ETF Teardown: The Best Financial Stocks

Noted for their simplicity and other advantages over mutual funds, exchange-traded funds have become a popular investing tool. ETFs hold a collection of stocks that share certain elements in common, so if investors want to capitalize on the ongoing need for financial services, for example, they can turn to Financial Select Sector SPDR (AMEX:XLF), whose top holdings include Citibank (NYSE:C) and Bank of America (NYSE:BAC).

But since this ETF invests in a number of banking and financial stocks, it gives investors a broad diversity that also limits their upside. For an investor who is, say, really hip to companies focused more on consumer credit lending and cold to those heavily exposed to the subprime market, this ETF wouldn't fit the bill.

Fear not, Fool -- in this edition of "ETF Teardown," we'll use some nifty tools to drill into the best the financial sector has to offer. To help, we'll use Motley Fool CAPS, our tool for screening and ranking stocks and stock pickers.

The power of tags
To help investors quickly locate great stocks, any of the 4,700 rated stocks that are profiled in CAPS can be "tagged" with a descriptor that groups the company with others that share a certain quality.

Selecting the "Financial Services" tag in CAPS presents a list of 27 financial investments that trade on American exchanges. This particular collection of investments has done well, yet still failed to match broader market returns in the past year, up only 16.4% versus the S&P gain of 25.3%.

To get a sense of which companies the CAPS community thinks are the best opportunities in financial services today -- and which they recommend staying away from -- we can sort this list by CAPS star rank, denoted by one to five stars, with five being the best. Each of the individual companies can then be viewed for exactly who -- from Wall Street to Main Street -- is bullish or bearish on the company and why.

Getting down to the nitty-gritty
Here's a sampling of some of the favored -- and not-so-favored -- financial stocks our screen pulled up today.

One firm at the top of our financial list was spun off from Automatic Data Processing (ADP) back in March: brokerage services firm Broadridge Financial Solutions. Broadridge is not a bank; rather, it operates as a one-stop shop for shareholder communication and securities processing services. While the company has a limited operating history out on its own, management has a long history with the brokerage services group at ADP. The experienced team and cash flow generated from the existing business lines gives 45 of the 47 CAPS investors ranking the company confidence that Broadridge can outpace the S&P going forward. Since many spinoffs have a good track record of unlocking value for shareholders once freed, shareholders are eyeing Broadridge's potential to do just that.

A very popular financial firm that has been beating the pants off the general market -- and one that investors largely think will continue to do so -- is banking behemoth Goldman Sachs. While some investors are concerned about performance in Goldman's hedge fund business and its exposure to subprime lending, many still see the investment banking giant as a leader in the booming investment banking space. With the market still strong and many IPOs coming into the public markets, more than 94% of CAPS All-Stars think Goldman can still beat the S&P going forward.

Not all financial stocks are coming up roses in CAPS-land, though, as more than a few investors have reserved some sour thoughts for stocks such as Bear Stearns and Motley Fool Income Investor selection National City. In the case of National City, investors have significant concerns on a few fronts -- the turmoil in the mortgage lending business being foremost in the minds of many. The company is largely focused on the Midwest region, though it has moved into a few Florida markets through a busy reorganizing process that should help it diversify its business.

While nearly three out of every four CAPS All-Stars are bearish on National City, the company has been buying back shares and increasing its dividend, leaving it with a 4.9% yield today. Contrarian investors may want to track progress at National City -- the market as a whole tends to overreact to financial crises and attach "gloom and doom" to a fixable business. At some point in time, National City may present a good value to investors.

You can lead a horse to water ...
Plucking individual stocks from a diverse sector such as financial services is, of course, a high-risk endeavor. Investors should always perform their own due diligence on companies rather than taking a recommendation. After all, even the best stock pickers can be horribly wrong on a stock.

So, do you agree that outsourced financial services stocks are still the best places to invest? Or are beat-up subprime lenders a better play today? Give your own opinion in Motley Fool CAPS.

The Motley Fool Income Investor newsletter scours the market for quality, high-yielding stocks. To see what other dividend-paying stocks will put cash in your pocket, take a free 30-day trial.

Fool contributor Dave Mock loves doing the teardown part -- it's the put-back-together part he hates. He owns no shares of companies mentioned here. Dave is the author of The Qualcomm Equation. First Marblehead is both an Inside Value and Motley Fool Hidden Gems recommendation. Bank of America and National City are Income Investor recommendations. The Fool has a disclosure policy.