Financials Not Ready For Prime Time

2/23/2009


Eventually, financial stocks will mount a sustained rally and investors will make a lot of money. The question is when.

Today’s answer: We don’t know, and neither does anyone else. But we’re having a hard time finding attractive buys in the sector.

As for tomorrow’s answer, get back to us tomorrow.

On the surface, the financial sector looks cheap and overdue for a rebound. But that also appeared to be the case a year ago — before the credit crunch blossomed into a global meltdown. Nobody knows precisely when financial stocks will break out of their funk. In fact, history teaches that when the stocks finally do begin that sustained rally, many investors will be on the sidelines, waiting for an “all clear” signal that never materializes.

Timing is everything. While we aren’t yet ready to get back into financials, now is a good time to start looking for opportunities. At the moment, we see both lingering concerns and reasons for optimism in the sector.

Beaten-down, washed-out stocks litter the landscape. The average financial stock is down 47% over the past year. Among the 260 financial stocks in the S&P 1500 Index, 245 (94%) have declined, with roughly 50% cut in half. The average financial stock now yields 4.9% — more than double the norm since 1994. But 2009 is shaping up to be the worst year for dividends since World War II. No yield is truly safe.

Price/earnings ratios have contracted, though they still appear a bit stretched. Excluding P/E ratios below zero or above 75, the average financial stock in the S&P 1500 trades at 14.5 times trailing earnings — down from 17.5 a year ago and below the average of 17.2 since 1994. More than 23% of the 260 financials have posted losses over the past year, well above the norm of 4% since 1994. While falling prices have put significant pressure on P/Es, deteriorating earnings have kept multiples well above the lows seen in the mid-1990s. At the end of 1994, financial stocks averaged a trailing P/E of 10.9.

Price/book (P/B) ratios are very, very low. S&P 1500 financials average only 1.1, down from 1.7 a year ago, meaning the typical firm now trades only slightly above its book value. Book value equals the value of assets minus the value of liabilities. The long-run average P/B is 2.3. Amazingly, nearly 30% of the 260 S&P 1500 financials have P/B ratios below 0.5. Write-offs and write-downs continue to weigh on asset values, further crimping book value. P/B ratios can be low without being cheap, and investors should put little stock in financial companies’ book value, also called shareholders equity, until the market has a better handle on what troubled debt is worth. The federal bailout plan could help put a price on thinly traded securities and whole loans, but such clarity will not come overnight, if at all.

VITAL STATISTICS
Lower prices have boosted dividend yields but pressured valuations and crimped return on equity and return on investment. For example, the average financial stock in the S&P 1500 Index now yields about 4.9%, up from 2.3% five years ago. The average price/earnings ratio has retreated, but not as much the price/book ratio, which at 1.1 is now less than one-half the norm since 1994.
————— Average For S&P 1500 Financials —————
Current
1 Yr.
Ago
5 Yrs.
Ago
10 Yrs.
Ago
Since
1994
Dividend yield (%)
4.9
3.7
2.3
1.8
2.4
Price/earnings ratio
14.5
17.5
17.9
19.4
17.2
Price/book ratio
1.1
1.7
2.4
2.8
2.3
Return on assets (%)
2.7
3.3
3.0
2.6
2.8
Return on equity (%)
9.4
12.3
14.9
16.8
15.2
Return on investment (%)
6.5
8.2
9.5
11.4
10.4
Note: Averages exclude negatives and some positive outliers.

Financials earn dismal Quadrix scores. The average Overall score for S&P 1500 financials is only 37 — its worst showing in the last 14 years. Financials earn the poorest scores among the 10 broad sectors of the index, far below the next-lowest group, materials, for which the average Overall score is 49. Quadrix warned about financial stocks at the right time. Scores have declined steadily since mid-2007, about the same time the stocks began to fall. Our interest in financials will likely perk up when the sector’s Overall scores recover.

Return on equity (ROE), a popular gauge of bank profitability, has plunged. ROE (net income divided by average equity) reflects returns on the capital provided by shareholders. At 9.4%, the ratio is at its lowest point in at least 14 years and far below the norm of 15.2% during that 14-year period. While the decline in ROE is troubling, if equity (book value) declines further, returns on equity could turn out to be higher than they currently appear.

All things considered, it seems premature to conclude that the worst is behind the financial sector. Intriguing names are available at seemingly bargain prices. But an uncertain economic backdrop, the unknown impact of government intervention, and a murky earnings outlook temper our enthusiasm for the sector. And until many institutions rid themselves of the mountain of bad assets they carry, stocks could continue to languish.

