Investing in financial services stocks

5 December 2023
investing in financials

Introduction

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The financial services sector is widely considered to be the lifeblood of the economy, and it’s therefore of unique significance. It provides individuals and businesses with the essential access to borrowing which is essential for economic growth. The sector’s vitality is underscored by its capacity to uplift or, conversely, pull down the broader economic landscape, as witnessed during the 2007-08 financial crisis.
Financial stocks, constituting more than 10% of the MSCI World market index, wield considerable influence, making them a substantial component even in the most passive portfolios. This post aims not only to unravel the complexities of the financial services sector but also to offer insights into navigating the intricacies of individual financial companies. It’s a comprehensive analysis of the sector’s nuances and hopes to provide guidance on astute investment strategies.

Understanding the diverse landscape of financial firms

The financial sector is a mosaic of diverse entities, broadly classified into four main categories: banks, investment firms, diversified financial services, and insurance companies – each requiring a unique analytical approach.

Banks, the cornerstone of financial services, engage in the pivotal function of accepting customer deposits and subsequently lending funds through both retail and commercial banking channels. The nuances of this category unfold further as we delve into the realms of retail banking, serving individuals, and commercial banking, catering to businesses. Their revenue model in based on the interest rate differential — profits generated by lending at higher rates than those offered on customer deposits.

Investment firms, on the other hand, act as custodians of clients’ funds, strategically investing across various financial markets. Their role, often referred to as asset management for institutions and wealth management for individuals, is to provide a service to those lacking the expertise, time, or inclination for direct investment. The primary source of income for investment firms is the management fee, typically expressed as a percentage of the overall assets under management (AUM). Some firms may also charge a performance fee on specific products, a percentage of the investment profit achieved.

Diversified financials, as the name suggests, encompass institutions offering a comprehensive array of financial services. Powerhouses like JPMorgan Chase, Goldman Sachs, Barclays, and Deutsche Bank exemplify this category. Beyond the realms of retail and commercial banking and asset and wealth management, diversified financial firms often house investment banking functions. These functions involve facilitating financing for other companies, including stock and bond sales, and orchestrating mergers and acquisitions. Investment banks also play a pivotal role in assisting investment firms in making and executing investment decisions through research, sales, and trading departments.

Lastly, insurance companies are financial institutions that provide protection against financial losses, essentially operating in the domain of risk management. Their core function involves balancing the likelihood of an event against its financial impact, with customers paying a fee to transfer risks they cannot afford to bear independently.

Analyzing banks

At the core of a bank’s revenue generation lies the ability to charge more for lending than the cost of borrowing. The net interest margin (NIM) is the key metric in evaluating a bank’s suitability as an investment. Expressed as a percentage and readily available in financial statements, NIM represents the difference between interest rates on loans and those on customer deposits. Quite intuitively, a higher NIM signals greater profitability.
A bank borrows money at short-term interest rates (think customer deposits) and then lends that money at long-term rates (think 30-year mortgages). A bank’s profit is therefore largely determined by the difference between short-term and long-term rates. The yield curve plots exactly this. When the curve steepens, the difference between short-term and long-term rates in an economy is widening – allowing its banks to increase their NIM.

One of the most common ways to assess the steepness of the yield curve is to focus on the difference between 2-year and 10-year US Treasury yields. The “short end” of the yield curve – the 2-year Treasury yield – reflects what moves investors expect central banks to make to interest rates in the near term. The “long end” of the yield curve – the 10-year Treasury yield – reflects longer-term economic growth and inflation expectations: the higher these hopes, the higher long-term yields will typically be. Taken together, this helps explain why banks and bank stocks tend to do well when the yield curve is steepening – when central banks are cutting current interest rates and/or investors’ growth and inflation expectations are increasing.

The efficiency ratio – calculated by dividing non-interest expenses by revenue – serves as another key metric, and it helps in assessing a bank’s performance. A comparatively lower efficiency ratio is indicative of better cost management.

