image

Contents

Foreword

Preface

Acknowledgments

Part I: Introduction

Chapter 1: Financials Basics

Financials 101

Financials Sector Breakdown

Part II: Industry Group Details

Chapter 2: Banks

Banks 101

Types of Banks

Banks Industry Group Characteristics

Bank Regulation

Chapter 3: Diversified Financials

Capital Markets

Consumer Finance

Diversified Financial Services

Chapter 4: Insurance Industry Group

Characteristics of Insurers

How do Insurance Companies Make Money?

How do Insurance Companies Act?

Regulation

Chapter 5: Real Estate Industry Group

What is a REIT?

REIT Characteristics

A Representative Example: Annaly Capital Management

Equity REIT Sub-Industries

Unique Measurements for REITs

Part III: Thinking Like a Portfolio Manager

Chapter 6: The Top-Down Method

Investing is a Science

The Top-Down Method

Top-Down Deconstructed

Managing Against a Financials Benchmark

Chapter 7: Security Analysis

Make Your Selection

A Five-Step Process

Financials Analysis

Chapter 8: Financials Investing Strategies

Adding Value at the Sector Level

Adding Value at the Country or Industry Level

Adding Value at the Security Level

Appendix A: Reference Material

Appendix B: Derivatives

Appendix C: Risk-Adjusted Balance Sheet

About the Author

Index

image

FISHER INVESTMENTS PRESS

Fisher Investments Press brings the research, analysis and market intelligence of Fisher Investments’ research team, headed by CEO and New York Times best-selling author Ken Fisher, to all investors. The Press covers a range of investing and market-related topics for a wide audience—from novices to enthusiasts to professionals.

Books by Ken Fisher

Debunkery
How to Smell a Rat
Markets Never Forget (But People Do)
The Ten Roads to Riches
The Only Three Questions That Still Count
100 Minds That Made the Market
The Wall Street Waltz
Super Stocks

Fisher Investments On Series

Fisher Investments on Energy
Fisher Investments on Materials
Fisher Investments on Consumer Staples
Fisher Investments on Industrials
Fisher Investments on Emerging Markets
Fisher Investments on Consumer Discretionary
Fisher Investments on Utilities
Fisher Investments on Health Care
Fisher Investments on Technology
Fisher Investments on Telecom

Other Books by Fisher Investments Press

Own the World by Aaron Anderson
20/20 Money by Michael Hanson
image

image

Foreword

I’m pleased to introduce the eleventh in a series of investing guides from Fisher Investments Press. This imprint—the first ever from a money manager—was launched in partnership with John Wiley & Sons to bring whatever my firm can in the way of educational materials to you, whether you’re an investing enthusiast, student or aspiring professional.

With this book on Financials, we’ve completed the 10 standard investing sectors (Energy, Materials, Consumer Staples, Health Care, Utilities, etc.) and 1 book on a region (Emerging Markets). Each book is intended to stand alone—read one or just a few on topics that interest you. However, if you like this one, you now have access to a full complement of sector investing guides—a comprehensive, do-it-yourself training program for capital markets analysis—from the comfort of your couch.

Financials may conjure bad feelings in some readers. After all, the big 2008 bear market was Financials-led and the accompanying recession particularly deep. But this book isn’t merely a retread of the primary causes and outcome of that episode—such a focus would be too narrow and wouldn’t help you shape forward-looking expectations for the sector.

Nor are Financials inherently bad. In fact, Financials firms are critical to the very functioning of healthy capital markets. All sectors, including Financials, have periods they lead and others they lag—sometimes badly. Individual sectors do occasionally fall big—but not forever. Over long periods, finance theory says all well-constructed equity categories (like sectors) should yield relatively similar returns, though traveling different paths.

And the “different paths” is where this book comes in. Your aim, as an investor, is to understand what drives a sector and its industries, and what makes it more likely for investors to bid stock prices up or down over the next 12 to 24 months.

For example, Financials firms can be particularly sensitive to new regulation. But how? They are also sensitive to interest rate moves—some industries more so than others. Which? And how do interest rates affect them? The book shows you. Financials, as I write, is the biggest standard sector (at 19% of the MSCI World Index) and is fully global—so any analysis must also include an understanding of global regulatory issues, interest rates, liquidity, securities demand and other key issues. A US-only focus can mean missing major factors that can drive the sector up or down. The book will walk you through how to understand global drivers and how to shape forward-looking expectations, no matter the market environment.

