Understanding the Financial Services Sector

 

The Financial Services sector is both exciting and scary for dividend investors. On one hand, you have solid banks that are the heart of our capitalist system; a sign of trust, stability, and growth. On the other hand, think about all the exotic financial strategies like mortgage-backed securities, options, and swaps. Even those who manufacture such products don’t always understand the complexity of the monsters they create.

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To simplify things, we divide financials into three groups:

  • Asset managers: companies that are managing/investing money for others. Mutual funds, hedge funds, real asset managers, and ETF managers are part of this group. Asset managers usually perform in step with the overall market. It is very rare to see an asset manager’s stock price increase during a bear market.
  • Banks: you can subdivide them into global and regional banks, and consider investment banking, commercial banking, and credit as distinct banking industries. It’s all down to deposits and loans. Banks like higher interest rates because the spread between rates on loans and those on deposits increases to their advantage.
  • Insurance: includes life, property & casualty, reinsurance, specialty, and brokers. Insurance companies need strong asset management skills to align their revenues with potential claims costs. It’s easier for them to manage their assets when interest rates are high.

Greatest strengths

Financials represent a true investing opportunity for dividend investors. Many strong asset managers, Canadian banks, and insurance companies share their wealth with shareholders. Just remember to not invest in one that you don’t fully understand.

Asset managers

With asset managers, for example, it’s important to grasp their business and the differences between the two types of asset managers: asset-light and asset-heavy.

  • Asset-light managers, such as Brookfield Asset Management (BAM/BAM.TO), manage funds coming from other investors and pension plans and devise strategies. They have few assets of their own. They charge fees based on total assets under management (AUM).
  • Asset-heavy managers like Brookfield Corporation (BN/BN.TO) do the asset-light manager’s job (strategy + earning fees on AUM), and also contribute with their own assets. Therefore, they benefit directly from their strategies, selling those assets later for a profit. They recycle assets, selling those that are at an excellent value and reallocating the funds to undervalued assets. The classic “buy low, sell high”.

They usually perform very well during bull markets. They enjoy a very sticky business with recurrent cash flow (fees paid by institutional investors). With the shift from mutual funds to ETFs and copious amounts of money to be made in wealth management, leaders in ETFs or financial advisory services will lead asset management going forward.

Banks

Man at ATM machine at night with blue lights surrougding the ATMUS and Canadian banks signal where the economy is going. They increase provision for credit losses (PCLs), lowering their earnings, when they expect more consumers to default on their loans. If they’re right, there’s no surprise; you were warned, and they were ready. If they’re wrong and consumers pay their debts, they recover the PCLs, which pushes their earnings up.

The Big Six Canadian banks are unique, in their highly regulated oligopoly that’s protected by the government. They use their core business in Canada to generate significant cash flow which they use to grow internationally. It’s why they’re able to pay a yield of ~4% and still boast mid-single-digit annualized dividend growth rates over decades, except when forced to pause growing their dividends in 2020-2021 due to the pandemic, which they resumed when allowed. Reputed as conservative, they show low payout ratios (40-60% range), even when they increase their (PCLs). Expect dividend increases in 2024.

Insurance

Not a big fan of insurance companies; they depend too much on external factors (catastrophes, interest rates, etc.). It’s an industry I’d rather ignore in my portfolio to focus on my strength, i.e., my knowledge of the banking industry.

That said, high interest rates are good news for both banks and insurance companies, even more so for life insurance companies. Roughly 50%+ of banks’ income is interest. While rate hikes can push some consumers and businesses toward bankruptcy, they improve banks’ interest rate spreads, which is their margin. To ensure their solvency, insurance companies must invest a lot of the premiums they receive from customers in bonds. With higher interest rates, they generate better results from this portion of their asset allocation.

Greatest weaknesses

A bank’s largest asset is the trust of the market. Lose that, all hell breaks loose. Canadian banks were barely affected by subprime mortgages in 2008, yet they lost around 40-50% of their value. Why? Lost trust due to a big panic.

Other bad examples in 2023 were SVB Financial Group (SIVB) and First Republic Bank (FRC) both failing. Banks must keep a lot of capital on their balance sheet. Since keeping cash generates low returns, they invest it in fixed-income products such as bonds.

What happens when interest rates rise rapidly? Fixed-income products drop in value, which means that banks’ collateral loses value. If a bank isn’t capitalized properly, that’s a problem. If it urgently needs capital to meet its obligations, it might sell assets or issue shares. This often causes panic in the market, as happened with SIVB and FRC, and their stock price crashed.

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Factors affecting financial services companies

Upward pointing arrow made up of blue neon lightsInterest rates and equity markets dictate if this sector does well or not. With low interest rates, banks see their spread (their margin) get thinner. Insurance companies have a similar problem. Since they invest premium payments to make money to cover future claims and generate a profit, an entire asset class (bonds) offering mediocre returns doesn’t help.

When the market goes sideways, many asset managers struggle. If you wonder why the market has been so volatile over the past 15 years, it’s partially due to hedge funds, options, and other “wild” trading strategies. Institutional investors shorting positions or entering massive positions through options can get into big trouble. When the market drops suddenly, fund managers get a margin call, but they don’t have enough liquidity to cover the minimum value. They’re forced to sell assets, pushing the market even lower.

Getting the best of the financial services sector

Understand your investments. Financial businesses often make money from complex strategies. If you don’t grasp how life insurance companies make money (and how they protect their premiums), move along; look for another sector or industry that you understand.

For insurance companies, focus on their underwriting process and size; the larger the company, the more data it gets from its contracts, and the easier it gets for it to manage risk for future contracts and price that risk accurately.

In a market panic, Canadian banks are likely going to get hit, but they’ll still offer you the most reliable dividends in this industry. They’ve proven their resiliency during the 2008 financial crisis, and again Closeup of someone's hand using the ATM keyboardthroughout the pandemic. They increased PCLs during that period but remained well-capitalized. Entering 2024, PCLs have been on the rise for a while, but banks remain well capitalized and all payout ratios, except ScotiaBank, are below 50%.

Invest in leaders with diversified business models rather than one-trick ponies. Leaders enjoy unrivaled economies of scale virtually impossible to compete against. BlackRock (ETFs), JPMorgan (banking from A to Z), and T Rowe Price (retirement funds) show such competitive advantages.

Who should invest in the financial services sector? How much?

The financial services sector offers a great variety of solid dividend growers with decent yields. It’s a great fit for both income and growth investors. You can aim for 10% to 20% of your portfolio in this sector but please, don’t buy all Canadian banks; one or two will do.

 

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