Financials: After the Fall, Some Look Undervalued

Some analysts advise leavening your portfolio with bigger banks that are ripe for an uptick. But don't overlook deals in beaten-down brokerages

Financial stocks have taken a drubbing since March, as subprime mortgage defaults have ratcheted up, igniting fears that other, higher-grade securities could eventually be infected. That has yet to be demonstrated, but Bear Stearns' (BSC) failed efforts to salvage two of its hedge funds that were heavily exposed to the low-grade loans has raised questions about the book value of assets on some banks' balance sheets.

So far, impaired assets haven't been a problem in financial companies' second-quarter results. Of 17 major U.S. banks that have reported earnings so far, more than half exceeded Wall Street forecasts and only four came up short.

Tighter Credit Spreads Squeeze Profits

But eventually the group will see profits squeezed by tightening credit spreads, experts say. Credit spread is the difference between the low interest rates paid to banks to borrow money on a short-term basis, and the higher interest earned on money they lend to companies making acquisitions over the longer term. Higher interest rates and stricter lending standards have reduced compensation for high-yield debt securities. Lenders, in a quest for higher returns, have moved into even riskier instruments such as subprime mortgages.

The tighter credit is also causing some companies to cancel debt financing for leveraged-buyout deals and buyback plans because they don't want to pay higher interest rates on the debt. This would hurt brokers and investment banks like Goldman Sachs (GS) and Lehman Brothers (LEH), which make most of their money by advising companies on mergers-and-acquisitions activity and organizing the financing of such deals.

"Five years ago, when credit spreads were really wide, you were really being compensated for the [lower] quality of those portfolios, but since then the credit spreads of corporate debt over Treasury bonds have plunged to around 2.5% from over 10%," says Lincoln Anderson, chief investment officer at LPL Financial Services in Boston.

This year, brokers and investment banking stocks have underperformed the large banks that are more diversified and have bigger balance sheets, says Meredith Whitney, an equity analyst atCIBC World Markets in New York (Whitney owns shares of some of the companies she covers and CIBC does investment banking with brokers). Merrill Lynch (MER) shares are down 14.9% and Lehman Brothers dropped 12.8%, vs. an 8.25% slide in Citigroup (C) and a less than 2% drop in JPMorgan Chase (JPM).

Advice for Investors

So what should an investor do? Some experts think that large diversified banks are a safer bet than the brokers and investment banks that are feeling the pain both from worries about low-grade mortgage pools that they buy and sell and the tightening credit spreads. Banks such as Citigroup , Bank of America (BAC), and JP Morgan Chase are prized for the size of their balance sheets and diversified revenue streams.

Jeff Arricale, lead manager of the T. Rowe Price Financial Services Fund (PRISX), believes the investment banks are currently delivering peak returns on equity. As a result, he has been paring the $465.85 million portfolio's positions in those stocks since last year, and adding shares of the bigger, more stable, and higher-dividend-paying regional and universal banks that have underperformed the brokers over the past couple of years.

His top ten holdings, which account for about 30% of the portfolio's asset value, include universal banks such as Citigroup, regional banks such as SunTrust (STI), First Horizon National (FHN) and Wells Fargo (WFC), and insurance names like American International Group (AIG), MetLife (MET), and Prudential Financial (PRU).

He no longer has positions in Goldman Sachs, Lehman Brothers, Merrill Lynch or Morgan Stanley, but thinks they're well-managed companies and would be willing to buy them on pullbacks in price. The one broker stock he has been adding is Bear Stearns, whose valuation of 1.5 times book value is what he looks for.

Big Banks Due for a Bounce

Another reason Arricale says he believes the big banks like Citigroup and Wells Fargo are due for a bounce in valuations is that they have been victims of a flat or inverted yield curve for the past 18 months, which has narrowed the net interest spreads they rely on to make money when making loans.

"When we get to a steepening of the yield curve, we think banks will get a boost in earnings," he said. "They're sitting on trillions of dollars in earning assets." Citibank alone has $1.5 trillion in assets on which it can earn spread income, but it was earning a net interest margin of only 2.4% in the fourth quarter of 2006, compared to 4.3% two years earlier, he added.

And since they pay regular dividends with yields of 3.5% to 5%, bank stocks offer shareholders more protection from further sell-offs, compared with much lower dividend yields of up to only 2% for the brokers, Arricale said.

Picking Up Bargains

Meanwhile, some analysts are seeing buying opportunities among the beaten down brokers and investment banks. Credit concerns are likely to create a bumpy ride for brokerage stocks over the next four to six weeks, but do not signal an end for the bull market in mergers and acquisitions and leveraged buyout activity, Sandler O'Neill Partners said in a research note on July 16. "Our timing advice for investors is to be selective buyers over the next month, but make sure you exit August long on investment bank stocks," the Sandler note said. (Sandler O'Neill doesn't do investment banking with any of the brokers.)

CIBC's Whitney agrees that this is the best time of year to buy the brokers, all of which are oversold at this point. She says the brokers have outperformed the Standard & Poor's 500-stock index in 10 of the past 11 years, and she expects that to be the case this year as well. What's more, she points out that investment banks can steal the spotlight, as they can generate higher fees from new and existing products, providing greater earnings potential.

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