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.

Depository Institutions

Today's uncertain stock market and paltry money fund yields aid banks and thrifts, says Bernard Horn, manager of Polaris Global Value Fund and Quant Foreign Value Fund. Lending activity is up with equity-timid investors buying real estate, and cash is moving from money market funds to higher-yielding bank products, he observes.

Banks are generating near-record profits despite being dealt problem loans by the sour economy, says Mike Rosinus, general partner in the Tiedemann Investment Group, a private hedge fund manager that focuses on bank stocks. Banks have not experienced much commercial loan growth in the last two years, as businesses have reined in capital spending and inventory. "So [if] commercial loan demand picks up and losses on nonperforming loans fall, the table is set for a ramping-up of earnings," Rosinus says, adding that the group is trading at the lower end of its historical P/E range.

Besides coveting institutions that buy back their stock to boost per-share earnings, seek ones that are diversified beyond mortgage origination to avoid exposure to a rise in interest rates. "If the refi (refinancing) wave ends, that business goes away," says Burnham's Schutz. "The pure S&Ls that fund off of CDs also benefited when rates fell, so they've had two good things going for them that would make it hard" to grow earnings if rates trend north.

Another reason for pursuing multi-faceted organizations is that you can't see inside loan or investment portfolios reported on a balance sheet. There is little reliable means of assessing the creditworthiness of loan customers or the investment risks of securities and derivatives held, says Eck. Service revenues, therefore, are attractive. Bank of New York is a significant holding in Cooke & Bieler's Tax-Managed Value Fund because it derives earnings from being a custodian and processor for mutual funds. "We view (it) as a non-bank bank," Eck says.

When it comes to size, the pros disagree on its importance. Eck, for one, likes J.P. Morgan Chase. "We think scale is going to matter and that the few really large banks may have an advantage for a while," he says.

Others, such as Rosinus, are shying away from the mega-companies and buying regional ones. A top position in the local market is one characteristic Rosinus looks for in a regional institution. "We like strong market share on the deposit side," he says, citing M&T Bank Corp. of Buffalo, N.Y., as an example. Rosinus also wants well-capitalized companies, with common equity at 8% of assets (or at least more than 6%) and a loan-loss reserve of more than 1.5% of loans outstanding.

Horn likes small California banks that are filling gaps created by consolidation. "As big California banks have merged and changed, a lot of the customers are fed up. They're finding better service and more attention at the smaller banks," Horn says. Unlike other parts of the country, the economy in southern California is percolating. Horn's picks include Pacific Crest Capital, a maker of Small Business Administration loans, and Hawthorne Financial Corp., which lends against commercial property. A 2002 acquisition by Hawthorne grew its assets and should reduce costs after the organizations are fully integrated, Horn says.

Schutz looks for newly public regional thrifts. "There's usually a three-year period before they can sell (to an acquiring institution)," he says, noting that Connecticut Bancshares and the Boston area's Port Financial Corp. recently turned three. Schutz also likes Brookline Bancorp, which has beaucoup capital and is thus potentially a large buyer of its own shares. Brookline finalized its public offering last summer, so it's not an immediate takeover candidate. "But I view them as on the path," Schutz says. "The chairman is 67. You've got to wonder what's the next step."

Securities

The securities business is unquestionably at low tide. Brokers have been hurt by a drop in trading volume, while asset managers have helplessly watched revenues drop in lock step with stock valuations. But even when things turn around, damaged psyches may prevent the arena from growing quickly.

"I don't think investors are going to steamroll back into the market" for several reasons, says Rich Meagley, a vice president at SAFECO Asset Management and manager of the Seattle-area firm's Equity Fund. "The first is that investors have lost confidence in themselves. People are beating themselves up, going, 'I never should have believed that 25% a year was right. I should have realized that 40 times earnings was too high.' No. 2 is the bear market. We've had three years in a row, so even after one or two good years, you're probably going to be looking at negative five-year performance numbers," Meagley says.

Finally, scandal has eroded investor confidence in corporate America and, to a lesser extent, Wall Street. With the confluence of these factors, says Meagley, "It could take five to seven years for a Schwab or a Morgan Stanley to earn what they did at the peak, if they get back. The next cycle doesn't have to be higher." Although securities firms could be acquired even in a slow-growth environment "there's not a lot in it for stock prices," he says. "It's not a theme."