Don’t expect to get tips on hot stocks or a “formula” or secret code for finding them. In my third of a century-plus investing money for private clients and big institutions, I’ve never run across such a thing. Rather, this book provides a workable, repeatable framework for increasing the likelihood of finding profitable opportunities in the Financials sector as well as managing risk. And the good news is the investing methodology presented here works for all investing sectors and the broader market. This methodology should serve you not only this year or next, but the whole of your investing career. So good luck, and enjoy the journey.

Ken Fisher

CEO of Fisher Investments

Preface

The Fisher Investments On series is designed to provide individual investors, students and aspiring investment professionals the tools necessary to understand and analyze investment opportunities, primarily for investing in global stocks.

Within the framework of a “top-down” investment method (more on that in Chapter 6), each guide is an easily accessible primer to economic sectors, regions or other components of the global stock market. While this guide is specifically on Financials, the basic investment methodology is applicable for analyzing any global sector, regardless of the current macroeconomic environment.

Why a top-down method? Vast evidence shows high-level, or “macro,” investment decisions are ultimately more important portfolio performance drivers than individual stocks. In other words, before picking stocks, investors can benefit greatly by first deciding if stocks are the best investment relative to other assets (like bonds or cash) and then choosing categories of stocks most likely to perform best on a forward-looking basis.

For example, a Financials sector stock picker probably did pretty well from 2003 to 2006—real estate trends were mostly favorable and lending robust. However, his picks did extraordinarily poorly in 2007 and 2008 as conditions reversed and financial panic ultimately set in. Was he just smarter earlier in the decade? Did his analysis turn bad somehow? Unlikely. What mattered most was stocks in general (and especially Financials stocks) did relatively well from 2003 to early 2006 and very poorly in 2007 and 2008. In other words, a top-down perspective on the broader economy was key to navigating markets—stock picking just wasn’t as important.

Fisher Investments on Financials will guide you in making top-down investment decisions specifically for the Financials sector. It shows how to determine better times to invest in Financials, what Financials industries are likelier to do best and how individual stocks can benefit in various environments. The global Financials sector is complex, covering many industries and countries with unique characteristics. Using our framework, you will be better equipped to identify their differences, spot opportunities and avoid major pitfalls.

This book takes a global approach to Financials investing. Most US investors typically invest the majority of their assets in domestic securities; they forget America is less than half of the world stock market by weight—over 50% of investment opportunities are outside our borders. This is even more important in the Financials sector because a larger proportion of the world’s Financials weight is based outside the US. Given the vast market landscape and diverse geographic operations, it’s vital to have a global perspective when investing in Financials today.

USING YOUR FINANCIALS GUIDE

This guide is designed in three parts. The introduction, Chapter 1, discusses vital sector basics, including the nature of the sector, its makeup and some core characteristics.

Part II, “Industry Group Details,” walks through the next step of sector analysis. Each of the four chapters will focus on one of the four industry groups. Here, we’ll take you through the global Financials sector investment universe and its diverse components. The Financials sector itself includes 4 industry groups, 8 industries and 26 sub-industries. Various firms are driven by enterprise spending, others by consumers and some by real estate trends. Many are leveraged to combinations of these, yet others are leveraged to none. We will take you through the industries in detail, how they operate and what drives profitability—to give you the tools to determine which industry will most likely outperform or underperform looking forward.

Part III, “Thinking Like a Portfolio Manager,” delves into a top-down investment methodology and individual security analysis. You’ll learn to ask important questions like: What are the most important elements to consider when analyzing property and casualty or commercial banking firms? What are the greatest risks and red flags? This book gives you a five-step process to help differentiate firms so you can identify ones with a greater probability of outperforming. We’ll also discuss a few investment strategies to help determine when and how to overweight specific industries within the sector.

Fisher Investments on Financials won’t give you a “silver bullet” for picking the right Financials stocks. The fact is the “right” Financials stocks will be different in different times and situations. Instead, this guide provides a framework for understanding the sector and its industries so you can be dynamic and find information the market hasn’t yet priced in. There won’t be any stock recommendations, target prices, political stances or even a suggestion of whether now is a good time to be invested in the Financials sector. The goal is to provide you with tools to make these decisions for yourself, now and in the future. Ultimately, our aim is to give you the framework for repeated, successful investing. Enjoy.

