new regulatory environment is forcing them to change their business models, the earning power of leading financial companies is greatly underestimated.
The fundamentals of the sector began to turn positive about 12 to 15 months ago, and we expect to see several very favorable developments during 2012.
Some of the positives that have quietly taken hold since the 2008-2009 crises are:
- Industry-wide additions to equity and reserves, leaving financial companies' balance sheets in the best shape in more than a decade.
- Significant write-downs of bad debts.
- Limited exposure to the European credit crisis.
- Improving credit trends in business and consumer loans and in credit card portfolios.
Some of these changes were below the radar as the stocks continued to suffer in 2011. But meanwhile, the fundamental story was improving. As we move through 2012, the results of these actions will be increasingly positive and visible.
The recent Fed-mandated stress test demonstrated that the U.S. banking system is in rock-solid shape -- most banks passed with flying colors. Immediately after the stress-test results were released, a number of financial institutions announced significant dividend increases and share buybacks. Loan activity is finally starting to pick up, and residential real estate is clearly bottoming; many areas of the country are actually showing signs of life.
Notwithstanding future periodic setbacks, the tide has turned, and we believe there is much more upside in select names over a multi-year period.
Among the financials we like here are the following four. We are focusing on dominant franchises that have strong fundamentals and compelling prices:
MetLife (MET) is a leading company in the global life insurance industry. The firm remained profitable during the 2008-09 financial crises and did not participate in TARP. With the acquisition of Alico Life from American International Group, MetLife re-accelerated its long-term growth rate. International operations now account for 30% of earnings, compared with 10% pre-2008. At the recent price of $36.82, MetLife trades for just 72% of book value of $51 and 7.0x 2012's EPS of $5.25. MetLife has historically traded above book value and at more than 10x earnings. We expect its return on equity to improve from 10% in 2011 to 13% by 2014. Its exit from banking and from Fed oversight later this year should be an additional catalyst to drive the stock higher.
Wells Fargo (WFC) was one of the few banks that did not lose money on an annual basis during the recent financial crisis, and it opportunistically bought Wachovia Bank at a distressed price. At its recent price of $33.88, Wells Fargo trades for just 10.3x 2012's EPS of $3.30, compared with a historical premium to the group at 13x to 14x earnings. We expect Wells' return on equity to improve from 13% to 18% within three years. Elevated credit losses and expenses for integrating Wachovia are masking the company's true earnings power. The post-stress-test 83% increase in its dividend is a show of its strength and its commitment to reward shareholders.
State Street (STT) is a long-term winner in global custody and asset-management services. State Street was also one of the few banks that did not post losses during the 2008-09 financial crises. The firm continues to garner global market share through astute acquisitions. At its recent price of $44.60, State Street trades for just 10.1x 2012's EPS of $4.40. State Street has historically traded at a premium to the group, at 15x-plus earnings. The firm's profitability has been significantly depressed by the low-interest-rate environment. The inevitable rise in interest rates will be an additional catalyst to accelerate the stock's move higher.
Morgan Stanley (MS) is emerging as a dominant force in the brokerage/investment-banking industry. The new CEO, James Gorman, has dramatically reduced risk-taking while simultaneously diversifying the firm into a steadier stream of lower-risk income with the acquisition of Smith Barney. At the recent price of $18.69, Morgan Stanley trades for just 67% of its $27.95 tangible book value. It should be able to earn $3-plus per share in the coming years. Morgan Stanley has historically traded for well above 1x book, indicating appreciation potential of more than 50% from current levels.