Decoding Financials: A Beginner's Guide & Top 6 Picks

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It would not be an exaggeration to say that Financials has been one of the worst-performing sectors in the S&P 500 over the last decade. In fact, over the last 3 years, while Technology, Consumer, and pretty much everything large-cap was exploding, Financials has been flat as a pancake. So, I get it, why bother.

Let me start by sharing where I stand. My own portfolio is ~50% Tech and Healthcare and that means almost half of my investments are spread across Financials, Industrials, Energy & Materials, and Consumer. Here are key reasons for doing so –

  1. In each sector, there are strong companies that continue to allocate capital efficiently, resulting in market share, revenue, and profit growth.
  2. The future of Financials will be written by leaders in the space rather than someone from the outside.
  3. Allocating across sectors provides much-needed diversification as all of them don’t move in lock-step allowing to rebalance when needed.

Here is a quick overview of the article. This is my fourth one and, in these write-ups, I hope to provide a high-level overview of a sector and discuss key sub-sectors and investment themes within it. My first article was on Healthcare followed by Technology and Industrials – all of these articles were very well received by the readers. So, if you haven’t yet, you should check those out. Today my hope is to demystify the Financials, show what drives its different sub-sectors, and how to invest in the sector with high conviction.

I am looking at the sector from a 5-year view and not looking to debate on how the sector would trade in the short term, especially if there is a sharp reversal in investor sentiment.

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The table above (last updated September 30, 2020) neatly summarizes the performance of all the key sectors within the S&P500 over different periods. As I mentioned earlier, Financials (XLF) has underperformed S&P by a wide margin over pretty much every time period. To cement that, let’s do the famous $10,000 test. If 10 years ago you had invested $10,000 in XLF, it would have grown to ~$24,900 – not bad, while the same in SPY would have resulted in ~$35,000. S&P wins by almost $11,000 (~44%). Plus, to add insult to the injury, the last 3 years have been terrible.

However, even though I am not a big value guy, I’m not able to ignore the valuation differentials. The excellent chart below from Yardeni research (updated October 14, 2020) shows that Financials forward PE is only 13.6 compared to 21.7 for S&P500. So the question is, are Financials in such a poor shape (in terms of growth, business cyclicity, and management) that they should trade at almost 40% discount to the S&P500? Let’s figure it out.

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Background

Before I get into the details, let me share my investment beliefs. You can skip this section if you have read my prior articles.

  1. Conviction – I resist investing unless I am convinced about the story. This lets me stick with a stock whether it’s sunshine or rain, and it has served me well in the past.
  2. Growth – I believe a lot of people misunderstand growth. It’s as simple as the power of compounding. Considering my focus on total returns, I always value companies that show their ability to grow revenues profitably.
  3. Flexibility – We don’t need to marry a single investing style (e.g., dividend growth). Even if you prefer dividend growth, it shouldn’t stop you from picking Alphabet (GOOGL) or Facebook (FB), if you believe in their story.

Btw, I recently wrote my perspective on how dividend growth investing has performed overall and some big ideas to help drive returns

My own portfolio is spread across ~40-45 securities, and I divide them into 3 buckets –

  1. Consistent Compounders – proven business models, above-average growth rate (Medium Risk, Medium-High Return) – Think of GOOGL, UnitedHealth Group (UNH), FedEx (FDX)
  2. High Flyers – growing at a rapid pace, may have little to no profits (Medium-High Risk, High Return) – Think of Amazon (AMZN), Netflix (NFLX), Peloton (PTON)
  3. Special Situations – depressed valuations due to short-to-mid-term challenges such as loss of confidence in management, significant debt, or industry overhangs (Medium-High Risk, Medium-High Return) – Teva (NYSE:TEVA), Simon Property Group (SPG), General Motors (NYSE:GM). This is sort of my gamble money.

You can read more about my journey, investment beliefs, and allocations to these buckets here. Now it would become easier for me to take a deeper dive into Financials and help you in developing a strategy that can outperform broad indices.

What makes up Financials?

Here is how State Street breaks down the Financials sector. I know when we think about Financials, the only thing that comes to the mind is those large banks, but there is more to this than JPMorgan (JPM) and Bank of America (BAC). Btw, Diversified Financial Services below is nothing but Berkshire Hathaway, and that is a stock market in itself. So, I am not going to spend too much time there.

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I personally like to divide Financials into 4 big buckets –

Banks – they do all sorts of things with your money and are the biggest constituents. Think of JPMorgan (JPM), Bank of America (BAC), Wells Fargo (WFC). KBWB is a good etf proxy.