Acknowledgments

A number of colleagues and friends deserve tremendous praise and thanks for helping make this book a reality. We would like to extend our immense gratitude to Ken Fisher for providing the opportunity to write this book. Jeff Silk deserves our thanks for constantly challenging us to improve and presenting new and insightful questions as fast as we can answer them. Our colleagues at Fisher Investments also deserve enormous thanks for continually sharing their wealth of knowledge, insights and analysis. Without these people, the very concept of this book would never have been possible.

We owe a huge debt of gratitude to Lara Hoffmans, Michael Hanson and Aaron Anderson, without whose guidance, patience and editing contributions this book would not have been completed. A big thanks is also due to William Glaser and Andrew Teufel—aside from making this book a possibility, both are core architects of much of the thought process herein. Amanda Williams helped make the book shorter—and clearer—with some heavy-lifting content editing and eagle-eyed copy-editing. Leila Amiri designed the terrific looking cover. A special thanks to Michael Kelly, Richard Bueche, Akash Patel, Charles Thies and Brian Kepp for contributing content, putting up with endless questions and offering their insightful opinions. We’d also like to thank Alex Nelson and the rest of Roger Bohl’s team of research associates for their help tracking down and formatting elusive data. Marc Haberman, Molly Lienesch and Fabrizio Ornani were also instrumental in the creation of Fisher Investments Press, which created the infrastructure behind this book. We’d also like to thank our team at Wiley for their support and guidance throughout this project, especially Laura Walsh.

Jarred Kriz would also like to specifically thank his wife, Dawn, for her love, understanding, patience and encouragement.

PART I

INTRODUCTION

CHAPTER 1

FINANCIALS BASICS

Trends within the Financials sector are often topics of heated debate, and for good reason—not only is it the largest sector in most broad equity indexes globally, but it revolves around one of the things most hold very dear: money. Money is transferred, multiplied, protected and placed at risk in the Financials sector. The sector is considered the lifeblood of the global economy—and while a properly working Financials sector can be a boon, its going haywire can have unfortunate consequences.

Many of this sector’s products and services are relatively simple, like making a cash deposit at a bank or using a charge card for your morning cup of coffee. And many are quite complex, like making a leveraged bet in a synthetic collateralized debt obligation. Financial innovation has transformed the sector from its simple roots into an incredibly complex system—so complex that, at times, it can engender great fear.

Globally, governments are well aware of the complexity and importance of the Financials sector, making it one of the world’s most highly regulated sectors. From central banks to financial services authorities to consumer protection agencies—the government’s hand in the Financials sector is a core concern, capable of promoting prosperity or driving disaster in the sector and economy as a whole.

This book’s intention is not to provide detailed instruction on complex financial structures’ construction, focus on the 2008 financial panic (as many other books attempt to do) or discuss in detail the impact of myriad proposed and existing regulations, but rather to help readers make better decisions about when to over- or underweight the sector (or the industry positioning within) as part of an overall portfolio strategy. Moreover, we attempt to demystify many of the sector’s complexities and allow for a better understanding of trends. The aim is not to provide definitive answers, but to help readers learn to think critically about this and, indeed, any other sector.


Global Versus Domestic
In our view, a global approach to investing is superior to a domestic-only approach because it allows for greater diversification and more opportunity. However, for data availability, consistency and reliability reasons, we often use domestic data to demonstrate a point. Most often, we refer to the S&P 500 for domestic trends and either the MSCI World or MSCI All Country World Index (ACWI) for global trends. The S&P 500 is an index of the largest US firms, the MSCI World represents the largest developed world firms and the MSCI ACWI also includes Emerging Markets.

FINANCIALS 101

The Financials sector is quite a bit more diverse than many who are new to analysis might assume. However, at a very high level, there are some overarching defining characteristics. First and foremost, it is, as of this writing, the world’s largest sector. In addition, the sector tends to be:

The Largest Sector

The Financials sector is the largest in most global and country-specific benchmarks simply because it represents more companies with more assets, income, equity and sales than any other sector.

