Sector Investing: Soar with banks, brokerages, and insurance companies

June 4, 2001

Low interest rates and new laws will bolster profits. Here&s where to catch the action.

 

Sector Investing

Soar with banks, brokerages, and insurance companies

Jump to:Choose article section...Through the financial microscope More than the sum of the parts Size matters The little engines that could Covering all bases Financial-sector mutual funds worth considering

Low interest rates and new laws will bolster profits. Here's where to catch the action.

By Leslie Kane
Senior Editor

Financial-sector mutual funds are helium balloons above a deflating market.

In the past 12 months, the Standard and Poor's 500 Stock Index declined 8.2 percent and the Nasdaq lost 37.1 percent, but financial-sector mutual funds gained 31.4 percent.* "This is an exciting time for a fairly boring industry," says Lanny Thorndike, chief investment officer at Century Funds in Boston. "Baby boomers' concerns about retirement income have made asset and pension management companies a vital and growing part of our economy."

Moreover, the best is yet to come, says Diana Yates, a financial-sector analyst with St. Louis-based brokerage A.G. Edwards & Sons. "Lower interest rates and recent legislation make conditions right for the sector to pick up speed in coming years."

When tech companies became supernovas, investors ignored slower-moving financial stocks. Now, the former tortoise is gaining fans. "Financial-services companies generally bring in a steady 15 to 20 percent growth in annual earnings," Thorndike says. "The sector's considered a safe harbor, which is especially desirable in this nervous market."

The financial-services category, which represents at least 15 percent of the overall stock market, includes three types of companies:

Banks. Low interest rates act like a protein shake to banks, and lately the Federal Reserve Board has been slashing rates. "Rate cuts let banks lower their lending rates, which leads more consumers to take loans, which means more revenue," says Marc Singer, an investment adviser with SingerXenos Investment Management in Coral Gables, FL. "Banks can also increase the spread between the rates they receive and those they charge, increasing profits."

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2001, which the US House of Representatives passed in March, could also boost banks' bottom line. The Senate passed similar legislation, and President Bush will likely sign the resulting compromise bill. The new regulation will make it tougher for people to file for Chapter 7 bankruptcy, which forgives most of their unsecured debt. Instead, many struggling consumers will have to file for Chapter 13 bankruptcy, which requires them to pay off their debts.

"This action can benefit banks and credit card companies, which bear the brunt when consumers default on credit card debts," says Yates. Last year, 838,885 nonbusiness Chapter 7 bankruptcy filings took place.

Mergers will also help several major banks. For instance, Summit Bancorp combined with FleetBoston Financial in March of this year, and J.P. Morgan joined with Chase Manhattan at the end of 2000, to form J.P. Morgan Chase. "Consolidations promote lower operating costs," says Singer. "Previously, a town might have had three separate banks; now one bank may own all three, close down two branches, and control the same amount of deposits. It could take years to see returns from integrating formerly separate banks, though."

What's more, challenges remain. "Online and ATM banking have not caught on as completely as banks had hoped," Yates says. "Companies still have to keep brick and mortar buildings open, as well as offer online capabilities. That's an expensive infrastructure."

In addition, banks that rely on consumer loans may suffer if the economy worsens. More layoffs could mean fewer people will borrow. "However, fee-based banks, which get most of their revenue from asset management, will continue to do well," Thorndike says.

Brokerages. These got a fuel injection from the 1999 repeal of the Glass-Steagall Act of 1933. The Act prevented any single company from offering securities, banking functions, and insurance services. Now, brokerages can provide banking services, and vice versa. "The wall is clearly down, and brokers will be able to operate as banks," says Yates. "Corporate clients like having their bank and brokerage under one house. This development can help increase business for brokerages."

Still, the plunging stock market has stung discount and online brokers. "Brokerages haven't lost clients, but the volume of trades has declined," Singer says.

Brokerages with large institutional customers haven't felt the same hit, however. "Institutions still trade regularly, and big, diversified brokerages, such as Merrill Lynch, barely feel the drop in retail investing," says James F. Catudal, a portfolio manager at Fidelity Investments in Boston.

