Editor's note: In today's part two of our U.S. equities roundtable, the trio of portfolio managers discuss post-meltdown picks in the financial-services sector.
Our panellists: Brad Willock, vice-president and senior portfolio manager, U.S. equities, at Toronto-based RBC Global Asset Management; Janet Navon, managing director, director of research and a member of the U.S. investment team at New York-based Epoch Investment Partners Inc., whose clients include CI Investments Inc.; and Gavin Ivory, vice-president, global equities, and head of the global equity team at Toronto-based Beutel Goodman & Co. Ltd. They spoke with Morningstar columnist Sonita Horvitch, whose three-part series began on Monday and concludes on Friday.
Q: The U.S. financial-services sector has undergone a major restructuring after the financial meltdown. Are there opportunities?
Ivory: We have had about 10% of the U.S. portfolio in this sector for some time. U.S. financial-services stocks have become of particular interest to us now, compared to what we see elsewhere in the world. The stocks are cheap. There have been so many issues affecting the U.S. financial-services industry. The most recent one is how the mortgage foreclosures were processed.
Navon: It will be costly for the banks to delay the process. It depends how long this takes.
Ivory: The banks were trying to get rid of the delinquent loans as fast as possible. This latest issue delays that process.
Willock: There has been an attempt to scope the size of the problem. Some investment managers have taken the most liberal view of the problem.
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| Janet Navon: In the big rally in the U.S. equity market in the last quarter, the banks were real laggards. | |
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Ivory: You can make the numbers up and it is difficult to refute them. The U.S. banks are in a different position than they were a year ago. They have raised capital and this is the cushion they will use to fight any litigation that results from this.
Navon: In the big rally in the U.S. equity market in the last quarter, the banks were real laggards. In the large-cap sector, we like names like MetLife Inc. MET and Prudential Financial Inc. PRU, which in addition to insurance are involved in wealth management. These are the two biggest financial-services holdings in CI American Value 
. We also own mutual-fund company Franklin Resources Inc. BEN and discount broker TD Ameritrade Holding Corp. AMTD.
Prudential recently traded at US$53 and is going to produce almost US$7 per share in earnings in 2011. It is a well capitalized business that is in a position to take market share from others. You also have greater transparency into insurance companies' asset bases than you do for the large money-centre banks. MET and PRU are generating lots of great cash flow. We are generally not involved in an investment bank, like Goldman Sachs Group Inc. GS or a money-centre bank, because so much of their income is non-recurring. In Goldman Sachs, you are relying on its trading desk to deliver again and again. A reason why our weighting in the financial-services sector went up recently is because we sold our holding in Visa Inc. V and bought some American Express Co. AXP. Visa is in the technology sector and American Express is in the financial-services sector.
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| Gavin Ivory: Wells Fargo is consistently one of the most profitable banks in the United States and the stock is cheap. | |
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Ivory: We own Fiserv Inc. FISV, which is a transaction processor for banks. It is in the same boat as it is in the technology sector. In financial services, we also own MetLife, which is a major weighting in the portfolio. Our biggest holding in financial services is Wells Fargo & Co. WFC, which made a timely acquisition of troubled rival Wachovia Corp. at bottom-of-the-market prices towards the end of 2008. Wells Fargo is consistently one of the most profitable banks in the United States and the stock is cheap.
Q: Janet and Gavin, your investment styles are similar.
Navon: We are cash-flow-oriented investors. We are long-term investors and have a low turnover. We like businesses that we can hold for the long term with a preference for businesses with recurring revenue streams. We look at the downside risk too.
Ivory: This is our approach. To us, the preservation of capital is paramount. We value every business on the basis of the present value of sustainable free cash flow. We have a low turnover and a concentrated portfolio of less than 30 names. We will make our investments below business value, with a minimum 50% total return over three years.
Navon: We have a similar requirement. In CI American Value, we have 40 to 60 names.
Willock: In RBC U.S. Equity , which is about US$2.5 billion, we have about 100 names. We are underweight financial services in the fund. Within the sector, we are overweight insurers, REITs (real estate investment trusts) and mutual-fund companies. Our biggest holding is JP Morgan Chase & Co. JPM. The stock has been one of the better performers among the banks. But the U.S. banks are out of favour, as there is so much uncertainty surrounding them. We also own Prudential and Franklin Resources. Another holding is ACE Ltd. ACE, a global insurer.
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| Brad Willock: U.S. banks are out of favour, as there is so much uncertainty surrounding them. | |
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Ivory: I am more favourably disposed toward banks than Brad and Janet. This is where the value is. We are looking at regional banks, which have been relentlessly pounded by an endless stream of significant and serious issues. The bad news will end.
Navon: My concern is that these regional banks are exposed to commercial real estate.
Ivory: Top-quality U.S. regional banks are cheap relative to book value. When we look around the world, U.S. banks stand out for us.
Willock: We do not have a three-year investment horizon. We think in terms of six to 18 months and often shorter. Our turnover is two or three times that of Janet and Gavin. We do not buy stocks before they start getting better.
Q: Can you provide a summary on the U.S. financial-services sector?
Navon: I would like to caution that the levels of profitability in the U.S. banks are unlikely to revert to what they were before. It is a leveraged business and if you reduce this leverage, it reduces the return on equity. You also have to put all the off-balance-sheet business on the balance sheet, which has capital implications.
Ivory: This is in the stock prices.
Willock: For the last decade, U.S. banks had a return on equity of 16% on average. Now the expectation is for a ROE of 10%. But, after the concerns about the banks' management of mortgage foreclosures, this could be high. Investors should be aware of this.
| JP Morgan Chase & Co. |
Wells Fargo & Co. |
MetLife Inc |
Prudential Financial Inc. |
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| Oct. 26 close | $37.20 | $25.91 | $40.51 | $53.52 | |
| 52-week high/low | $35.16-$48.20 | $23.02-$34.25 | $32.16-$47.75 | $43.41-$66.80 | |
| Market cap | $148 billion | $136.6 billion | $33.5 billion | $25.2 billion | |
| Total % return 1Y* | -14.7 | -8.2 | 14.7 | 13.1 | |
| Total % return 3Y* | -5.9 | -6.6 | -15.0 | -17.0 | |
| Total % return 5Y* | 3.2 | 0.3 | -2.4 | -3.9 | |
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| *As of Oct. 26,2010. All figures are in U.S. dollars Source: Morningstar |
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Photos by: www.paullawrencephotography.com
