The financial services sector is widely considered to be the lifeblood of the economy – and it’s therefore uniquely important. When financial firms are healthy, they provide people and businesses with the widespread access to borrowing that’s essential for economic growth. But when the sector grows sick – as during the 2007-08 financial crisis, for example – it can drag down everything and everyone else. What’s more, financial stocks account for more than 10% of the value of the MSCI World market index, meaning they’re likely to form a considerable portion of even the most passive portfolio. In this Pack, though, we won’t just demystify the financial services sector in general – we’ll also show you what to look for when investing in individual financial companies. So without further ado, let’s get started.
The financial sector encompasses many different types of firm. Most fall into four main categories, however: banks, investment firms, diversified financial services, and insurance companies.
Banks are financial institutions that take in money in the form of customer deposits and then lend it out again as loans. You could further subdivide such activity into retail banking (deposits from/loans to individuals) and commercial banking (deposits from/loans to businesses). Banks of both types primarily make money by pocketing the difference between the interest rates at which they lend and those at which they themselves “borrow” – i.e. the rates they offer on customer deposits.
Investment firms pool clients’ money and invest it on their behalf across different financial markets. They essentially provide a service, sometimes called asset management (for institutions) or wealth management (for individuals), catering to those who lack the knowledge, time, or desire to invest themselves. Investment firms’ primary source of income is the management fee they charge customers, normally expressed as a percentage of their overall assets under management (AUM). Some companies also charge a performance fee on certain products – often a percentage of the investment profit achieved.
Diversified financials – as you may have worked out from the name – are institutions that offer a wide range of financial services. Big names such as JPMorgan Chase, Goldman Sachs, Barclays, and Deutsche Bank are all examples of this. As well as retail and commercial banking and asset and wealth management, however, diversified financial firms often have investment banking functions as well. This typically involves helping other companies raise financing (including via stock and bond sales) and execute mergers and acquisitions. Investment banks also help investment firms take and implement investment decisions through their research, sales, and trading departments.
Insurance companies, finally, are financial institutions that provide protection against financial loss. Insurance companies are essentially in the business of risk management: they balance the likelihood of something happening against the cost of it coming true, with customers paying firms an appropriate fee to assume risks they can’t afford to run themselves. Insurance companies variously offer coverage in the event of accident, illness, and even death – but seeing as we’ve already got a dedicated Pack on the industry, we’re not going to cover its investment opportunities here.
Remember: the main way banks make money is by charging more to lend than it costs them to borrow. The difference between these two interest rates is captured in one of the most important financial ratios used to analyze banks’ suitability as an investment: net interest margin (NIM). NIM is expressed as a percentage and banks always disclose it in their financial statements, so you never have to worry about calculating it yourself.
At risk of stating the obvious, the higher a bank’s NIM, the better – it means more money is being generated by its deposits and loans. While a bank’s own policies, and particularly the quality of its loan management, play a major role in determining its NIM, the yield curve – a product of the wider “macroeconomic” environment and therefore beyond the bank’s control – is also a highly influential factor. It’s worth taking a minute to make sure you understand this important concept.
If you think about it, a bank borrows money at short-term interest rates (think customer deposits and overnight central bank loans) and then lends that money at long-term rates (think 30-year mortgages, business loans, and so on). A bank’s profit is therefore largely determined by the difference between short-term and long-term rates. The yield curve plots exactly this: how similar bonds’ yields differ based on how distant their maturity dates fall due. 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.
In addition to looking at it visually, 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, meanwhile – 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.
NIM is useful when measuring a bank’s profitability. When it comes to evaluating performance,, investors often turn to the efficiency ratio. This metric, which is also a fixture of banks’ financial statements, assesses the cost-effectiveness of a bank’s operations by dividing its “non-interest expenses” by revenue – non-interest expenses including things like sales and marketing, salaries, property rent, and so on. When analyzing a bank as a potential investment, it’s always a good idea to compare its efficiency ratio with that of its competitors. The lower the ratio, the better.
A third important area of analysis is banks’ loan portfolios – which makes sense, given that these are their main moneymaker. If you’re considering investing in a bank, look into how the total value of its loans has changed over the past few years – and which sort of customers it’s lending to. A loan portfolio that’s overly concentrated in a particular sector or geography may be a red flag, given its outsized exposure to a single risk reducing the likelihood of repayments. Take a Texan bank with half its portfolio made up of loans to local energy companies, for example – how do you think its stock price performed during the 2015 oil price crash?
On a related note, banks actually set aside cash to cover potential future defaults by borrowers. These loan loss provisions reflect a bank’s overall estimate of future uncollected loan payments due to borrowers not being able to pay. Loan loss provisions are also reported in banks’ financial statements and are worth paying attention to: growing provisions are rarely a good sign. You can divide loan loss provisions by total loans to work out a percentage figure that’s easier to compare across different banks. The lower the percentage, the better.
Recall that the primary way investment firms make money is by charging clients management fees, often reported as a percentage of overall AUM. That means there are two key drivers of an investment firm’s revenue: the level of its AUM and the level of its management fees. Let’s consider each in a little more detail.
