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How to Analyze, Understand, and Invest in Financial Services



Introduction

The financial services sector is a cornerstone of the economy, and its health has a ripple effect on various other sectors. Investing in financial services is not just about diversifying your portfolio but also about understanding the intricacies of the sector. This blog post aims to provide a comprehensive guide on how to analyze and invest in financial services stocks, including banks, investment firms, diversified financials, and insurance companies.

  • Importance of the Sector: Financial services account for more than 10% of the MSCI World market index.

  • Role in the Economy: They provide essential services like lending, which is crucial for economic growth.

  • Risks: A failing financial sector can have detrimental effects on the economy, as seen in the 2007-08 financial crisis.

How to Categorize Financial Firms

Financial firms can be broadly categorized into four types: banks, investment firms, diversified financial services, and insurance companies.

  • Banks: These are institutions that take customer deposits and provide loans. They make money from 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

  1. Retail Banking: Deals with individuals. (deposits from/loans to individuals)

  2. Commercial Banking: Deals with businesses. (deposits from/loans to businesses)

  • Investment Firms: These firms manage assets for clients and charge a management fee based on the assets under management (AUM). Some companies also charge a performance fee on certain products – often a percentage of the investment profit achieved.

  1. Asset Management: For institutions.

  2. Wealth Management: For individuals.

  • Diversified Financials: These are large institutions like JPMorgan Chase and Goldman Sachs that offer a range of services, including retail and commercial banking, asset management, and investment banking. 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 executing mergers and acquisitions.

  • Insurance Companies: They are financial institutions that provide protection against financial loss. These firms offer various types of insurance and 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.

Analyzing Banks

When it comes to banks, several key metrics can help you assess their investment potential. Remember: the main way banks make money is by charging more to lend than it costs them to borrow:

  • Net Interest Margin (NIM): This is the difference between the interest rates at which banks lend and borrow. the higher a bank’s NIM, the better – it means more money is being generated by its deposits and loans.

  • Yield Curve: The yield curve, which plots the difference between short-term and long-term interest rates, can influence a bank's NIM. If you think about it, a bank borrows money at short-term interest rates (think customer deposits and overnight central bank loans) and then lend 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.

  • US Treasury In addition 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.

  • Efficiency Ratio: When it comes to evaluating performance, investors often turn to the efficiency ratio. This ratio 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. A lower ratio is better.

  • Loan Portfolio: 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. Look at the diversity and quality of the bank's loans. A portfolio concentrated in a particular sector may be risky.

  • Loan Loss Provisions: reflects a bank’s overall estimate of future uncollected loan payments due to borrowers not being able to pay. funds set aside for potential loan defaults. A growing provision is a red flag.

Analyzing Investment Firms

Investment firms primarily make money through management fees, which are often a percentage of the overall AUM. that means there are two key drivers of an investment firm’s revenue:

  1. Assets Under Management (AUM): Look at how AUM has been trending and what has been driving that growth.

  • Client Inflows: A higher-quality source of AUM growth.

  • 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.

2. Management Fees: Assess the level and trend of management fees. Compare this with industry trends and peers.

Analyzing Diversified Financials

For diversified financials, you need to look at each of their individual divisions, such as banking and investment management.

  • Cyclical Performance: Their performance is often tied to economic cycles. For example, investment banking departments do well when there's high corporate deal-making activity.

Investing in Financial Firms

Investing in the financial sector can be approached in two primary ways: through sector-specific ETFs or by investing in individual stocks. This section aims to provide you with a comprehensive understanding of both approaches, along with key metrics to consider

  • Sector-Specific ETFs: Various financial ETFs are available that either track the entire financial sector or focus on specific areas within it.

    • Broad Funds: ETFs like XLF track the entire financial sector.

    • Focused Funds: ETFs like KBE focus solely on banking stocks.

    • Resource: A pre-defined screen for financial ETFs can be found on etfdb.com.

  • Individual Stocks: If you're more inclined towards individual stocks, the metrics discussed earlier for analyzing banks, investment firms, and diversified financials will be invaluable.

  • Valuation Metrics: The Price-to-Book (P/B) ratio is particularly useful for comparing banks. It represents the relationship between a company's market value and its net asset value.

  • Return on Equity (ROE): This metric measures how well a company uses shareholders' money to generate profit. It's crucial for assessing both banks and investment firms.

  • ROE and P/B Ratio: Banks with higher ROE generally deserve higher P/B ratios. Keep this in mind when comparing valuations.

  • Practical Application: These metrics are not just theoretical; they are disclosed in the financial statements of investment banks and can be used for practical investment decisions.

Conclusion

Investing in the financial sector is not just about picking stocks or ETFs; it's about understanding the underlying metrics that drive their performance. Whether you're a seasoned investor or a beginner, this guide aims to equip you with the knowledge you need to make informed investment decisions in the financial services sector.


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