Wednesday, March 28, 2012

Time To Overweight Financials?

There is a time for everything, and a time for every purpose under heaven.
                                                                      -Ecclesiastes 3:1

In 2011, the key to outperforming the S&P 500 was how you were positioned in the financial sector. 

Despite a fourth quarter rally, stocks in the financials were easily the worst performing sector in the market.  While the S&P gained slightly more than +2% last year, financials fell more than -18%.

But as the Bible reminds us, there is a time for everything, and 2012 might be the time for the financial sector.

The problems for the group remain daunting, including:
  • Loan growth remains anemic. 
  • The small difference in yields between short maturities and intermediates hurts bank profits. 
  • Low bond yields hurt insurance company profitability.
  • Corporate underwriting activity has increased, but competition is fierce, and pricing is under severe pressure.

Oh, and that little problem with credits in the euro zone could resurface and overwhelm the banking system.

And yet a case can be made that most of the problems in the financial sector are already reflected in the prices of the stocks.

The money center banks, for example, are trading at the low end of their historic price/book range. The same is true for the shares of the property/casualty insurance sector, where nearly all of the stocks are trading below book value.

Even Berkshire Hathaway - which is at its heart the world's largest reinsurance company - is trading at its lowest level in decades.

Earlier this year we added to positions in the financial sector in institutional accounts where performance relative to the S&P 500 is a crucial measure of success.

We had been largely underweight the group for most of 2011, but the risks of maintaining such a bearish position were too great.

The financial sector remains unloved among the Wall Street strategist group.  Most are recommending a continued underweight, citing all of the factors I mentioned earlier.

But cheap valuations and bearish sentiment usually mean opportunity, and I think financials fit that description to a T right now.