Financials: From Zero To Hero

Includes: ALL, BCS, TRV
by: Elliott Gue

Financials were the worst-performing sector in 2011, with the S&P 500 Financials Index falling more than 17 percent compared to a total return of about 2.1 percent for the broader market including dividends.

But so far this year the picture is the exact opposite with the erstwhile laggards, financials and materials stocks, leading the market higher while last year's big winners including utilities and consumer staples lag the broader indexes.

The litany of headwinds facing the banks is well-known and widely recognized including the ongoing sovereign credit mess in the European Union, weak loan demand in the U.S., the still-moribund U.S. real estate market and an increasingly unfavorable regulatory environment. But despite the ongoing drumbeat of bad news facing the banks, the sector has more or less been trading sideways since midsummer (see my chart below for a closer look).

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Moreover, the S&P 500 Financials Index failed to make a new low in late November even as the yields on Italian government bonds spiked well over 7 percent and the EU sovereign credit crisis appeared to intensify. When markets fail to react to bad news it can be a sign that the worst is already priced in and there's opportunity for some near-term upside.

In addition, banks are only one segment within the financials industry. Property and casualty insurance companies have been outperforming the rest of the financials sector since the beginning of the fourth quarter thanks to the first sustained upward momentum in commercial and personal lines insurance premium pricing since 2005. The group continues to trade at a historically attractive valuation.

In my Friday January 13th Seeking Alpha article "7 Stocks on My Watchlist," I profiled seven companies I am considering as short to intermediate term trade ideas in my Cocktail Stocks service, including banking giant JPM Morgan (NYSE:JPM). Here's a look at three more financials stocks that are setting up for further upside.

Travelers (NYSE:TRV) - Travelers is a property and casualty insurance company formed through the merger of Travelers and St. Paul completed in April, 2004.

The company does sell personal lines insurance products such as the automobile and homeowner's insurance offerings familiar to all consumers but its largest division is business and commercial. The business insurance segment offers worker's compensation products, commercial property and automobile insurance, general liability protection and a number of industry specialized products such as policies aimed at the energy industry.

Insurance companies make money through two main avenues: underwriting profits and investment gains. Insurers generate underwriting profits when premiums paid by policyholders exceed the amount of cash paid out as insurance claims plus expenses related to processing claims and selling policies. But, insurers don't just sit on the cash they take in as premiums; instead, that capital is invested in a portfolio of bonds and, to a lesser extent, stocks to earn a return on investment over time. The returns earned by this portfolio constitute investment income.

The environment for insurance underwriting has improved significantly since the beginning of 2010. The severe global economic downturn of 2007-09 reduced demand for insurance; after all, when the economy is weak there are fewer cars, businesses and homes that need to be insured.

But, to make matters even worse, premium pricing was soft from 2005/06 through to the end of 2009. Ironically, the reason insurers have been cutting their premiums is that for much of this period the incidence of major catastrophes that generate insurance claims was lower than average. This meant that insurers generated large amounts of capital from their underwriting business and the build-up in capital across the industry led to cutthroat competition on premium rates in both commercial and personal lines. But, check out my chart below.

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Since the beginning of 2010, an uptick in catastrophes as well as falling yields on investment portfolios have helped to deplete excess capital in the insurance industry. Meanwhile a recovery, albeit anemic, for the global economy has powered demand for insurance.

The result: this chart shows premium pricing trends for commercial lines insurance have turned higher for three consecutive months for the first time since 2005 with pricing for worker's compensation coverage leading the way. With its solid exposure to commercial lines insurance, Travelers should continue to benefit handsomely from this turn.

While the stock saw a considerable run-up in the fourth quarter, it's still cheap by conventional valuation measures such as price-to-book. Further evidence of premium improvement could easily see the stock push above its 2011 highs and rally to the $90 to $100 level in 2012.

Allstate Corp. (NYSE:ALL) - In contrast to Travelers' focus on commercial lines, Allstate is a market leader in personal lines in the U.S. with about a 12 percent total market share.

While premiums in the personal lines business took a bit longer to turn higher that's changing led by an upside in homeowner's insurance rates. In particular, a number of catastrophes over the past year such as the devastating rash of tornadoes to affect States across the south, Midwest and Northeast last April and the unusual East Coast earthquake last summer have eliminated some of the excess capital in personal lines.

Allstate's automobile insurance business should also continue to benefit from the recovery in new U.S. automobile sales. Total U.S. auto sales remain well off their pre-crisis levels but have recovered nicely from a low of around 9.5 million annualized units in 2009 to recent highs around 13.5 million annualized units. In addition, the average age of a U.S. passenger vehicle recently hit a record of 10.8 years, meaning that a large number of Americans will need to replace their cars over the next few years. Those cars will need to be insured.

Barclays Plc (NYSE:BCS) - London-based Barclays remains one of the three largest banks in the UK, a market that still accounts for roughly 40 to 50 percent of revenues and earnings. However, the bank has expanded into commercial and investment banking operations on a global basis.

No bank was completely untouched by the 2007-09 recession and financial crisis but Barclays came through that period in much better shape than its U.K. peers Lloyds and Royal bank of Scotland (NYSE:RBS) and was not forced to turn to the government for a major bailout. The bank also took advantage of the global credit crunch, purchasing some of Lehman Brothers' most attractive assets out of bankruptcy at fire-sale prices.

In the third quarter, Barclays reported it had reduced its exposure to the sovereign debt of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) by nearly a third from GBP11.6 billion ($18 billion) at the end of June to just GBP8 billion ($12 billion) at the end of September, comfortable exposure for a bank of its size. And the firm's exposure to U.K. residential and business banking (RBB), a segment that hurt the bank during the credit crunch, is also showing improving trends with impairments for bad debts falling by 41 percent year-over-year and 20 percent quarter over quarter.

The bank has a Core Tier 1 capital ratio of 11.0 percent and indicated that under Basel III rules, the bank faces a still-healthy Core Tier 1 Ratio of 10.2 percent. That should give it enough of a cushion to withstand continued weakness in some parts of its lending portfolio such as its relatively high exposure to construction lending in Spain. In total, Barclay's has some GBP34.5 billion ($54 billion) in exposure to mortgages within the badly battered PIIGS nations where loan losses are likely to remain elevated for the foreseeable future.

One of the main knocks against Barclays has been its heavy dependence on volatile profits from investment banking division Barclays Capital (BarCap). In the first nine months of 2011, for example, BarCap accounted for nearly GBP2.7 billion ($4.2 billion) in pre-tax profits, nearly half of total income. The good news is that BarCap continues to perform well compared to most of its key global peers - total income was off only 12 percent in the first nine months of 2011 compared to the same period in 2010.

There's no doubt Barclays continues to face some headwinds but, trading at a price to tangible book value of less than 0.50, the stock is already pricing in a great deal of bad news. The London-traded shares recently broke above their October highs on heavy trading volume, completing a roughly six month old basing pattern.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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