4 Financial-Sector Stocks to Watch

Find out which UK bank has earned a space on Morningstar's list of favourite financial sector stocks

Stephen Ellis 2 January, 2014 | 10:58AM
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Long-time favourites such as Capital One Financial (COF) and Berkshire Hathaway (BRK.B) are reappearing on the list this quarter. However, we’re also adding insurer Aegon (AGN) and Lloyds Banking Group (LLOY). For Aegon, we think it is being treated more like a European insurer when it generates the majority of its profits within the United States and it has yet to receive substantial investor recognition for its turnaround efforts. We see potential in Lloyds as it moves beyond its legacy issues towards a brighter future in the cosy UK banking market.

Aegon

We believe that the market does not fully understand the company's operations, which is ultimately being reflected in its share price. While the firm generates more than 70% of its profits from its US-based Transamerica franchise (with the rest coming from the UK and the Netherlands), investors continue to treat it like it is a European heavy insurer with limited growth opportunities. The company has also received little recognition for its turnaround efforts in the aftermath of the financial crisis, which have involved de-risking its business and making a gradual shift towards a more fee-based revenue model. As such, Aegon has been trading at around 0.5 times book value, not much higher than the 0.4 times book value seen on average between 2009 and 2012, and well below the average price/book multiple of 1.2 times from 2003 to 2008.

Berkshire Hathaway

We remain impressed with Berkshire Hathaway's ability to generate growth in book value per share in excess of its benchmark, believing it will take some time before the firm succumbs to the impediments created by the sheer size and scale of its operations, as well as the longevity of Warren Buffett and Charlie Munger. The company’s shares continue to trade at a discount to our fair value estimate, providing investors with the potential for double-digit upside from today’s market prices. We would also note that Berkshire has effectively created a floor under the company's stock price by announcing that it would buy back both Class A and Class B shares at prices up to 120% of reported book value (which stood at $126,766 per Class A share and $84.50 per class B share), implying downside protection for investors at prices 10%-15% below current trading levels.

Capital One

We think Capital One is undervalued because of the following factors: loan growth in automotive and commercial lending is not being considered in the valuation; under-appreciation of the firm’s credit quality as total non-performing loans represent only 1.5% of total loans. Capital One is still a top five credit card issuer in the world, but it is also a misperceived company in transition. Credit card loan growth will be challenging as Capital One repositions its portfolio to more traditional commercial bank lending. However, Capital One has good prospects for loan growth in automobile lending with its US platform, and commercial lending done locally in high-density markets like New York and Washington DC In addition, funding is not an issue as CapOne completed the acquisition for $83 billion in online deposits from ING’s (INGA) US operations (now called CapitalOne 360) during 2012, which has significantly helped liquidity, adding lower-cost funding.

Lloyds

We've long seen the UK's concentrated banking market as particularly attractive and we think that Lloyds, as the only UK retail-focused bank, is poised to prosper as the British economy recovers. We're encouraged that Lloyds has run off 60% of its non-core portfolio since 2010 and that credit quality in Ireland finally seems to be turning the corner—as result, we think that the strength of Lloyds' core businesses, rather than losses from legacy businesses, will be the primary driver of profits going forward. We're also impressed with Lloyds' strengthened capital position, which we think may allow the bank to pay a nominal dividend for 2013 and will almost certainly allow for a substantial dividend in 2014.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Stephen Ellis  Stephen Ellis is a senior stock analyst on the Energy Team.