Rate Fears Obscure Bargains in Financial Sector, Fund Managers Say
By Ian McDonald
Senior Writer
5/13/00 10:00 AM ET
Will they or won't they?
No, we're not wondering whether Alan Greenspan and his pals at the Fed will raise interest rates on Tuesday; prognosticators up and down Wall Street say that's a foregone conclusion. But will the rate hike trigger another round of selling in the downtrodden financial sector?
Several financial sector fund managers say it won't. Of course, it's no surprise they're talking up the sector in which they invest for a living. But they're not the only ones saying a rate hike is already priced into the sector's stocks or that investors often overestimate the pinch rising rates can put on financial firms' margins and earnings.
"They've been hit hard and long enough," says Jim Schmidt, who has co-managed John Hancock's Regional Bank and Financial Industries funds since their 1992 and 1996 inceptions. "Most financials' earnings streams aren't vulnerable to rising rates, but the stocks are. I'm not sure I can explain that." (For more on the phenomenon, see this Saturday's Streetside Chat with value manager Wally Weitz.)
Life wasn't always so confounding for financial-sector fund managers. These funds beat the S&P 500 index in the mid-1990s, but rising rates and investor enthusiasm for faster-growing sectors, like technology, have put financials in the doghouse.
As a result, investors have fled the sector, adding even more pressure to the stocks. For the past seven quarters investors have taken more money out of financial funds than they've invested. Last year alone more than $5.7 billion flowed out of the category. In the first quarter of this year, a little more than $900 million bled out.
Those Were the Days
Financial sector funds are in a funk for the third consecutive year, but are they a bargain now?
1995 1996 1997 1998 1999 2000
Financial Sector Funds Ave. Return 41.8% 28.6% 45.8% 6.2% -1.4% -3.6%
S&P 500 Return 37.5% 23% 33.4% 28.6% 21% -4.2%
Source: Lipper. Performance figures through May 11.
There's a natural connection between interest rates and the health of financial stocks, but it's not as strong as it used to be.
When rates rise, banks and other lenders have to pay depositors and CD holders more for the capital they loan out, and they often can't raise the rates they charge borrowers to compensate. More broadly, rising rates slow the economy, which can eventually take a bite out of revenues earned by brokers, investment bankers and asset managers. Investors traditionally sell financials, particularly banks, en masse whenever rates are expected to go up.
But that instinct might be misguided these days because some financial companies have found ways to buffer themselves from revenue-eroding rate hikes. They've done so by raising fee income, expanding into less rate-sensitive businesses like asset management and into short-term loans and credit cards that adjust their rates within 12 months.
Still, pro and amateur investors alike have sold off the whole group, ignoring those that are buffered against a rate increase. For the most part, the only stocks that have been spared are those of brokers and investment banks, whose results have been buoyed a bull market. Since the Fed started raising rates last June, the KBW Bank Index is down more than 15% and the average financial sector fund is down 12.3%, according to Lipper.
"I think the reaction has been overdone, but it has created value," says Marc Halperin, who manages Federated Global Financial Services.
Halperin likes banks with diversified earnings streams that he thinks have been oversold, like Mellon Financial (MEL:NYSE - news - boards), PNC Finanical Services (PNC:NYSE - news - boards) and FleetBoston Financial (FBF:NYSE - news - boards). As a group, they're selling more than 16% below their 52-week highs with price-to-earnings ratios of 16.9, 10.4, and 14.1, respectively, compared with the S&P 500's 31.4.
He's also anticipating potentially lucrative consolidation among mutual fund management firms like Eaton Vance (EV:NYSE - news - boards), Pioneer (PIOG:Nasdaq - news - boards) and Waddell & Reed (WDR:NYSE - news - boards), all of which lack the "critical mass" to compete with biggies like Fidelity, Putnam and Janus. Pioneer announced in March it was exploring a possible sale of the company.
Hancock's Schmidt likes regional banks like Comerica (CMA:NYSE - news - boards) and insurer AIG (AIG:NYSE - news - boards) because they don't have strong ties to the stock market, but have still managed to post solid revenue and earnings growth. Invesco's Morris likes Wells Fargo (WFC:NYSE - news - boards) for the same reason.
If you're looking for a broader financial play, Schmidt suggests giant Citigroup (C:NYSE - news - boards), which offers access to virtually every sub-sector of the financial world. He thinks investors might want to stay away from brokers and investment banks, which could come down in the world if the economy does finally slow.
But before you charge into the sector, keep in mind that these stocks probably won't head up until it looks like the Fed's inflation-fighting jihad is over.
And interest rates aren't the only problem. In addition to the ongoing series of rate hikes, financial stocks are pressured by overblown consolidation expectations. Last year, Depression-era regulations barring banks, brokers and insurers from combining were repealed, but consolidation didn't heat up. Major acquirers like Bank of America (BAC:NYSE - news - boards) have had trouble digesting their acquisitions, dampening enthusiasm for further consolidation, says Federated's Halperin.
"Financials seem very cheap, for sure. But a lot of people thought financials were a good idea last fall after deregulation and a lot have lost money," says Scott Cooley, a Morningstar analyst who covers financial funds. He admits, however, that financials do look cheaper than the hotter sectors like tech and will probably offer a good return over the next few years.
So buying banks and other bedraggled financials might take guts, but it could pay off long-term. "Everybody's hates these, but you never want to buy stocks that are on everybody's list," says Dave Ellison, manager of the FBR Financial Services fund.
When will the tide turn? Fund managers say once the end of the hikes is in sight, the sector could sharply rise. Hancock's Schmidt thinks that will be in the fall. The recovery may have already begun. Since the KBW Bank Index hit a low on March 10, it's up 15.3%, though it's still in the red since Jan. 1.
Some diversified fund managers may be to thank for that bounce. They may be building up their financial stock positions as techs and other expensive sectors have tumbled.
"We're not in a bull market anymore, baby. Fund managers bought Motorola (MOT:NYSE - news - boards) because they couldn't stomach eBay (EBAY:Nasdaq - news - boards). Where are they going to go now?" asks FBR's Ellison.
Good question
thestreet.com
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Been getting ready to some DD on the sector. The cash outflow is troubling.
Jack |