While the Forecasts doesn’t provide specific guidance on sector weightings, we only recommend one financial stock for purchase. Consider that our suggestion to underweight the financial sector, which currently represents about 10% of the S&P 1500 Index’s stock-market value. In the following paragraphs, we discuss the one insurer we like and two beleaguered bellwethers from key groups.

Insurance
Until the last few weeks, Aflac ($18; AFL) had ducked most of the problems plaguing its peers. But the stock plunged in January on fears that some of the banks connected with Aflac’s $9.1 billion portfolio of European hybrid securities could be nationalized. At the end of December, Aflac valued the hybrid securities at about $8 billion, down more than $1 billion from book value. Aflac realized $262 million in investment losses in the December quarter and ended the year with $1.2 billion in unrealized investment losses, up 36% from the amount reported in September but less than 2% of its $68.55 billion in investments and cash. The stock recovered briefly from January lows but is still down 62% so far this year.

In 2009, Aflac expects sales to improve as much as 5% in both the U.S. and Japan and per-share profits to rise between 13% and 15% at constant currency. Aflac’s continued rollout of cancer and medical insurance sold in banks and post offices should drive much of that growth in Japan. Consensus estimates, trending upward over the past 60 days, project per-share-profit growth of 20% this year. Trading at four times that 2009 estimate, Long-Term Buy-rated Aflac offers plenty of upside.

Consumer finance
American Express ($14; AXP) has made several moves to stabilize its balance sheet. It converted to a bank holding company, making itself eligible for debt guarantees and $3.4 billion in U.S. Treasury loans. Amex also raised liquidity to meet funding needs for the next 12 months. A restructuring plan should lower 2009 expenses by $1.8 billion, or about 7%. Other cuts to investment and discretionary spending could save an additional $1.1 billion.

Squeezed by weak consumer spending and high credit costs, Amex remains under pressure. In 2008, per-share profits fell 29% to $2.42. Average spending by U.S. credit-card holders declined 13% in the December quarter, and rising unemployment could increase charge-offs and further reduce spending in 2009.

Credit quality is key to Amex’s profitability. While the company boasted a strong credit profile from 2002 through 2006, quality fell in the second half of 2007 and 2008 and could deteriorate further this year. These fears have weighed on consensus 2009 profit estimates, down 41% in the past month to $1.06 per share. American Express is rated Neutral.

Banks
Bank of America ($5; BAC) is off to a rocky start this year, with its stock down 65% versus a 13% decline for the S&P 500 Index. Shares trade at less than eight times expected year-ahead earnings, but that doesn’t make Bank of America a good buy. An avalanche of write-downs will probably continue in 2009 as Bank of America wrestles with falling values on leveraged loans, collateralized debt obligations, and assets related to subprime loans.

The company is bloated from more than 20 acquisitions over the last six years, spending more than $140 billion. The latest deal, an $18.5 billion purchase of brokerage Merrill Lynch, is causing heartburn. Merrill lost $15.3 billion in the December quarter, and executives are fleeing the firm. Over the last six years, Bank of America’s market capitalization fell by about two-thirds to $23.68 billion.

Bank of America received federal relief — a $45 billion cash infusion and a $118 billion guarantee for troubled assets. But such help comes at a high cost, in the form of increased regulatory oversight as well as high interest rates on the loans. In addition, the government forced Bank of America to slash its once lush quarterly dividend to $0.01 per share. Bank of America is rated Neutral.

GLOOMY PROFIT PICTURE
Regardless of industry or niche, financial stocks in the S&P 1500 Index have seen their profit outlook for 2009 deteriorate in recent months. For example, asset-management firms on average are expected to see per-share earnings fall more than 20% this year, with earnings estimates revised downward by 8% over the past month and 18% over the last three months.
— Estimated 2009 Per-Share Earnings —
——–— Revisions —–——
Avg.
Change
(%)
1
Month
(%)
3
Months
(%)
Asset Management & Custody Banks
(20.7)
(8.4)
(18.1)
Consumer Finance
(20.0)
(30.0)
(38.1)
Investment Banking & Brokerage
8.4
(7.7)
(19.6)
Life & Health Insurance
5.6
(3.4)
(11.0)
Multiline Insurance
6.0
(4.2)
(13.9)
Office REITs
(5.4)
(1.4)
(4.0)
Property & Casualty Insurance
1.2
(5.1)
(4.9)
Regional Banks
(15.5)
(28.3)
(35.6)
Residential REITs
(7.2)
(8.7)
(13.2)
Retail REITs
(4.1)
(5.1)
(10.6)
Specialized Finance
(6.7)
(9.5)
(17.7)
Thrifts & Mortgage Finance
2.9
(14.8)
(18.4)

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