The third quarter did little to assuage investors' fears, as an untenable debt situation in Europe continues to threaten many of the continent's financial institutions. Additionally, the U.S. economy remains listless, with the European situation increasing the possibility of a double-dip recession.
Investors should not expect to get rich quickly by investing in financial stocks. The major factors contributing to depressed prices--a pan-European debt crisis, continued deleveraging in developed economies, and an uncertain regulatory environment in US--are unlikely to be resolved soon. The effects of higher capital levels on profitability are yet to be determined, and several U.S. and European institutions are facing multibillion-dollar lawsuits over their mortgage-related behavior during the boom years. We therefore see few catalysts that are likely to drive financial stocks higher in the near term.
Along those lines, stock selection may be more important in financial services than in any other sector. Much as in 2008, inadequate balance sheet capital and questionable asset quality could mean that many companies' stocks are not as cheap as they might appear, particularly names with significant European exposure. For firms with capital to deploy, the potential to grow will prove valuable, as many companies will struggle to expand their balance sheets and top lines as customers pay down debt and regulators continue to crack down on sources of fee income. Companies with the ability to win market share from troubled peers and those with a presence in developing markets could be great investments at the right price.
As always, we believe competitively advantaged narrow- and wide-moat firms are best positioned to deal with near-term headwinds and thrive at the expense of troubled peers.
Jim Sinegal is the associate director of the financial team at Morningstar.