Balance Sheets

In terms of assets and shareholder equity—two main components of any company’s balance sheet—the Financials sector accounts for $89 trillion in assets and nearly $7 trillion in equity.1 That’s 72% of assets of all firms in the MSCI All Country World Index and 32% of all shareholder equity (see Table 1.1).2 Simply put, the Financials sector dwarfs all others.

Table 1.1 Percent of Assets and Shareholder Equity by Sector

Source: Thomson Reuters; MSCI, Inc.,3 as of 12/31/2010.

MSCI ACWI Sector Assets Equity
Financials 72% 32%
Industrials 5% 9%
Consumer Discretionary 4% 9%
Energy 4% 14%
Utilities 3% 6%
Materials 3% 8%
Telecommunication Services 2% 6%
Consumer Staples 2% 6%
Information Technology 2% 6%
Health Care 2% 5%

Definitions: Assets and Shareholder Equity
Assets are items of economic value that can be converted to cash, like equipment, securities or real estate. To many financial companies, loans or securities tied to loans are core assets.
Shareholder equity, also known as net worth, is equal to assets minus liabilities.

Income Statements

Using the income statement to value a company is a common technique. Often, a company will be valued based on a multiple of its total sales or net income. When it comes to Financials sector firms, both measurements are often used. Each illustrates the sector’s size, but to a lesser degree than assets or equity (as shown in Table 1.2).

Table 1.2 Percent of Aggregate Sales and Net Income by Sector (2004–2010)

Source: Thomson Reuters; MSCI, Inc.,4 as of 12/31/2010.

MSCI ACWI Sector Sales Income
Financials 17% 22%
Energy 16% 16%
Industrials 13% 10%
Materials 13% 10%
Consumer Staples 11% 8%
Consumer Discretionary 7% 8%
Health Care 6% 8%
Information Technology 6% 7%
Telecommunication Services 6% 6%
Utilities 5% 5%

Comparing the balance sheets and income statements of companies within the broad market, the Financials sector’s large weight seems reasonable. In fact, with the sector accounting for 22% of net income and 32% of equity, it is easy to understand why the Financials sector plays such a prominent role in most broad equity market indexes.5


Financials Sector Weight
Thanks to financial innovation, increased credit penetration and growing acceptance of debt, the Financials sector has more than doubled its weight in the S&P 500 over the last 20 years (see Table 1.3). This trend illustrates the US economy’s transition from an industrial economy to a more information- or knowledge-based economy. But it’s not just in the US. Globally, knowledge-based sectors like Technology and Financials have grown, while Industrial and Manufacturing sectors have shrunk. The difference is more pronounced in developed economies since many emerging economies remain more dependent on raw materials and manufacturing.

Table 1.3 Financial S&P 500 Weights Since 1990

Source: Thomson Reuters; ICB Classifications; S&P 500 Index from 12/31/1990 to 12/31/2011.

image


A More Volatile Sector

The Financials sector tends to be more volatile on average than others yet also tracks closely with broader markets. From 12/31/1974 to 12/31/2011 (a period for which we have good sector data), the Financials sector returned a 9.6% annualized average compared to the S&P 500’s 11.5%.6

Don’t take that to mean Financials is a below-average sector. No—all well-constructed categories of stocks should yield similar returns over very long time periods. There’s no fundamental reason one category should be any better or worse than any other—though they will all go through periods of leading or lagging. For example, from 12/31/1974 to 12/31/2007 (before 2008’s financial crisis), the sector was in line with the S&P 500. Its poorer relative average return now is due to the pretty steep Financials sector-led bear market in the late 2000s.

A relative return index is an easy way to plot the trend of two data series’ relative performance over time. In Figure 1.1, the gray line represents the value of the S&P 500 Financials index divided by the value of the S&P 500 index, while the arrows show general directional trends. As the Financials index outperforms the S&P 500 index, the line moves higher, and vice versa.