Insurance companies. Several factors look positive for this category. The Glass-Steagall repeal is one. In addition, insurance companies are buying brokerages and banks, giving them entree into a lucrative business that fits well with their operations.

Because life insurance is a stable sector, it's becoming more desirable as economic growth slows, says Singer. In addition, the tax-deductible limits on 401(k) plans may rise, which would help insurance companies that administer the plans. Also, as baby boomers transfer wealth to their children through insurance and investments, the life insurance group should benefit.

Finally, insurers can earn from invested assets. "These companies control an enormous amount of money, and they can do whatever they want with it until they have to pay it out in claims," says Singer. That will give them an investing edge when the market starts to turn around.

Because a sector fund has such a narrow focus, your stake in one should generally be no more than 10 percent of your portfolio. "However, the financial sector is traditionally less volatile than most; you could safely raise that allotment to 15 percent," says Catudal.

Rather than invest in financial-sector stocks directly, it's safest to do so through mutual funds, which give you a diversity of companies. Here's a look at some we consider promising.

Through the financial microscope

Century Shares Trust leans heavily toward insurance companies, whose earnings have surged thanks to recent premium increases. But the credit for much of its success belongs to analysts' careful scrutiny of companies' financial statements, says Lanny Thorndike, of Century Funds, which owns and runs the fund. "Reserve amounts for banks and financial companies are more subjective than those of companies with physical products, like clothing," he says. "We examine financial information in great depth, to make sure earnings and profits really are what they appear to be."

"In addition, we look for companies whose strategy and execution have led to superior returns over the past three to five years," Thorndike says. It's not easy for stocks to squeak through that barrier—one reason the fund tends to hold only about 50 stocks.

The portfolio's annual turnover rate is only 11 percent. This means that instead of buying and selling stocks frequently, the fund tends to hold on to them, which lowers the capital gains tax investors pay. The fund's 0.82 percent expense ratio is also the lowest among the financial-sector funds.

A key holding is American International Group, one of the world's largest insurance companies. "It's one of the few sizable financial firms with a global footprint in the US, Europe, and Asia," says Thorndike. AIG provides property and casualty insurance, as well as life and health insurance for individuals and groups. The company has grown consistently, and its diverse businesses keep earnings steady even when one group falters. International expansion and domestic price hikes should keep the company humming. AIG's share price has risen from an average of about 23 in 1996 to its current 83.

Another portfolio staple is J.P. Morgan Chase. Although earnings fell last year due to merger expenses, the biggest costs have been absorbed, and earnings should rebound. The company also made major investments in capital markets businesses, which should contribute to strong revenue growth. J.P. Morgan Chase has investment banking, asset management, or consumer banking operations in more than 60 countries.

More than the sum of the parts

FBR Small Cap Financial Fund gathers local stars into a top-performing portfolio. Manager David H. Ellison focuses on small companies, particularly regional banks that do well within their own areas. He also looks for solid growth. "I don't make big bets; I want boring companies with simple and effective business strategies," says Ellison.

FirstFed Financial, the holding company for First Federal Bank of California, is a prime example. The bank has 25 branches in southern California. Business has remained strong, like FirstFed's stock price, which has doubled in the past two years.

Berkshire Hills Bancorp, the holding company for Berkshire Bank, went public about a year ago, and since then its stock's price has risen nearly 50 percent. The company is the largest financial institution in Berkshire County, MA, and it operates 12 offices in western Massachusetts. Berkshire Hills recently expanded into insurance and investment services.

Size matters

Fidelity Select Financial Services Portfolio favors large companies that indomitably rack up earnings. "We look for corporations with strong growth prospects and balance sheets, and a robust business model," says James Catudal, the fund's portfolio manager. "We stay away from any company whose price-earnings ratio has gotten too high, and we sell a stock when its price reaches the number we targeted, or when the company's earnings or growth rate starts to deteriorate."

