Playing the Financial Stocks

As a group, the stocks in the financial sector had a stellar 2012, rising +26% last year compared to +13% for the S&P 500.

Last year's results were the direct opposite of the financial sector in 2011, when banks, brokers and insurance stocks declined by -18% while the S&P was essentially unchanged in price.

Put another way, finance went from being the worst performing sector in the S&P to be best performer.

As the results of the past couple of years illustrate, investing in the financial group since the credit crisis of 2008 has been tricky, to say the least.

For a number of quarters, investors favored "safer" financial names found among the regional banks and property casualty insurers.  Meanwhile, valuations of more credit sensitive stocks such as money center banks and brokers traded at historically low levels.

That all began to change in the middle of last year.  Suddenly, investors began to rotate into stocks like Citigroup and Goldman Sachs as it became evident that not only were these companies going to survive, but it was also possible that they would emerge stronger and more profitable than before.

The chart above illustrates what happened in 2012.

So what about now?  How should we be playing the financials in 2013?

In my opinion, we will continue to see more performance divergence among the stocks in the group.

Today's "era of financial repression" means that interest rates will remain low for the foreseeable future, creating a difficult environment for a group that tends to prosper in higher interest rate environments.

In addition, the trading profits for brokers may not achieve prior levels due to higher regulatory capital requirements.

Last year I had used the Financial Sectors exchange-traded fund (XLF) as a way to play the group.  I was frustrated by the lack of clarity on the financial health of many of the companies in the group, yet their attractive valuation meant that I needed a lower risk way of getting client money invested in the stocks.

But no longer.  As I wrote in an internal memo to my fellow managers yesterday, I am exiting my position in XLF in favor of money center banks (JPM, BAC, C; HBC); credit card companies (COF); and asset managers (BLK). 

Here's my explanation:

In my opinion, the time has come to exit my Financial ETF (XLF) position, and put the proceeds into specific financial stocks in the sector.

I first used XLF for two reasons:  first, because it was the quickest way to add to the financial sector last year, when I was vastly underweight the group. XLF offered me the opportunity to take advantage of the historically cheap valuation of the Financial group, yet avoid taking single security risks.

And, second, I felt that too many stocks in the sector were unanalyzable, with vast off-balance sheet exposures, uncertain legal exposure, and unknown regulatory response to the 2008-09 credit crisis.

While some of these “unknowns” might still be true, I think that we now have enough clarity in terms of the macro and regulatory environment that I should exit XLF.

I think that several factors will emerge over the next year.

First, the yield curve will steepen, with interest rates rising modestly on the longer end.  This will definitely help the banks.  It might also help the insurance companies, esp. the life insurers who need higher rates to meet annuity liabilities (even though life companies have a track record of destroying shareholder capital).

Second, housing will continue to improve rapidly.  However, mortgage rates will remain stubbornly high relative to government bonds, since many of the major lenders have either left the market (e.g. BankAmerica) or have imposed very conservative underwriting standards. The remaining players will be the beneficiaries (e.g. Wells Fargo).

Third, I think that more dealers will be exiting unprofitable trading activities, especially bond trading.  While this may hurt bond investors (e.g. Franklin Resources) who want to try to do swaps or actively manage portfolios, it will also allow the financial service companies to focus their attention on more profitable areas, such as investment banking or money management (!).

Finally, if we are truly on the verge of a shift from bond mutual funds to stock mutual funds, equity oriented money managers might be the beneficiaries, although the two largest (Vanguard and Fidelity) are privately held. However, Blackrock, which offers both active management as well as ETF’s, should also be a beneficiary.

I don’t think that everything in financials does well.

Regional banks are overvalued, as are most REITs.  Custody banks (Northern Trust and State Street) are also in a tough spot, as short term rates will probably stay low for several more years. And the PC insurance stocks have been favorite hiding spots for investors, so they too are less appealing based on valuation, in my opinion.