The strong survive. That's the logic behind investing in financial-services stocks whose prices have been battered in the subprime mortgage mess.
The best-run firms with quality core businesses will turn out to have been bargains once the storm calms down, some experts said. The weaker ones will likely have been washed away, merged or diminished in size.
Of course, this represents a leap of investor faith that carries risk because no one can say with certainty when the credit trauma will end or if it will worsen significantly. A recession, for example, could drive down stocks in the sector even further.
"A lot of good companies are getting thrown around with a lot of the less-stable ones, and the credit environment is getting worse," said Jeffrey Arricale, portfolio manager of the $416 million T. Rowe Price Financial Services Fund, whose one-year annualized return of 6 percent places it in the top third of financial-services funds. "We have been somewhat defensively postured but are getting more aggressive."
Some stocks in the financial field have been unfairly punished and are worth owning, Arricale said.
For example, Lazard Ltd. is down 19 percent this year but doesn't even lend money, he said. Rather, it has a global brand in investment banking. Two-thirds of its business is mergers and acquisitions, with one-third asset management. Half of its business comes from outside the United States.
American International Group is down 11 percent despite its minimal exposure to any subprime loan collateral, Arricale said. It derives two-thirds of its business from insurance and has significant and growing operations in China and Japan.
H&R Block Inc. is down 15 percent in the midst of some board turmoil and shareholder controversy over management goals and execution. Yet it derives two-thirds of revenues from lucrative tax operations that could be made even more profitable in the future, Arricale said.
"The credit crisis has been overblown, but if you think it actually has planted seeds of recession, then it isn't time for you to buy financial stocks," said James Paulsen, chief investment officer for Wells Capital Management in Minneapolis. "Even if you believe we're going to get through this just fine, you might instead choose industrial, tech or retail stocks because of less balance sheet risk than financials."
Paulsen said most big money center banks have only a small amount of mortgage exposure, insurance companies very little direct exposure and regional banks even less.
"There is still risk in the financial-services stocks, though the real problem is that we can't quantify it," said Richard Bove, the Tampa-based financial institutions analyst for Punk, Ziegel & Co. of New York. "For example, there are trillions of dollars worth of a variety of debt securities out there and we don't have a clue about what they are and what they are worth."
Bundling mortgages into securities for sale to investors had been a highly profitable business for some time, but hundreds of bonds have since been downgraded by the ratings agencies. With all those variables in mind, an investor who buys a financial stock now is making a "religious" commitment rather than basing it on underlying numbers, said Bove, who currently categorizes himself as a bear on the sector.
Nonetheless, Bove expects the government will provide a massive bailout of the mortgage sector. He recommends shares of Washington Mutual Inc., Wells Fargo & Co. and SunTrust Banks Inc. He'd steer clear of pure mortgage companies.
The best stock values among financial-services companies are found in the insurers, Arricale said, especially Genworth Financial Inc., Prudential Financial Inc. and MetLife Inc., all of which he owns. In addition, Bear Stearns Cos. and UBS AG are investment banks he recommends and owns.
Credit Suisse Group, one of the world's largest private banks and wealth managers in terms of client assets, is recommended as a bargain by Morningstar Inc. Although the investment banking that makes up the bulk of its profits can be cyclical, the wealth-management business is steady and highly profitable.
Other financial-services stocks that Morningstar considers worthy of purchase are CapitalSource Inc., E-Trade Financial Corp., Newcastle Investment Corp., Bank of America Corp., American Express Co., Progressive Corp. and Lehman Brothers Holdings Inc.
As always, a lower price in any stock is never assurance you're getting a bargain.
"If we get through this crisis, the financials and the retailers are really going to bounce back and the stock market will hit new highs," Paulsen said. "However, if economic reports start going south to the point where recession is a possibility, we'll see the stock market go down to significant lows."
Andrew Leckey is a Tribune Media Services columnist.Copyright © 2015, CT Now