Have Banks Beaten the Business Cycle? If So, Their Stocks are Undervalued

Investors haven't given financial services its due, according to a recent report from strategic consulting firm Mercer Oliver Wyman (New York).

In January 2004, the market value of the global financial sector was valued at $6.7 trillion-surpassing its prior peak of $6.5 trillion in February 2001. In the meantime, non-financial companies, valued at $26 trillion, have yet to recover from their prior peak of $38 trillion in September 2000.

The financial sector could surpass $12 trillion by 2013, the report says, as long as earnings growth and strong demand continue as expected. But the industry will also have to convince the investment community that it's worth a better valuation.

Over the past 30 years, investors have tended to discount equities in the financial services sector. For reasons both macro- and microeconomic, the P/E ratios of financial firms have been approximately 35 percent lower than those of non-financial firms. "Investors doubt the ability of the sector to realize earnings growth in line with non-financial companies in the near future," according to the Mercer Oliver Wyman report.

Some of those doubts are as outdated as yesterday's business models. For instance, banks have demonstrated greater success in riding out the business cycle than in the past. "The cyclicality traditionally displayed by financial services companies will likely be dampened in the future through the increased use of risk-transfer mechanisms," the report says.

Yet other doubts have a 21st century vintage. "Investors may perceive a substantial threat from IT firms and other types of non-financial firms entering the financial sector," the report indicates.

Financial institutions can counter this perception through the use of technology. A recommendation from the report: "Individual firms need to prove that they can systematically develop, fund and execute cutting-edge ideas to generate superior margins for a sustained period."

Another alternative, according to the report, is to tailor financial services to specific market segments, in order to "erect more sustainable firm-specific barriers to entry."

Finally, in wooing investors, it can't hurt to show a little skin. As it stands, "investors have little confidence in underlying growth and risk assumptions" when performing cash-flow valuations, argues Mercer Oliver Wyman.

Thus, increased transparency could help banks, analysts and shareholders alike.

TOP FSI PERFORMERS IN 2003

Diversified FIs: Citigroup

Universal Banks: HSBC, BNP Paribas

Commercial & Retail Banks: Royal Bank of Scotland

Investment Banks: Lehman Brothers, Merrill Lynch

Insurance Providers: Manulife

Specialty Providers: Eaton Vance

Source: Mercer Oliver Wyman, "State of the Financial Services Industry 2004"