Financial services stocks offer varying opportunities.
Is the financial services sector going to be a replay of the high-tech meltdown?
Kermit Eck thinks it could be, even if the free fall doesn't induce quite the same degree of vertigo. "We're a little skeptical about the entire industry," says Eck, a partner and portfolio manager at Cooke & Bieler, a value-oriented investment management firm in Philadelphia.
Why? "Financial services companies are telling us that as soon as the recession ends, they will get back to the growth rates they enjoyed in the late 1990s. We don't think that's going to happen," Eck says. "Our feeling is that the industry got overdone, and there is too much capacity. Frankly, you don't need as many people like us."
He could be right. After years of steady increases, the number of mutual funds has been slowly declining since early 2002, according to the Investment Company Institute in Washington, D.C. And once-proud consumer personal finance publications such as Mutual Funds Magazine and Bloomberg Personal Finance no longer exist. Eck says the industry "is going to take time to unravel as consumers ask, 'Do I really need all these services?'"
As unsettling as Eck's comments may be for anyone working in the money biz, as an investment manager, you need to know the prospects for financial stocks because clients probably own them. At the end of the first quarter of 2003, they constituted 20% of the market value of the Standard & Poor's 500 and 34% of the weighting of the Russell 1000 Value Index. Yet even if the industry grows little over the next four or five years, as Eck suggests, investing in financial services can be profitable because of the arena's diverse nature.
"It's a sector that really isn't a sector. It's a series of subsectors broad enough to find attractive values in any environment," says Anton Schutz, portfolio manager of Burnham Financial Services Fund, the leading sector performer based on three-year returns through the end of last year. Among the components of financial services are insurance, depository institutions and securities brokerages, Schutz told advisors at the recent DATAlynx Discover2003 Conference in Denver.
Insurance
Despite strong-arm pricing power-which of your premiums hasn't shot through the roof?-insurance carriers are a battered bunch. Property and casualty underwriters are still reeling from the losses of September 11 and wrestling with the implications of the war on terrorism, notes one fund manager. Insurers' portfolios have suffered during the bear market. And some life companies report that annuities are no longer hot cakes. With Murphy's Law prevailing, many managers are cautious about the shares of carriers.
One area of opportunity is specialty lines, says Nik Fisken, an analyst with Stephens Inc., an investment bank in Little Rock, Ark. "Certain risks are not being bound (covered) by some of the big carriers, so insureds are forced to go to the excess and surplus lines and pay considerably more than they would in the standard market. In this firm rate environment, specialized carriers are able to charge great prices on things that are not as risky as some perceive." Fisken touts Markel Corp., whose niche includes insuring commercial water sports such as jet-ski rentals.
Rather than buying carriers to play rising premiums, you could purchase insurance brokers. These businesses earn commissions by selling others' policies-the higher the premium, the higher the broker's revenue. Shareholders ride the upside of pricing power while evading the underwriting risk of a carrier. Although massive rotation out of the subsector earlier this year pushed the group down, insurance brokers' shares have nevertheless quadrupled since 1998.
And, it remains a fact (no matter how unpleasant) that catastrophes are good for insurance brokers. "If we have a hurricane or an earthquake, or another terrorist attack, rates will go up," Fisken says. He also points out that brokerage follows a simple business model. Therefore, accounting issues are extremely unlikely to crop up. Fisken's favorites include Brown & Brown, which has EBITDA margins of 36% vs. the industry average of 28%, and Hub International Ltd., which his firm helped take public in 2002 and sells insurance on New York City property. Hub has begun making acquisitions-vital for growth in the middle-market brokerage business, according to Fisken, who believes Hub management can improve the firm's below-average margins.