Be careful with financials
Yield hunters beware: In the financial sector, even the strongest companies appear vulnerable.
With fallen giants Merrill Lynch ($20; NYSE: MER) and Washington Mutual being taken over and such notables as Citigroup ($15; NYSE: C) and American International Group ($2; NYSE: AIG) scrambling to raise capital, investors should be wary of even the biggest names.
The most obvious fallout from the mortgage and credit crisis — sharp declines in stock prices — has caused dividend yields to jump. The average financial stock in the S&P 1500 Index has delivered a negative 27% return over the last year, with only 53 of the 253 stocks up.
But dividend cuts have become commonplace in recent months, and it’s still a bit early for bottom-fishing. All too often, the factors that caused a stock’s price to fall could also cause its dividend to shrink. Before you dive into treacherous waters, consider two things:
First, the number of players has shrunk, with many of the survivors likely to emerge much larger than they are now. Investment angle: Bigger doesn’t always mean better. Shotgun deals may end up saddling buyers with more liabilities than they expect.
Second, the government will sometimes take on the risk of dubious securities to protect financial firms. Investment angle: Until the market gets a better idea what these troubled securities are worth — government auctions should help in that regard — stock valuations remain in doubt.
Now that many financial companies enjoy federal backing and trade at historically low levels, value or income investors might wonder which stocks to pick up. For now, we suggest avoiding the whole mess, with one exception: insurer Aflac ($49; NYSE: AFL).
Rough road ahead
The immediate future for America’s largest financial companies looks bleak. Citigroup reported an operating loss for its fourth consecutive quarter, including a $1.44 billion loss on credit-card loans packaged into bonds. September-quarter profits for J.P. Morgan Chase ($42; NYSE: JPM), Bank of America ($25; NYSE: BAC), and Goldman Sachs ($95; NYSE: GS) fell at least 70%. American Express ($30; NYSE: AXP) announced plans to cut 10% of its work force — and warned it does not expect to meet financial targets until conditions improve.
A multibillion-dollar commitment from the federal government should help shelter beleaguered banks as the next wave of defaults hits, an ugly assortment of bad loans for automobiles, commercial real estate, and small businesses. Companies with the financial resources to buy rivals have an advantage, but the balance-sheet risks they inherit can be difficult to measure.
Just two years ago, for example, Wachovia ($7; NYSE: WB) acquired Golden West Financial for $25.5 billion. By the end of next year, Golden West’s loan losses are expected to reach $26.1 billion, more than Wachovia paid for the mortgage lender. The bad mortgage loans contributed to Wachovia’s downfall, and Wells Fargo has now agreed to purchase all of Wachovia for less than half of the price Wachovia paid for Golden West.
As a whole, the financial sector looks unhealthy. The average Quadrix Overall score for the financial stocks we cover is just 38, reflecting subpar fundamentals. In the following paragraphs, we discuss two troubled industries.
Brokerages are dealing with bad investments that led to huge write-downs, which in turn sapped investors’ confidence and drove down stock prices. To survive, Merrill Lynch ($20; NYSE: MER) agreed to sell itself to Bank of America ($25; NYSE: BAC), while both Morgan Stanley ($19; NYSE: MS) and Goldman Sachs ($95; NYSE: GS) became bank holding companies. Commercial banks have easier access to low-interest loans and insurance on deposits.
Brokerages have increased their leverage in recent years. Morgan Stanley’s assets/equity ratio (also called the financial-leverage ratio) trended upward for five years before peaking at 33.6 in the August 2007 quarter, well above the 10-year average of 26.6. Goldman and Merrill also had higher-than-average financial leverage in the second half of 2007. All three of the big brokers have since become more conservative.
In the most recent quarter, Morgan and Goldman had leverage ratios of 27.6 and 23.7 respectively, levels just above the companies’ 10-year averages. Brokerages tend to run at higher leverage ratios than banks. The average financial-leverage ratio for the 10 largest U.S. banks was 12.7 in the most recent quarter and 12.1 over the last 10 years. While Morgan and Goldman have gone commercial, they have not revealed whether they intend to continue deleveraging until they look more like traditional banks.
Morgan and Goldman may have pre-empted government takeovers by finding their own financing. Morgan received a $9 billion investment from Japan’s Mitsubishi UFJ Financial Group in exchange for a 21% share of the company. Goldman sold $5 billion in preferred stock to Warren Buffett’s Berkshire Hathaway ($3,950; NYSE: BRKb) and issued $5 billion in new common stock. In September, Goldman reportedly approached Citigroup ($15; NYSE: C) to propose a merger, though no formal talks were held.
While the brokers trumpet their strong capital position, the market lacks confidence in the financial sector in general, and brokerages in particular. All three of the big investment banks are down at least 55% this year, worse than the S&P 1500 Financial Sector Index’s 42% decline. Morgan, Goldman, and Merrill are rated Neutral, and we would not want to own any of the stocks at this time.
The financial crisis has whetted big banks’ appetites for acquisitions, and none seems hungrier than Wells Fargo ($35; NYSE: WFC). A $14.9 billion deal to buy Wachovia will give Wells Fargo one of the most extensive banking networks in the nation, with more than 10,700 branches. The deal also leaves Wells Fargo with a loan portfolio that could generate $65 billion in losses.
Other large, relatively strong banks — such as J.P. Morgan Chase ($42; NYSE: JPM) and Bank of America ($25; NYSE: BAC) — have gobbled up ailing financial firms in recent months. J.P. Morgan paid $1.4 billion for Bear Stearns and has agreed to buy Washington Mutual’s banking operations from the government for $1.9 billion. Bank of America will purchase Merrill Lynch ($20; NYSE: MER) in a deal now worth about $31 billion. Further consolidation is likely, as those companies strong enough to obtain financing absorb the weak.
Most banks posted anemic profits in the September quarter, but Wells Fargo and J.P. Morgan topped consensus estimates substantially, helped by a “flight-to-quality” effect — both appear to be perceived safer than other banks, which provides an advantage in attracting customers. In an effort to address its problem mortgage loans, J.P. Morgan said it will delay all foreclosures for 90 days, offering about 400,000 homeowners loans with different terms. Morgan didn’t estimate the cost of the program, but preventing a large number of loans from going into foreclosure could reduce losses in coming quarters. Wells Fargo, J.P. Morgan, and Bank of America are rated Neutral, as we are not confident in their financial strength and profit potential.