The third dimension of analysis looks into a bank’s loan portfolios, analyzing changes in loan values and the diversification of lending activities. An excessively concentrated loan portfolio in a particular sector or geography may signal heightened risk exposure. Loan loss provisions, reflecting the cash set aside to cover potential future defaults, serve as an essential element in risk management evaluation. These provisions are reported in financial statements, and a growing trend is often viewed with caution. Calculating the ratio of loan loss provisions to total loans offers a comparative metric across different banks, with a lower percentage indicating better risk management.

Analyzing investment firms

For investment firms, the primary revenue stream is from management fees, often represented as a percentage of AUM. The two principal drivers of an investment firm’s revenue are therefore the level of AUM and the level of management fees. Evaluating AUM growth and composition is the basis to assess the firm’s performance and sustainability.

While robust AUM growth is desirable, the source of this growth is equally important. AUM generally increases due to the rising value of investments and new client cash inflows. Client inflows are considered a higher-quality source of growth, reflecting the firm’s ability to attract (as well as retain) clients through superior performance. Examining the composition of AUM across geographies and asset classes provides insights into the firm’s risk diversification strategy.

The client base is another determining aspect, and there are generally two types of clients: retail and institutional. Institutional clients, such as pension funds and sovereign wealth funds, are typically more “sticky” and therefore more attractive: they tend to keep their money with an investment firm for longer than retail clients.

Management fees, the lifeblood of investment firms, are influenced by the weighted-average fee across all products. Monitoring trends in management fees relative to industry standards is essential, particularly given the industry-wide decline in fees due to competition from low-cost alternatives like index-tracking ETFs.

Analyzing diversified financials

Diversified financial firms present a multifaceted structure, demanding a nuanced analysis of individual divisions within the institution. While the pillars of banking and investment management analysis have been presented above, the presence of investment banking departments adds an additional dimension to performance.

Investment banking divisions experience cyclical performance trends: economic upturns and increased corporate deal-making activities favor the advisory arms of investment banks, resulting in higher fees and profitability. Conversely, their trading divisions thrive in periods of heightened market volatility, translating to increased commission income from executing trades.

Investing in financial firms

As with any sector, you can go about investing in financials in one of two ways: sector-specific ETFs or individual stocks. Each options presents distinct opportunities and considerations for investors.

Sector-specific ETFs offer diversified exposure, catering to a range of preferences. Investors can choose between broad funds covering the entire financial sector or more focused ETFs targeting specific areas, (such as banking stocks). The choice depends on individual investment goals and risk tolerance.

For those inclined towards investing in individual stocks,

If you’re interested in investing in individual stocks, by now you should a good idea of what to look for in banks, investment firms, and diversified financials. As for valuation – especially with regard to bank stocks – one more metric is important to mention: the price-to-book ratio (P/B ratio). This is the relationship between its market value and its “book value” or net asset value (the value of the assets minus liabilities). P/B ratios are a particularly valuable for comparing banks because most of their assets (loans) and liabilities (deposits) are constantly being revalued at market rates. In other words, a bank’s book value is a pretty good guide to its market value. That makes P/B ratios a practical way to assess a bank’s valuation relative to those of competitors.
One of the main drivers of a bank’s P/B ratio is its return on equity (ROE). ROE measures how well a company is using shareholders’ money to generate profit. It’s calculated as net profit over a certain period divided by the average shareholder equity over that same period. Banks that can generate higher ROE deserve higher P/B ratios, so take that into account when comparing bank stocks’ valuations.

ROE is also useful for comparing different investment banking stocks against each other. Since investment banks undertake diverse activities, the easiest way to compare their overall profitability is to find their individual consolidated ROEs (which are always disclosed in the).

Conclusion

The financial services sector, intricate and multifaceted, demands a thorough understanding of the unique dynamics governing each type of financial firm. Analyzing banks, investment firms, and diversified financials involves delving into their operational intricacies and deciphering performance indicators specific to each category. Whether opting for the diversified exposure provided by sector-specific ETFs or the targeted approach of individual stock investments, investors can leverage these insights to make informed decisions.

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