Capital Markets – They enable you to make money (or an illusion of) from your money. Big names include BlackRock (BLK), S&P Global (SPGI), Charles Schwab (SCHW). IAI is a good etf proxy. Even though, Goldman Sachs (GS) and Morgan Stanley (MS) are part of this group, they are becoming (or aspiring to) be more like conventional big banks so I would rather club these with the Banking sub-sector.

Insurance – They promise to protect you from major losses. ~18% of the sector. Think of Progressive (PGT), MetLife (MET), Travelers (TRV). IAK is a good etf proxy.

Financial Technology – aka Fintech. These are not officially part of the sector, but one can’t understand the full picture of Financials without looking at these. Think of Mastercard (MA), PayPal (PYPL), Square (SQ). I particularly like GFIN etf as a good proxy for the sub-sector.

Let’s look at how these sub-sectors have performed compared to Financials as a whole and SPY –

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I don’t think anyone would be surprised by the conclusion that the banks (KBWB) have been the worst while Fintech (GFIN) has given a stellar performance. But I am also intrigued with Capital Markets / IAI, this relatively overlooked one has done quite well compared to the banks or insurers. It would be interesting to see what’s driving that performance and if we can get any good investing ideas from there. To dissect these sub-sectors further, I would look at the top 10 holdings to get some perspective on the past as well as the future potential of each of these subsectors. So, let’s get going.

Banks

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This is absolutely the worst place to be apart from I guess oil & gas stocks. But seriously, when you can compound your money at ~14% just by buying SPY, why would you even think about thinking about banks that have given returns of ~7% CAGR over the last decade. Anyway, I guess, I had to get this out. So –

Are bank stocks good investments?

The short answer is yes. And there are three reasons for being optimistic about banks after the lost decade. First, the digital transformation of banks is real and will help in driving down the efficiency ratio or in other words result in higher profit margins. Second, the American banking landscape is extremely fragmented and continued move towards digital and associated costs would lead to consolidation and / or continued expansion of leading ones. Lastly, the PE multiples are extremely compressed, and any associated revision combined with dividend and earnings yield could lead to excellent returns from here.

Now in terms of individual securities, you can’t go wrong with JPMorgan. It has continued to execute and is more prepared than anyone to take advantage of any emerging opportunities in the sector. Its double-digit returns over the last decade (only bank to do so) are a testament to its performance and I’m confident that will continue. The chart below shows how well it has grown on its Return on Equity (ROE) over the last few years, and that will play a central role in enabling JPM to post excellent profits. The recent 2nd quarter results further showed Mr. Dimon’s ability to lead the bank.

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Now if you are willing to go north of the border, TD Bank is another excellent pick. It is one of my top 10 holdings and one of the only two banks I own. Its ROE has come down a bit over the last few years but at close to 14% it’s even better than JPM’s. So with a 5%+ dividend yield, a PE of ~10, and conservative management that is continuing to invest in profitable growth means TD is another great pick.

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Now the last and completely unexpected one is Wells Fargo (WFC). I’m pretty sure that anyone who has owned WFC over the last few years has cried at least once. Once upon a time, it had an industry-leading ROE of close to 13%, and as of 2019 end that stands at roughly 9%. Plus a dividend cut of 75%. Are you kidding me? The Q2 2020 results were also a disaster and led the stock to crater by another 6%. Anyway, WFC is a turnaround bet. The stock is trading cheaply (0.6 P/B vs 1.2 for JPM and TD). It’s pretty much at the lowest since the financial crisis. All this to say if you want to be a contrarian go ahead and bet on this dead horse as even a small movement can give you enough to thank Mr. Scharf.

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Capital Markets

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This is a curious bunch and I would say the best-kept secret. The median returns for this group are 20%+ while they trade at the forward PE of <25. Btw, just to reemphasize the 20% annual return over the last 10 years means you have multiplied your money 6 times. In other words, $10,000 invested 10 years ago, would have been $60,000+today. This is even better than some leading technology stocks and ETFs. Don’t believe me? Check those out. The other good thing to note is that the returns over the last 5 years are even better, so definitely this group is not slowing down.

Now you can separate this group into four segments – Mutual Funds / ETF providers (BlackRock, T. Rowe Price, State Street, MSCI), credit rating firms (S&P Global, Moody’s), exchanges (CME Group, Intercontinental Exchange), and investment platforms (Charles Schwab, MarketAxess Holdings).

Mutual Funds / ETF Providers – I see this as the commodity service with intense competition and a race to the bottom. The presence of Vanguard as the super low-cost alternative has made the need to scaling up obvious. BlackRock has been the toast of the town with continued growth in Assets under Management (AUMs) but the revenue growth is still anemic. All this has led me to stay away from this group. I want to highlight MSCI though, as they provide the indexes on which these ETFs are built. Even though, MSCI has done very well by putting a small tax on all the ETFs that are based on its indices, the overall consolidation of the etf market and continued entry of new index providers (e.g., Bloomberg) may hurt them a bit.

