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Investing in financial stocks

Investing in financial stocks

The financial sector sounds like banks to most people. Although banks are the largest part of the financial sector, there are other segments, such as insurance, mortgages, financial services, fintech, blockchain and cryptocurrencies.

Types of financial stocks

Financial sector companies differ greatly in function, size, growth potential, and other factors. Financial stocks are shares of companies operating in the financial sector. Investing in financial stocks falls under the moderately conservative (moderate risk of default) investments. Nevertheless, you should asset the risks separately for each issuer.

Financial stocks can be divided into several categories, including:

  • Banks, and as previously mentioned, bank stocks make up the bulk of the financial sector. These include commercial banks, such as Wells Fargo (NYSE: WFC), which provides deposit accounts and loans to individuals and businesses; investment banks, such as Goldman Sachs (NYSE: GS), which provide services to institutions and wealthy investors; and universal banks, such as JPMorgan Chase, which serve both commercial and institutional clients.
  • Insurance. The second-largest part of the financial sector is the insurance subsector, which includes property and casualty insurers, life and health insurers, specialized insurers, and insurance brokers. The largest company in the insurance subsector is Berkshire Hathaway.
  • Financial services - some companies provide investment and public market opening services without being banks or insurers. S&P Global (NYSE: SPGI) rating agency and CME Group (NYSE: CME) futures exchange are both good examples of financial service providers.
  • Mortgage REITs (Real Estate Investment Trusts) own mortgages and other financial, real estate tools, known as real estate mortgage investment trusts. They represent another group within the financial sector.
  • Fintech (financial technology companies) use technology to create new solutions for the financial industry. The most notable representatives of this category are Visa (NYSE: V), PayPal Holdings (NASDAQ: PYPL), and Square (NYSE: SQ).
  • Blockchain and cryptocurrencies - some companies in the financial sector develop products and services using blockchain technology and conduct business related to cryptocurrencies, such as Bitcoin (CRYPTO: BTC).
  • SPAC (Special-purpose acquisition company) is a specialized company for targeted mergers and acquisitions, created exclusively to raise capital through an initial public offering (IPO). Then there is a merger with another private company seeking to enter the stock exchange, bypassing the IPO procedure. SPACs, also known as "blank check" companies, are considered part of the financial sector.

The best financial stocks for beginners

The following are several easy-to-understand financial sector companies with solid, long-term stable ratings. They will be a reasonable choice for first-time investors:

  1. Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) is not always considered a financial sector stock, but basically, it is an insurance company. Berkshire, led by Warren Buffett, is the parent company of GEICO, and it also runs large-scale reinsurance operations. The company's investors access its vast stock portfolio, including large stakes in several major U.S. banks.
  2. JPMorgan Chase (NYSE: JPM) is the biggest U.S. bank and the largest company in the financial sector. The bank consistently reports some of the highest profit margins in the industry and runs extensive transactions in both consumer and investment banking.
  3. Visa (NYSE: V) operates the world's largest payment network and, along with Mastercard (NYSE: MA), holds nearly half of the payment processing industry duopoly. By 2021, the company had reached a transaction processing rate of about $9 trillion a year. That's a small segment of the global cashless payments market that continues to grow, valued by company executives at $185 trillion.

Among exchange-traded funds of the financial sector (ETF), the best one to buy would be Vanguard Financials ETF (NYSEMKT: VFH). For a low annual fee, this fund provides access to a portfolio for the entire financial sector as well as access to 408 different financial sector stocks, ranked according to their market capitalization. Most of the fund's assets are invested in larger financial companies.

Besides the three companies already mentioned, such major financial holdings are also attractive for investment:

  • Bank of America (NYSE: BAC);
  • Citigroup (NYSE: C);
  • BlackRock (NYSE: BLK);
  • Morgan Stanley (NYSE: MS).

Investment analysis in the financial sector

Investors can assess investments in the financial industry using both standard metrics, such as Price-Earnings ratio, and those adapted for this sector. For the banking and insurance subsectors of the financial industry, there are several particularly important indicators to consider before investing.

These indicators are extremely useful for analysis of bank shares:

  • Return On Equity (ROE) and Return On Assets (ROA) are two most widely used indicators to express profitability; ROE and ROA are a company's annual profit expressed as a percentage of equity and total assets, respectively. The standard industry benchmark is 10% ROE and 1% ROA.
  • Net Interest Margin (NIM): most banks earn most of their profits simply by lending money and charging interest to customers. The bank's net interest margin is the difference between the average interest rate the bank receives (on loans) and the average rate it pays (on deposits).
  • The efficiency ratio shows how much the bank spends to generate income. For example, an efficiency ratio of 60% means that the bank spends $60 for every $100 of income. The lower this parameter, the better.
  • Net Charge-Off Ratio (NCO). Calculating this ratio can be useful for comparing the quality of assets of different organizations, since the NCO ratio shows the annual percentage of bank loans that it eventually writes off as bad (irrecoverable) debt.
  • Price-to-Book Ratio (P/B): when valuing a bank's stock, the price-to-book value ratio can be just as useful as the P/E ratio. The P/B ratio is the market price of a company's stock divided by the value of the company's net assets per share.

Two key indicators to analyze insurance reserves:

  • Combined ratio. This is the amount of all the insurance company's claims payments and other business expenses divided by the amount collected by the insurance company from insurance premiums. If the result is less than 100% (the less the better), the company is profitable, if less than 100%, the company is unprofitable.
  • Investment margin: insurers profit from the underwriting policies, and also make money by investing the premiums collected, rather than simply holding that money to pay any claims. It matters how profitable the insurer invests, namely, its investment margin, since investment income is often the main source of profit for an insurance company.

Make long-term investments in the financial sector

Bank stocks were among the worst performers during the COVID-19 pandemic. Financial stocks, especially banks, can be cyclical, which means they are vulnerable to losing value during recessions (economic slowdowns). With rising unemployment, consumers and businesses often have difficulty paying their bills, which can lead the banks to accumulate large amounts of bad debt.

Before making any investment, you should be aware of the risks and consider the overall outlook of the financial company, rather than just one or two metrics. Also, you should keep in mind that financial sector stocks work best as long-term investments.

In the short term, many factors can affect financial stock prices, and most of these factors, such as weak economic conditions or falling interest rates, have nothing to do with the stability of an issuer's business.

If you consider an investment time horizon of five years or more, then adding some of the best financial sector stocks to your portfolio is a smart choice.

Bank stocks and risks

Bank stocks rank in the middle of the overall risk spectrum of the stock market. The two main risk factors are that their prices may be affected by the recession and be sensitive to interest rate fluctuations. But like most other businesses, the risks associated with bank stocks can differ widely among specific issuers.


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