The first area to investigate when analyzing an investment firm is how its AUM has been trending recently. While strong growth is always preferred, speed isn’t necessarily everything: it’s also important to understand what’s been driving that growth. A firm’s AUM generally increases for two reasons: the value of its investments rising and fresh inflows of client cash. The former factor is much more dependent on financial market movements: if stocks around the world are going up, then an investment firm will likely see its AUM increase. But this kind of growth is cyclical and, to an extent, outside the company’s control. That’s why client inflows are considered to be a higher-quality source of AUM growth: they imply the firm is doing a good job at beating benchmarks’ and competitors’ performance and is consequently attracting more business.
Another important thing to look at is the composition of the investment firm’s AUM. Is it diversified across different geographies and asset classes – think stocks, bonds, commodities, and so on – or is it highly concentrated in just a few places? You’d generally favor the former scenario. Take, for example, an investment firm with the bulk of its AUM invested in emerging-market stocks. If for whatever reason emerging markets experience an extended period of underperformance, that’ll hit the firm’s AUM – and therefore its profit. An investment firm with a more diversified AUM composition would meanwhile fare much better.
And it’s not only where the AUM is that matters, but who it is – in other words, what sort of clients are invested in the firm. As previously mentioned, there are two main types of client: individual retail investors who invest in the firm’s products either directly or through an intermediary, and big institutional investors such as pension funds, endowments, sovereign wealth funds, and so on. This latter bunch are typically more “sticky” and therefore more attractive: they tend to keep their money with an investment firm for longer than retail clients.
The second principal driver of an investment firm’s revenue is the weighted-average management fee charged across all of its products. Once again, it’s worth considering not just the absolute amount (the higher the better) but the trend. Note, however, that the entire industry has seen management fees decline over the past decade, thanks to competition from low-cost passive investment alternatives like index-tracking exchange-traded funds (ETFs). So don’t be too surprised if you see a downward trend in a firm’s management fees – what’s perhaps more telling is how this compares to its peers.
We won’t spend too much time on this: successfully analyzing diversified financials involves looking in detail at their individual divisions, and so you already know how to analyze a diversified financial firm’s banking and investment management aspects
But it’s true that these companies may also have investment banking departments. The main thing to remember here is that performance is cyclical: when economic times are good and corporate deal-making activity is on the rise, investment banks’ advisory arms get lots of business, lots of fees and lots of profit. Their trading divisions, meanwhile, tend to do best when market volatility is high: this leads to a higher volume of buying and selling and therefore more commission from executing trades. In both instances, the opposite also holds true.
As with any sector, you can go about investing in financials in one of two ways: by purchasing sector-specific ETFs, or by investing in individual stocks. On the former front, here’s a pre-defined screen for financial ETFs from useful resource etfdb.com. Note that you have a choice between very broad funds tracking the entire financial sector, such as XLF, and more focused ETFs that invest in a narrower area – such as KBE, which backs only banking stocks.
If you’re interested in investing in individual stocks, then you should now have a good idea of how to analyze banks, investment firms, and diversified financials. Just a quick word on valuation – especially with regard to bank stocks. A company’s price-to-book ratio (P/B ratio) is the relationship between its market value and its “book value” or net asset value – that is, the value of its assets minus its liabilities. P/B ratios are a particularly popular tool for comparing banks because most of their assets (think loans) and liabilities (think deposits) are themselves constantly being revalued at market rates. Put differently, a bank’s book value is a pretty good guide to its market value. That makes P/B ratios a handy way to assess a bank’s valuation relative to those of competitors.
Remember this important detail, though: 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 (a.k.a. equity) to generate profit. It’s calculated as net profit over a certain period (e.g. one year) divided by the average shareholder equity (i.e. book or net asset value) over that period. Banks that can generate higher ROE deserve higher P/B ratios, so take that into account when comparing bank stocks’ valuations.
ROE, by the way, is also a really useful metric for weighing up 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. Helpfully, these are always disclosed in the investment bank's financial statements.
So what are you waiting for? Get out there and try these techniques on a few intriguing financial firms – and inject some health into the economy while you’re at it. And if you feel like it, be sure to share your findings with other Finimizers in your Premium group chat!
🔹 The financial sector, made up of banks, investment firms, diversified financial services, and insurance companies, is widely considered to be the lifeblood of the economy.
🔹 Banks make money by pocketing the difference between the interest rates at which they lend and borrow. This is captured in the bank's net interest margin (NIM), which is heavily influenced by the yield curve in the wider economy.
🔹 Assessing a bank's loan portfolio – its growth, composition, and loss provisions – is a crucial step to take before investing.
🔹 Investment firms primarily make money by charging percentage management fees. Such firms’ main revenue drivers are therefore AUM and the weighted-average management fee across all products.
🔹 You can analyze an investment firm by looking at the characteristics of its AUM and how management fees compare to peers’.
🔹 You can invest in the financials sector by purchasing ETFs or by investing in individual stocks. If choosing the latter route, price-to-book ratios provide a useful way to weigh up bank stocks in particular.
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