Credit Rating Firms – This is my favorite group among the four due to the recession-resistant nature of the business and, if anything, today’s low-interest-rate environment has only pushed the companies to raise more debt driving more business for such firms. I particularly like Moody’s with their continued ability to grow revenue in high single digits and translating that to mid-teens growth in EPS. On top of this, they give a 0.8% dividend (I know…but something is better than nothing). What not to like.

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Exchanges – This is a very high margin business and both the major exchanges – CME (think of commodities & derivatives) and ICE (stocks and options – NYSE) – have compounded in the mid-teens over the last decade. The primary driver of revenue is trading so it doesn’t matter if stocks go up or down as long as trading volumes are high. ICE has also been picking up exchanges globally though not sure how long that can continue. Overall, each of these stocks looks solid though I am not sure if they can continue to post significant revenue growth and profitability to justify their valuations.

Investment Platforms – This group also suffers from intense competition and commoditized service so not a big fan. However, MarketAxess (MKTX) has caught my attention with its ability to compound at 40% over the last decade. Just so we are clear, this means you would have multiplied your money 29X over a period of 10 years, which is out of this world. What do they do? They are trying to revolutionize the trading of bonds, which still happens using phones and paper. I can’t believe it too.

Here is an overview of the company –

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Overall, this is a huge market that is ripe for disruption, and MarketAxess seems to have figured this out. The stock is expensive, but the combination of a huge addressable market, high revenue growth, and excellent margins are pushing me to give it a deeper look. You should too!

Insurance

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I don’t understand this sector at all. One thing I do know is that the process of getting insurance of any kind is still the same as it was in the stone age. And that has led me to allocate some of my money to Lemonade (LMND). It was recently IPOed and has little to show in terms of revenue (~67 M) to justify the market cap of ~4 B, but I guess I am so frustrated that willing to bet on anyone promising to bring us the 21st-century experience and efficiency in the industry. If you want to know more about this stock, check out this excellent article from Trevor Jennewine explaining how everything works. Apart from that, I’m staying away from this industry altogether.

Fintech

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This is my favorite subsector and rightly so. You can put the word ‘Technology’ anywhere and the stock prices start rising. I am just kidding. In a world starved for growth, seeing revenue rising by 19% on an average over the last three years is incredible, and is vastly different than the 6-8% average revenue growth we saw in the other sub-sectors. Now look at the consistency of returns over the last 3 years – every stock is a winner (except maybe American Express). Having said that, this sub-sector is priced for perfection, but one thing I have learned in my 12 years of investing is to rather pay up for quality than getting stuck in the value trap. I personally own Mastercard (MA), Square (SQ), Adyen (OTCPK:ADYEY), XP Inc. (XP), nCINO (NCNO), and Redfin (RDFN) from this group, and I don’t have plans to make any changes to the portfolio (i.e., I am positive on all these names). Though, my advice would be to not roll the dice and just buy GFIN or anything else that may give you solid exposure to this sub-sector. I would also go as far as saying to allocate 50% of your Financials $ into this one. So, if you are thinking of assigning 10% of your portfolio to Financials, keep at least 5% here.

Final Thoughts

Taking a deeper look into Financials is a must for anyone trying to build a diversified portfolio. Even though the sector performance lagged the S&P 500 by a wide margin, the next decade might look a bit different than the last one. Looking within the sector, I am especially positive on best-of-breed bank names along with Capital Markets, which seems to have done well and may continue to deliver growth. The FinTech space has been everyone’s favorite, and we as investors should not ignore that. My recommendation would be to pick some high-quality buys from each of the sub-sectors, while the exposure to FinTech can be best done using an ETF. So to wrap it all up, here are my favorites in no particular order –

  1. Banking – JPMorgan (JPM) or TD Bank (TD) (depending on what you prefer)
  2. Banking – Wells Fargo (WFC)
  3. Capital Markets – Moody’s (MCO)
  4. Capital Markets – MarketAxess (MKTX)
  5. Insurance – Lemonade (LMND)
  6. FinTech – Goldman Sachs Finance Reimagined ETF (GFIN)

All six of them should give solid returns, and from my perspective, the future of Financials will be shaped by innovative and nimble companies within the sector rather than from the outside.

The objective of the article was to generate some interesting ideas from a sector that has been left for dead but has exceptional companies that may deliver alpha to the portfolio. I would expect you to take a deeper dive into the names before buying. If you want to read my perspective on other sectors, checkout Healthcare, Technology, and Industrials.

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Disclosure: I am/we are long TD, WFC, LMND, MA, SQ, ADYEY, XP, NCNO, RDFN, GOOGL, UNH, FDX, NFLX, PTON, TEVA, SPG, GM, FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.