Should You Be Overweight or Underweight Financials?

Maintaining a diversified portfolio can help most investors minimize risk and sleep better at night, while also ensuring they don't miss out on winning sectors.

Diversification usually means spreading your bets among a variety of industries. But wanting some exposure to a variety of industries doesn't mean you'll want the same amount of exposure to all industries.

What of the financial sector? Should we dig in or pull back right now? Let's take a look.

Performance
Here's how performance has broken down among the S&P 500 industries:

Sector

Month-to-Date Performance

Quarter-to-Date Performance

Year-to-Date Performance

Financials

3%

3%

14.2%

Industrials

1.4%

1.4%

14%

Consumer Discretionary

2.1%

2.1%

12.3%

S&P 500 Overall

1.7%

1.7%

6.7%

Materials

3.3%

3.3%

5.7%

Consumer Staples

0.1%

0.1%

5.2%

Energy

3.3%

3.3%

3.4%

Health Care

0.1%

0.1%

3%

Information Technology

1.2%

1.2%

2.9%

Utilities

2.8%

2.8%

(2%)

Telecom Services

1.3%

1.3%

(4.4%)

Source: Standard & Poor's as of April 6.

The financial sector endured a long, hard fall during the economic meltdown, but it's come roaring back since. As the chart shows, financials have enjoyed a stellar 2010 so far. Will the party continue, or will financials cool off?

A closer look
Here's a peek under the hood of some of the major U.S. financial stocks:

Company

Market Cap

Subsector

Return on Equity

Price-to-Tangible Book Value

Berkshire Hathaway (NYSE: BRK-A  )

$200 billion

Insurance

6.7%

2.0

Bank of America (NYSE: BAC  )

$185 billion

Diversified Financial Services

3.1%

1.6

JPMorgan Chase (NYSE: JPM  )

$182 billion

Diversified Financial Services

7%

1.7

Wells Fargo (NYSE: WFC  )

$167 billion

Commercial Banking

11.6%

2.5

Citigroup (NYSE: C  )

$123 billion

Diversified Financial Services

NM

1.0

Source: Capital IQ, a Standard & Poor's company.

Though the much-debated "too big to fail" financial institutions dominate the top of the list, the financial segment is more than just banks.

To keep it simple, we can break up the sector into three primary subsectors: banks, insurance companies, and real estate investment trusts. Several companies largely fall outside these classifications -- think American Express (NYSE: AXP  ) or BlackRock -- but they otherwise capture the lion's share of the financial industry.

Let's not kid ourselves about the sector's performance as a whole. The five companies listed above comprise 41% of the total market cap of the 100 largest U.S. financial companies. So while we can dig down and find smaller and potentially more interesting companies like Charles Schwab and Leucadia National (NYSE: LUK  ) , these furious five provide most of the sector's clout.

Putting it all together
While the financial sector doesn't account for quite as much of the S&P 500 as it did before the crisis, it remains a substantial contributor. Unless you think financials will perform terribly, you'll probably want reasonable exposure to the sector.

Though the financial industry has been on the mend over the past year, a slight pall still shadows it. Perhaps counterintuitively, I think this dark cloud could signal a good time to be overweight in this sector.

I don't say that lightly; I still think financials could be a minefield. But investors may still have a few ways to score here.

For those with somewhat lower risk tolerance, conservative banks like Wells Fargo and BB&T may still be able to deliver solid gains without setting off major risk alarms. The same low-risk group could find similar prospects beyond U.S. borders, perhaps with Canadian banks like Royal Bank of Canada (which still pays a decent dividend).

For those willing to take on more risk, much-derided banks like Bank of America and Citigroup could still deliver some fireworks. As far as I can tell, financial reform may end up softer than a Twinkie. That would be good news for too-big-to-fail banks eager to hit their pre-crisis stride.

The best opportunities, though, likely await investor willing to dig into the smaller companies in the financial sector. Sometimes, Mr. Market will decide to scorn an entire sector indiscriminately, which can yield big opportunities among good companies that most investors overlook. Mercury General and Alleghany are two relatively smaller names that have been on my radar lately.

Are you bullish or bearish on the financial sector? Scroll down to the comments section and share your thoughts.

Don't think the financial sector has the right stuff? Todd Wenning is ready and willing to tell you the stocks that you need to know.

American Express and Berkshire Hathaway are Motley Fool Inside Value recommendations. Berkshire Hathaway, Leucadia National, and Charles Schwab are Motley Fool Stock Advisor picks. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


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