How to Profit From the Financial Revolution
thestreet.com
Remember when we all thought that financial companies such as Charles Schwab, Merrill Lynch (MER:NYSE - news - commentary - research), American Express (AXP:NYSE - news - commentary - research) and American International Group (AIG:NYSE - news - commentary - research) were leading a global charge that would revolutionize the way everyone from New York to New Delhi handled their money? That long-term story was easy to believe when the sector was riding high, but what about now?
Has the meltdown in the shares of Merrill Lynch and Charles Schwab with the collapse in trading volume changed the long-term prospects for those stocks? Merrill Lynch is down 22% this year and Schwab has tumbled 53%. How about the huge losses in the junk bond portfolio at American Express? The evaporation of the Internet IPO market that Morgan Stanley Dean Witter (MWD:NYSE - news - commentary - research) had so carefully cultivated? American Express has declined 29% in 2001 and Morgan Stanley has fallen a bit more, by 30%. Even the consistent cash flow from insurance and asset management hasn't prevented both American International and State Street (STT:NYSE - news - commentary - research) from declining 17% for the year to date.
Well, you know what? Despite this very real near-term pain, I still believe in this story, and I still believe that we're less than halfway through that global financial revolution. Despite the temporary collapse in trading volume on U.S. stock markets, despite the huge losses recorded in venture capital funds and junk bond portfolios, despite fears of rising defaults from corporations and consumers in a soft economy, I still think that long-term growth investors should have a hefty chunk of financial stocks in their long-term portfolios.
That's why my conservative long-term portfolio, the 50 Best Stocks in the World, includes American Express, American International, AXA (AXA:NYSE - news - commentary - research), Citigroup (C:NYSE - news - commentary - research), General Electric (GE:NYSE - news - commentary - research), Fannie Mae (FNM:NYSE - news - commentary - research) and Merrill Lynch. And it's why I'd like to add more financial stocks to the more aggressive long-term picks, such as Charles Schwab and E*Trade (ET:NYSE - news - commentary - research), in the Fantastic Future 50 portfolio.
Four Trends of the Revolution
But which financial stocks? As a long-term investor, I think you want to own stocks that will participate in the four major trends that add up to the still-unfolding global financial revolution.
Trend 1: The Americanization of global finance. Credit cards, cash management accounts, self-directed retirement accounts such as 401(k)s and IRAs, electronic trading -- all the things that now characterize the financial system in the U.S. -- are gradually making their way around the world. Root causes include the growing middle class population in parts of the developing world; aging populations in the developed world that are saving and investing for retirement; and the failure of traditional financial systems in countries like Japan.
Not all the new products will be sold by U.S. companies or even by foreign players of any nationality, but U.S. firms such as Citigroup, American International, Fidelity, General Electric and Charles Schwab have gradually worked their way into the most promising markets in Asia, Europe and Latin America. And I don't think investors trying to profit from this trend should underestimate the potential opportunity that weakness in the global financial system gives these aggressive global giants right now. In May, for example, Citigroup bought Banacci, the holding company for Mexico's second-largest bank. The deal gives Citigroup 1,300 new retail branches in Mexico -- that's three times more branches than Citigroup has in the U.S. Citigroup now has $85 billion in Latin American assets, more than any other U.S. bank.
Trend 2: Market segmentation by service and price point. This is most obvious in the brokerage business, but it's true throughout the financial industry. The goal for most financial companies now isn't to create one massive brand matching services (and price) to customer groups. Instead, companies are aiming to create multiple brands that appeal to distinct market segments (if the company is big enough) or to specialize in products tailored to a specific market segment.
Want a broker who will hold your hand full-time -- and charge for it? Go to Merrill Lynch. Want a brand name you trust, lots of backup and a full range of products ranging from bonds to CDs to financial planning? How about Schwab or Fidelity at $15 to $30 a trade? At $10 to $20 a trade, E*Trade and its Internet-oriented system address a different market segment at a different price point. And so does Ameritrade (AMTD:Nasdaq - news - commentary - research) at $8 a trade, and so on.
American Express traditionally practiced the same kind of segmentation with its green, gold and platinum cards and has recently moved into another segment with the blue card. Capital One Financial (COF:NYSE - news - commentary - research) uses its massive database to even more carefully tailor card to customer by mixing and matching rates, credit limits and fees. The day is not too far away when a company like Capital One will sell customized one-of-a-kind financial products tailored to what it knows and what it thinks it can predict about each individual customer.
Trend 3: Be narrow: Do just one thing, but do it well. Once upon a time, being a car maker meant that you had to own iron mines, railroads to transport the ores and coke, steel mills, battery and seat cushion factories, car assembly plants and auto dealerships. Now auto companies are busy outsourcing as much of the process of making what goes into a car as possible so they can concentrate on the few functions -- engineering and design, manufacturing and marketing -- where they can add value to the product.
The same trend is reorganizing the financial industry. Few mutual fund companies handle their own shareholder bookkeeping; they let State Street do it. Credit card companies farm out their transaction processing to a specialist like First Data (FDC:NYSE - news - commentary - research). Brokerage firms like Charles Schwab haven't attempted to build a network of financial planners, but instead decide they can make more money by letting existing planners do the planning while Charles Schwab handles the bookkeeping and executes the transactions.
Trend 4: Build a category killer. The bulk of the profits go to companies that dominate their markets. That's why General Electric and American International, already No. 1 and No. 2 in most segments of the capital equipment leasing business, are out to gobble up other leasing companies. (And that consolidation trend is one reason Warren Buffett's Berkshire Hathaway (BRK^A:NYSE - news - commentary - research) owns 15% of GATX (GMT:NYSE - news - commentary - research), a top-three lessor of railroad cars and aircraft.) That's why Washington Mutual (WM:NYSE - news - commentary - research) has been on a buying binge that has made it the No. 2 home mortgage lender in the country. And why MBNA (KRB:NYSE - news - commentary - research) has been waging a neck-and-neck battle with Citigroup to see who will be the top issuer of credit cards. In the financial sector, it's not just size that counts -- the sector is full of big companies that don't make any money -- but the ability to wring excess profits out of controlling the No. 1 or No. 2 slot in a market. |