Figure 1.1 S&P 500 Financials Sector Relative Return Index

Source: Global Financial Data, Inc.; S&P 500 Financials Sector versus S&P 500 Index from 12/31/2004 to 12/31/2011.

image

Most major stints of relative under- or outperformance have been event driven—meaning some major, largely unanticipated event shocked the system some way and changed the sector’s relative trajectory. (Again, see Figure 1.1.) After fairly in-line performance from the 1970s to mid-1980s, the sector underperformed through the early 1990s as the Savings & Loan (S&L) crisis (as well as multiple sector-specific issues) weighed on it. Outperformance from the early 1990s to the late 1990s was tied to attractive valuations, innovation and a generally stable economic environment. Long Term Capital Management, the Asian Contagion and the tech/Internet boom drove Financials sector underperformance into 2000—until the “new economy” blew up and Financials performed well since the sector was relatively insulated from the Internet debacle. Investors moved to value investing, and real estate trends buoyed bank credit quality. In the late 2000s, however, the sector vastly underperformed tied to increased losses from souring mortgage loans, which intensified as a financial panic arose.

Globally, the trend is similar except for a stark difference during the late 1980s and early 1990s: While US Financials was plagued with domestic issues such as the S&L crisis and bad oil sector loans, foreign Financials was not. As a result, foreign Financials outperformed during the late 1980s. Conversely, as domestic Financials recovered in the early 1990s, foreign Financials was pressured as US financial companies re-emerged on the global scene and competition increased. Trends between US and foreign Financials in the 1970s, early 1980s and from the mid-1990s to early 2000s are similar, but since foreign Financials did not suffer through the late 1980s, it has outperformed domestic Financials since 1974.

While sector returns over long periods of time are similar, each sector does vary in its return volatility. One common measure of volatility is standard deviation.


Standard Deviation
Standard deviation measures the historic deviation from average returns over time. The higher the standard deviation, the higher the swings in returns during any given time period.
There are three levels of deviation. A one-standard deviation event demonstrates events within a 64.2% probability band. A two-standard deviation event demonstrates events outside the 64.2% probability band. A three-standard deviation event is something that doesn’t happen 99.6% of the time. When given the standard deviation of returns, this number typically illustrates a one-standard deviation event—meaning if the sector’s standard deviation is 23.3% returns will vary from 23.3% above to 23.3% below its average return over time with a 64.2% probability.

The Financials sector globally and domestically has the second highest standard deviation of returns over time, just behind the Information Technology sector (see Figure 1.2). Even stripping out the unusually high volatility associated with 2008’s financial panic and the subsequent sovereign debt crisis, Financials still remains the second most volatile sector by this measure.

Figure 1.2 MSCI World and S&P 500 Sector Standard Deviation of Yearly Returns

Source: Global Financial Data, Inc.; Thomson Reuters; MSCI World Sector Indexes and S&P 500 Sector Indexes, Rolling 12-Month Returns from 12/31/1974 to 12/31/2011.

image

So, Financials is typically more volatile than the market average—but that doesn’t mean it widely deviates from the broad market direction. Remember, a rising tide lifts most boats. When broad markets rise, so do Financials—usually. And when markets fall, so do Financials—most of the time. However, because of Financials’ exposure to capital markets–related functions—like asset management, brokerage and investment banking—and its high leverage, which amplifies gains and losses, it tends to be sensitive to overall market trends (i.e., it has a relatively high beta).


Beta, Correlation and R-Squared
Beta is a measurement of how responsive a financial asset is to the market as a whole. An asset with a beta of 1.1 is expected to perform roughly 10% better than the market in a rising market and 10% worse in a falling market.
Correlation is a statistical measure of how two securities move in relation to each other. The measurement, or coefficient, ranges between 1 and −1, with 1 being a perfectly positive relationship and −1 being perfectly negative. R-squared is calculated by squaring the correlation coefficient and represents the explanatory relationship between two securities. In other words, when compared to the S&P 500, a stock with a correlation coefficient of 0.80 would have an R-squared of 0.64, which means 64% of its movement can be generally explained by the S&P 500’s movement.

The S&P 500 Financials sector has a beta of 1.10, and the MSCI World Financials Index has a beta of 1.18, relative to the respective broad market indexes, since 1974.7 This makes it the highest beta sector globally and third highest domestically. (See Table 1.4.) Typically, a higher historical beta is indicative of a sector that is more economically sensitive over time—sectors like Technology, Financials and Consumer Discretionary fit the bill. A beta greater than 1 tells us the sector typically goes up more than the market in up markets and down more in down markets—but this relationship is not static, as you can see in Figure 1.3.

Table 1.4 Sector Beta

Source: Global Financial Data, Inc.; Thomson Reuters from 12/31/1974 to 12/31/2011.