In Uncategorized on August 13, 2009 at 23:12

Financial-services stocks have bounced back dramatically from the market’s nadir of early March. During the past month alone, the S&P Financial sector popped 21%, making it the best-performing sector within the S&P 500 Index  for the period.

If you were off enjoying your summer vacation and missed this rally, you may be wondering: Is it too late to dive back in?

The short answer: Take the longer view. The stocks have been recovering because investors are betting that the strong have survived. “From a bigger picture point of view, I think the next three to five years will be a period of great opportunity to make noticeable returns in financial services stocks,” says David Ellison, manager of FBR Small Cap Financial Fund .

After the demise of Lehman Brothers and the near-meltdown of the global financial system last fall, it appears government intervention has successfully staved off the death of capitalism as we know it. However, with unemployment still high, foreclosures climbing, and troubled commercial real estate loans looming, there are still significant challenges for banks and other financial-services companies. Nearly all of the major players in the financial sector are digging out from the downturn, which hit banking, mortgage finance, consumer finance, investment banking and brokerage, asset management and custody, corporate lending, insurance and real estate.

More recently, however, the sector has been helped by good news. In May, the government released the results of its stress tests of the nation’s 19 largest banks. The results were generally viewed as positive, although 10 banks were instructed to raise additional capital, which they accomplished easily by selling new stock. In fact, May was the biggest month ever for secondary equity issuance. In recent weeks, quarterly earnings for some of the nation’s largest banks, such as Goldman Sachs , Bank of America , and JP Morgan  exceeded expectations.

“We changed the debate on large financial-services companies from a debate about survival to a debate about earnings power. That’s a very healthy development for the sector,” says Benjamin Hesse, manager of Fidelity Select Financial Services Portfolio .

The tide turns

As the recent upturn demonstrates, there is a growing sense that perhaps the worst is over for financial-services companies. For the three-month period ended Aug. 6, financials were the market’s second best-performing sector, rising 11.85%. Year-to date, the sector’s 14.61% gain exceeds the 11.95% gain in the S&P 500 Index.

But the recovery has been uneven. A closer look at the wide variety of industries within the sector reveals dramatically varying performance. For example, while insurance broker stocks fell 7.5% year-to-date through August 7, investment banking and brokerage firms soared 77.8%.

These divergent results underscore the importance of being selective when looking at the financial-services sector. While you may be tempted to take a flyer on beaten-down stocks like AIG  or Citigroup , investing in a diversified sector fund could be a more prudent way to participate in any recovery, since the diversification will reduce downside risk.

One such diversified fund is Hesse’s Fidelity Select Services Portfolio , which holds large-cap stocks from both the United States and overseas. Hesse says consolidation within the industry, declining delinquencies on consumer credit cards, and higher capital reserves are all positive trends.

In recent months, he has favored bank holding companies with high exposure to the investment banking industry. He thinks these companies will profit from an uptick in bond issuance and wider bid and ask spreads in their trading operations. Beaten-down insurance companies have earned a more prominent spot in the fund as well.

Hesse also has increased the fund’s exposure to foreign banks in China — where he believes banks can expand their return on equity — and Japan, where valuations have been extremely low.

While Hesse is heartened by the recent recovery in financial stocks, he is mindful of the risks that still loom on the horizon, including tougher regulations on the industry. That is a mixed blessing for the banks, since it could limit competition but also add new costs.

“Over the long-term, government regulation may be a barrier to entry, so maybe you see a little bit of pricing power coming back over time,” Hesse says. “But in the near term it probably means lower returns.”

New consumer protections for mortgage loans, home equity loans and credit cards under consideration in Washington could put a dent in the future earnings potential of large financial services companies, he says. “I think that what happens with the regulatory framework is one of the biggest overhangs for the sector,” Hesse says.

In the small-cap sector, FBR Small Cap Financial Fund  invests in banks, thrifts and other financial-services companies with market capitalizations of $3 billion or less. Manager Ellison, who has been at the fund’s helm since its inception in 1997, looks for companies with strong management teams and that are big enough in their markets to have some pricing power.

“This is a great time to be in this space, because I think it’s all about management now,” Ellison says. “Three to four years ago, we were dealing with a whole bunch of what I call  ‘Enrons.’ These were companies with very complicated balance sheets and income statements. Now we’re going back to de-levered, de-risked, de-complicated balance sheets, which will eventually show up in much more stable earnings.”

Ellison’s 26 years of experience analyzing and managing financial-sector funds has taught him valuable lessons about managing during a crisis. Having survived the savings and loan crisis of the late 1980s, he is much quicker to sell holdings and raise cash when danger is on the horizon. After having more than 60% of the fund’s assets in cash early in 2009, Ellison has since reduced cash to about 8%. While his fund did not escape unscathed, the move to raise cash helped reduce damage from the market meltdown.

Ellison thinks today’s low interest rate environment will help bank certificates of deposit compete with brokerage firm’s money market funds, many of which are yielding less than 1%. A steepening yield curve (meaning longer-term bonds have significantly higher yields than short-term bonds) also helps banks borrow money cheaply and lend it out at higher rates. “The loans banks are making today are vastly superior to the loans they were making two years ago,” Ellison says.

Despite recent gains, the financial services sector is not completely out of the woods. “There are still significant challenges ahead of us in terms of the economy, home prices, unemployment, commercial real estate prices, and tighter underwriting standards,” Ellison says. “This recovery is not a two-month thing. I look at it as a three- to five-year event and maybe even a seven-year event.”

Fund picks from Fidelity

Strategic Advisers Inc., a Fidelity Investments company, has sifted through the thousands of funds available through the Fidelity FundsNetwork, including Fidelity and non-Fidelity funds, to identify funds in a variety of investment categories, including financial services stocks. Analysts evaluate several criteria, including:

Performance: At least three years of performance data is required

Risk: Only funds with the highest three-year risk-adjusted returns (the so-called Sharpe Ratio) within each category are selected

Loads and fees: Funds that charge a transaction fee or sales load are not considered

Funds must have a minimum of $100 million in assets, be open to new investors, and have an investment minimum of no more than $2,500


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