Dodging the mortgage bullet

(Fortune Magazine) -- The credit crunch has many holders of bank and brokerage stocks quaking in their boots. But Chuck Lahr, manager of Franklin Templeton's Mutual Financial Services fund, isn't one of the worriers. Four years ago Lahr began shifting money out of U.S. financial services and into European financial stocks, which held up better in the recent turmoil.

Thanks in part to that move, the fund posted an average total return of 13.7% annually over the past three years, according to Morningstar, vs. 8.0% for the Dow Jones financial services index. Lahr, who is also co-manager of the diversified Mutual Discovery fund, recently shared his take on the financial sector with Fortune's Jon Birger.

Chuck Lahr has been finding more opportunities abroad recently.

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What led you to get out of U.S. financial stocks?

Toward the end of 2004 we started to see a lot of really bad underwriting practices. By keeping in touch with management and by speaking to people who were going out there and mystery shopping, it became clear that a lot of the loans being offered just didn't make sense.

It wasn't just the anecdotal evidence. You had a flood of new money coming into the business, and a lot of the people making the loans weren't the most experienced. The way the volumes were spiking was troubling, as were the affordability ratios [the ratio of average home price to average family income] in certain parts of the country. On top of all that, the stock valuations weren't as attractive as they were before. So it was a signal to us to take our profits.

And you reinvested those profits in European stocks?

It's not like we just took the capital and invested it in Europe, because there are plenty of economies in Europe that make the froth in the U.S. housing market look pretty paltry - Spain and Ireland, for instance. We looked for economies with lower valuations, better growth profiles, and a much healthier consumer sector, like Sweden and Norway.

Which U.S. stocks do you still like?

One is U.S. Bancorp (Charts, Fortune 500). It's trading at a little over ten times next year's earnings. What's attractive about this one isn't just the dividend yield, which is around 5%, but you also have really a bulletproof balance sheet. These guys are completely allergic to credit risk - very limited subprime exposure. But the real gem is the hidden value from their fee-income businesses like credit card processing that they don't get credit for. [Lahr is in good company: U.S. Bancorp was Warren Buffett's second-largest bank holding as of June 30.]

What are your other favorites now?

Intesa Sanpaulo (ISP.MI), which is Italy's largest retail bank. You have a banking network that spans the country, and despite a pretty lethargic macroeconomic backdrop in Italy, the actual lending markets are reasonably sound. What's most interesting about Intesa is that whether the economy works or it doesn't, they're sitting on a significant amount of excess capital. On top of that, there's the valuation - the stock trades at about ten times earnings - and I think you're going to get close to double-digit earnings growth. Factor in a 6.5% dividend yield, and I think the name trades at least 30% below where it should.

How about a stock outside of the banking sector?

One we like a lot is Deutsche Börse (DB1.F), an exchange domiciled in Frankfurt. Its cash equity trading volumes are growing strongly, and cash equity exchanges are generally valued at 18 or 19 times earnings. Derivatives are about 40% of its business; derivatives markets are typically valued at over 30 times earnings. Yet if you look at the valuation, Deutsche Börse is trading at only seven or eight times earnings.