Is Now The Time To Invest In Financials?

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David Evanson and Oliver Pursche

Forbes.com, Spring, 2012

Should investors get into financials now? Maybe. The answer has to do with the fundamentals of financial services companies, but also on your tolerance for risk.

On the fundamental front, there’s plenty of improvement. Lending margins are improving, loan-loss provisions are declining, loan activity is increasing, the regulatory environment appears to be stabilizing, earnings are rising and dividends are increasing.

A good jumping off point for answering this question is to understand the difference between the various “financial” companies. There are the asset managers such as Goldman Sachs (GS), Federated Investors (FII) and State Street (STT) (Goldman, of course, is a large investment bank too, but it has been building its asset management business, and for now I’m going to put them in this category.)

There are the investment banks like Morgan Stanley (MS) and JPMorgan Chase (JPM)–although the latter also falls into the retail banking sector with significant exposure to home mortgages.

Then there are the conglomerates such as Citigroup (C), Bank of America (BAC) and Wells Fargo (WFC). Of course, there are also the regional banks that tend to be mostly commercial and mortgage loan driven.

There are entire tomes devoted to investing in banks and financial services companies. Recognizing this limitation, here are some key points to keep in mind:

First, look at the balance sheet of each. You’ll see Wells Fargo, Federated Investors, JPMorgan and State Street Bank are in better fiscal shape than Morgan Stanley or Citgroup. If you dig a little deeper in the financial and the notes, you’ll find JPM, Morgan Stanley and Goldman Sachs have the greatest exposure to European debt.

Keeping these two points in mind, recognize that amid another financial crisis–here or abroad–the weaker companies are likely to collapse and require another bailout, which may or may not be forthcoming. Moreover, the survivors are likely to get severely punished and decline sharply.

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So far this year, the Financial Select Sector SPDR ETF (XLF) is up more than 13%, and was the best performing sector in the first quarter. Overall, when compared to the broader market, financials have held up pretty well, in essence directionally moving with the market. This last piece of data should be somewhat reassuring to investors who are already exposed to financials.

For those considering making a leap into the sector I advise careful consideration of risks.

In our view, asset managers such as Federated Investors, which pays a hefty 4.7% dividend, and State Street are among the least risky financial sector firms (disclosure: we own FII, but not STT, mostly because we are still underweight the sector).

We are also fans of JPMorgan, the only “true” bank we are invested in. We feel JPM did superb work managing its business before, during and after the crisis. Moreover, the management team is deep, the balance sheet is strong and, in our view, the stock still has significant upside.

Wells Fargo, which we do not own, also appears to be attractive and seems to have a strong balance sheet and the characteristics that investors should look for in this sector.

Note also that, according to the latest 10K filings, Wells Fargo, at just 5.1% of total loans, has the least exposure to foreign, and potentially troublesome markets. By contrast, BAC and Citi, have much larger exposures at 25.1% and 20.4% respectively.

Most importantly, we believe that investments in the financial sector will require close monitoring and the willingness to either realize gains or cut losses in the event that the sector deteriorates. No doubt, the financial sector offers some very attractive opportunities for aggressive investors. If you are more concerned with the protection of capital, other investments are likely more suitable.

As an aside, if you own variable annuities with living benefits that offer certain guarantees of principal, exposure to financials within this vehicle may allow you to be exposed to the appreciation opportunity without being exposed to the downside risk. Make sure to speak to your financial advisor and read the prospectus and statement of additional information before investing in any variable annuity, or for that matter ETF or mutual fund. It’s your money, take good care of it.