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3 Undervalued Picks From The FTSE 100: Barclays plc, Aviva plc and Direct Line Insurance Group plc

The financial services sector offers attractive contrarian opportunities, because of uncertainties surrounding regulations and market conditions. Weak market sentiment explains why the sector trades at relatively lower multiples on earnings. But, with the generally improving economy in the UK and strengthening consumer sentiment, the outlook for the sector is improving. Here are three FTSE 100 financial shares, which are trading at a discount to their peers:

Barclays

Barclays (LSE: BARC) has undertaken much restructuring since the financial crisis, by creating a non-core division to sell and run-off underperforming assets, including its European retail and commercial bank and some investment banking assets. Under Jenkins, Barclays has also been reducing the bank’s exposure to investment banking, as profitability lagged behind the rest of the bank and new regulations increase its capital requirements.

Retail and business banking in the UK, Barclaycard and its Africa banking units now generate about 87% of the group’s core profits, with the investment bank generating the remainder. The average return on equity (ROE) of these three non-investment banking businesses was more than 12% in 2014. However, the ROE for its investment bank fell to 2.7% in 2014, significantly lagging behind its US peers.

Barclays, as a whole, only trades at 0.81 times its book value or 11.6 times its expected 2015 earnings. But improving market conditions should accelerate the run-off of its non-core division. And as the bank re-allocates capital to its core businesses, Barclays would come closer to meeting its ROE target of 12%. 

Aviva

Aviva (LSE: AV) has one of the lowest valuations in the life insurance sector, as it trades at a P/E of 10.7. Its shares also offer an attractive dividend yield of 4.1%. Although Aviva is more focused on slower growing UK and European markets, it benefits from its strong market position in the UK, which gives it scale and cost advantages.

Aviva’s recent acquisition of Friends Life increases its market share in the UK insurance and pension market, by bringing in around 5 million additional customers. The insurer expects to achieve cost savings of around £225 million per annum by the end of 2017. Friends Life has also bolstered Aviva’s balance sheet and increased its cash flow generation.

But this deal was completed as the government’s pension reforms have been introduced, which will likely lead to much reduced annuity sales. Nevertheless, strong life insurance demand should offset the decline in annuity sales, and the uncertainty surrounding annuity sales could represent a buying opportunity for Aviva’s shares.

Direct Line Group

Direct Line’s (LSE: DLG) earnings growth has been slowed by tough competitive conditions and rapid claims inflation, even as the insurer cuts costs. But there are signs that the market is bottoming out, particularly for UK motor insurance. Direct Line has also become more profitable by raising premium prices, even as it loses market share.

Direct Line is particularly attractive because of its dividend yield and the prospects for special dividends to be made in 2015. With the sale of its international division, Direct Line has yet to fully distribute the proceeds of the sale to shareholders. This has put the insurer in a position of excess capital. The company already pays a regular dividend of 13.2 pence per share, which equates to a 4.0% yield. But, analysts expect the insurer will pay special dividend of at least a similar amount to last year, which could boost its forward dividend yield to more than 8%.

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Jack Tang has no position in any shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.