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By Philip Guziec

Our sector spotlight pans in on our favorite financial names in this panicky market.

We use Morningstar's proprietary industry-level data to find sectors and industries attractive for option-based investment strategies. The charts at the bottom show much the average implied volatility for each sector differs from its trailing three-month and one year average (vertical bars, indexed on the right-hand scale), the change in implied volatility from week to week (dark blue line, indexed on the left-hand scale), the implied correlations of small- and large-cap stocks with the average implied volatility of U.S.-listed equity options for reference, and the history of implied volatility for financials companies.

Sector implied volatility rose 12%-22% across the board during the last week. Cyclically sensitive industries are most uncertain relative to the trailing quarter and year.
The dramatic market correction drove uncertainty up across the board. Only real estate, health-care, and utilities now show implied volatility levels within two standard deviations of their trailing quarter and year average. Our sector standout chart below shows how much the average implied volatility for each sector differs from its average over the last year and last quarter. Vertical bars (indexed on right-hand scale) show present sector volatilities with respect to historical averages. The dark blue line (indexed on the left-hand scale) shows change relative to the previous week.

Despite the rise in uncertainty, implied correlations remain muted.
We compare the implied volatility of the options on the average small- and large-cap stocks with the options on the index to estimate implied correlations, or expectations that all stocks will rise and fall in unison. During times of panic, this measure spikes, and it approached 100% during the crash in March 2009. Although implied correlation spiked on the recent one-week drop, it still remains muted relative to the trailing-year peak, or what we consider to be panic levels.

Broadly falling prices and spiking implied volatility is best used for selling downside exposure, on undervalued names, since upside exposure is typically expensive.
Undervalued and falling share prices combined with high and rising volatility is the classic time to sell downside volatility on fundamentally sound companies.

Implied volatility on companies in the financial-services industry is at year-long highs.
The four most undervalued financial services companies that our analysts most like are Banco Santander Brasil SA/Brazil (BSBR), First American Financial (FAF), Wells Fargo (WFC), and Allstate (ALL).

Banco Santander Brasil is the third-largest non-government-controlled bank in Brazil. It has around $250 billion in assets, more than 2,000 branches, and roughly a 10% deposit and loan market share. Commercial loans constitute about 70% of its $100 billion loan book, and credits for individuals make up the rest. Traditional commercial banking provides about four fifths of the company's core earnings, while global banking is responsible for 15%; asset management and insurance make up the balance. In our view, Banco Santander Brasil has a promising future. It is part of Brazil's highly profitable bank oligopoly in which net interest margins (net interest income/earning assets) above 7% and returns on equity exceeding 20% are pretty much the norm for non-government-controlled institutions. In comparison with its two larger peers, Itau Unibanco (ITUB) and Banco Bradesco (BBD), Santander Brasil's credit quality is slightly worse, and its reserve coverage ratio (allowance for loan losses/nonperforming loans) is lower, so we think loan-loss provision expenses will remain relatively high. Nonetheless, after its initial public offering, Santander Brasil is flush with capital that it can put to work by expanding its branch network and making loans to new customers. In our opinion, this means that, absent a frightful misstep at the helm, the firm will be able to capitalize on Brazil's economic growth and credit penetration potential.

Click here for the prices of Banco Santander Brasil options.

First American is the United States' second-largest title insurer and also offers similar products internationally. The firm also has a small presence in specialty insurance, primarily homeowners and home warranty insurance. The title insurance industry took a beating when the housing market collapsed in 2007, and First American was no exception. Title premiums fell 18% in 2007 from the prior year and another 19% in 2008. First American reacted as quickly as possible by slashing costs across the board and raising prices in those states where it could. As a result, First American turned a profit in 2009 and 2010, despite a near depression in real estate markets. We think First American has rightsized its operations to benefit from a gradual improvement in housing markets, though that could take some time to develop. With costs under control, First American stands to make a small profit even if housing continues to languish, but a turnaround will lead to increasing margins. We think the firm can earn $2-$3 per share in better times.

Click here for the prices of First American options.

With the purchase of Wachovia, Wells Fargo has become a nationwide bank and was catapulted into the top tier of U.S. banks. The bank has $1.26 trillion in assets and 6,600 offices across the nation. The bank is one of the clear winners of the financial crisis, gaining a nationwide footprint. Using its package-based sales approach and concentration on getting every customer's deposit account, Wells Fargo has achieved a stable, higher-than-average net interest margin that has directly contributed to enviable returns on equity, year after year. As credit quality improves, Wells is starting to release excess reserves, padding earnings. As credit and the allowance trend closer to normal during the next two years, Wells earnings growth is likely to come through modest loan growth and its newly initiated expense savings plan. Although future asset growth might be significantly lower than historical rates, returns will still be the envy of the industry, in our opinion.

Click here for the prices of Wells Fargo options.

On the basis of premium sales, Allstate is the second-largest U.S. personal lines property-casualty insurer. Personal auto represents an increasing percentage of sales, as the firm is trimming homeowners' insurance to reduce catastrophic exposure. Life insurance contributes less than 10% of sales. Allstate products are sold in North America by independent agents, banks, and brokers, in addition to 13,000 company agents. Although the property-casualty insurance industry is very competitive, Allstate is one of the few companies to benefit from an economic moat. Its captive agents create stickier customers, which should allow the firm to generate higher returns over time. We believe that fears that the Internet will make agency business obsolete ignore the value an agent can provide for customers. Recent returns have been depressed by an unusually high level of nonhurricane catastrophes, a trend we do not expect to continue. We believe the market has overreacted to the recent results and is pricing the stock as if it will never earn a return above its cost of capital, which we believe is overly pessimistic. Furthermore, despite running into difficulties during the financial crisis, we believe Allstate has taken the right steps to lower the risk of its balance sheet and its operations.

Click here for the prices of Allstate options.


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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Option Spotlight: Cash In on Uncertainty in Financials