What's Ahead for Financials
What's your outlook on interest rates, and how does that feed into your stock selection?
The Fed will talk about raising rates but isn't going to do it anytime soon. This is too fragile a recovery to take away the punch bowl.
A year ago, I owned a lot of companies tied to the mortgage market, particularly real estate investment trusts such as American Capital Agency (AGNC). These companies got a lift as the Federal Reserve aggressively cut rates. The easy money has been made there. Now they're caught in a no man's land as rates bottom out. It's an area I'm avoiding.
Who benefits in a low-rate environment?
I like banks because they're getting core deposit inflows from saving, checking, and money-market accounts for the first time in decades, instead of noncore deposits such as certificates of deposit. Core accounts cost banks very little to operate. Until recently banks were in an interest rate war. Weaker banks gathered the bulk of deposits by offering higher yields on certificates of deposit. That forced other banks to match those rates, cutting into profits.
I'm also eyeing banks that gain market share by rolling up troubled rivals. A good example is BB&T's (BBT) purchase of Colonial BancGroup (CBCGQ) in August. BB&T bought most of Colonial's assets from the Federal Deposit Insurance Corp. in a deal that could boost earnings by as much as 50 cents a share. The FDIC agreed to shoulder about half of Colonial's losses.
My portfolio is full of smaller banks that I expect will work out similar kinds of deals with the FDIC. One is 1st United Bank (FUBC), which had a $40 million market capitalization but just raised $70 million. That's how confident the market is in funding stronger banks.
Some big insurers are among your top holdings. Who will be the winners there?
I expect the winners to be the stronger companies, even though the winners in the equity markets lately have been companies that took money from the government to stay afloat. Credit quality still matters a lot. Take MetLife (MET), the nation's largest life insurance company. Even after $1.4 billion in credit losses, the average bond in its portfolio is rated single-A. By comparison, its competitor Torchmark (TMK) owns lower-rated debt.
In property and casualty, Travelers (TRV) is boring, and boring is still good. Property-and-casualty prices have stayed stable because there's too much capital in the industry—we haven't had massive hurricanes or other disasters that deplete that capital safety net. American International Group (AIG) is cutting prices to retain business, but they're grasping at straws because consumers want policies from companies that aren't being propped up by the government.
Travelers and MetLife have a chance to acquire weaker AIG units. Both stocks stand to gain 10% to 20% with the right acquisition.
Will third-quarter earnings for the sector mirror the second quarter, when companies beat earnings estimates but revenues lagged?
The third quarter is going to be different because you have a lot of noncash events going on. Companies that reported unrealized losses in the past will now have unrealized gains. There is going to be a huge uptick in the value of corporate debt, and investors will see those gains reflected in stock prices.