Wells Fargo and Company, the San Francisco-based banking giant formed when Wells Fargo and Norwest merged in 1998, fits Catudal's criteria. It's growing by acquiring large and small banks and financial firms. Since the merger, revenues have expanded faster than operating expenses. And wisely, management is integrating the Wells Fargo and Norwest computer systems slowly, to maintain good service and avoid alienating customers. The stock's price has done accordingly well; it has more than doubled in the past five years.

Catudal also holds Fannie Mae (formerly known as Federal National Mortgage Association), the country's largest provider of residential mortgage funds and its third-largest corporation, ranked by assets. Fannie Mae buys, sells, and guarantees mortgages to banks and other lenders, to make sure they have adequate money available for lending. An excellent performer in a steady industry, Fannie Mae's stock has returned an annualized 22.1 percent for the past five years. The corporation is also progressive; last year it was named one of the nation's top 100 e-businesses by InternetWeek, a leading trade magazine.

The little engines that could

Mutual Financial Services Fund focuses on small- and mid-cap companies, which carry more risk than big firms but offer greater potential for growth. The average market capitalization of stocks in the fund is $3 billion, compared with $33.9 billion for Fidelity's Select Financial Services Portfolio.

Portfolio manager Raymond Garea looks for value. The average price-earnings ratio of the fund's stocks is 15.2 percent, compared with 23.3 percent for Century Shares Trust. Mutual Financial Services Fund also keeps 12 percent of its assets in foreign stocks, more than comparable financial-sector funds invest abroad.

Top holdings include Metris Companies and Heller Financial. Metris, one of the nation's fastest-growing direct marketers, went public in 1996 and is now on the New York Stock Exchange. The company markets credit products, extended-service plans, and fee-based services such as debt-waiver programs to moderate-income consumers. In an aggressive move, Metris became the first credit card issuer to offer its products on the new MasterCard Spanish-language Web site, which should reach a large and profitable market.

Heller Financial, an 80-year-old company, provides equipment financing and leasing, working-capital loans, real estate financing, and other loans to middle-market and small business clients in the US and abroad. Its international segment operates in Asia, Europe, and Latin America. The equipment-leasing industry is poised for strong performance, which should help boost earnings.

Covering all bases

T. Rowe Price Financial Services Fund carefully diversifies its holdings, which include banks, insurance companies, and specialty-finance companies such as mortgage insurers. The fund owns a relatively small number of stocks—40 to 50, mostly large-cap companies. Portfolio co-manager Anna M. Dopkin tends to buy and hold stocks, as evidenced by the low annual turnover rate of 37 percent.

One top asset, Citigroup, includes Citibank, Salomon Smith Barney Holdings, the Travelers insurance companies, and other corporations, which gives the financial giant a wide scope. Citigroup continues to expand its reach and plans to acquire European American Bank, a major New York-based firm. This addition would bolster the company's already strong position in the New York financial arena. Citigroup's extensive Internet operations and significant foreign holdings will likely keep profits soaring, too.

Freddie Mac (formerly known as Federal Home Loan Mortgage Corp.) also keeps the fund's portfolio buoyant. The company competes with Fannie Mae, so it works to increase the supply of money that mortgage lenders can offer home buyers and people purchasing multifamily dwellings as investment properties. Freddie Mac's share price has almost tripled over the last five years, and in the past year, the stock has returned about 44 percent.

*All figures in this article as of May 10. Where applicable, historical stock prices have been adjusted to reflect the value of subsequent splits.

Financial-sector mutual funds worth considering

 1 yearTotal return 5 years (annualized)Load
Century Shares Trust (800-321-1928)35.1%16.8%None
FBR Small Cap Financial (888-888-0025)55.3N.A.None
Fidelity Select Financial Services Portfolio (800-544-8888)27.720.03.0%
Mutual Financial Services­Class A (800-342-5236)47.5N.A.5.75
T. Rowe Price Financial Services (800-638-5660)30.9N.A.None
Average of financial-sector mutual funds31.417.6N.A.

 

Leslie Kane. Sector Investing: Soar with banks, brokerages, and insurance companies. Medical Economics 2001;11:46.