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This month at The Motley Fool, we're committing ourselves to getting back to basics, culminating on September 25 with Worldwide Invest Better Day. So far, my Foolish colleagues have armed you with information like the worst investment advice we've received and our favorite investing books. In a previous article, we reviewed stock diversification, a key fundamental of investing. We're looking at stock sectors one by one, focusing today on financial services.
Overview of the financial services sector
Sensitive to the health of the economy and changes in interest rates, the sector includes companies in banking, consumer finance, capital markets, and insurance. The financial services industry grew quickly in the early 2000s because of rising home values, loose lending standards, the invention of new products, and the increased use of debt.
By 2008, the environment started to change, and falling asset values and rising loan losses led to a worldwide credit crunch, meaning a sudden reduction in the availability of loans and an increase in the cost to obtain loans. The sector is currently experiencing the impacts of the credit crunch, among them increased financial reform and regulation, a reduced use of debt, and lower profitability for the industry.
So how will these changes impact financial services companies?
Industry dynamics, major players
Megabank Bank of America (NYSE: BAC ) has been cutting jobs, all part of CEO Brian Moynihan's strategy to shrink the lender in an effort to boost profitability. It'll have shed close to 16,000 by year's end. B of A's botched-up $5 monthly debit-card fee was nearly the nail on the coffin, but the company is banking instead on the after-effects its job shedding and QE3 to prove a windfall for the bank's bottom line. Bank of America's stock is up 58% year-to-date despite revenues being down over 50% since 2009.
Meanwhile, the fallout hasn't been as systemic for regional banks like US Bancorp (NYSE: USB ) and BB&T (NYSE: BBT ) . It's what these banks aren't that makes them attractive for investors: They don't have comparable investment banking reach and didn't participate in aggressive lending to the same degree as their "too big to fail" colleagues. Therefore, these banks have relatively strong capital positions and less underlying risk. Mosey on over to this primer on bank stocks if you'd like to learn more.
Industry trends including enthusiasm for new products like exchange-traded funds (ETFs) should help drive revenues for companies with exposure to capital markets. With $3.5 trillion in assets under management, the world's largest asset manager BlackRock (NYSE: BLK ) generates fees by managing customers' money. Over 85% of BlackRock's revenues are derived this way. When investing in asset managers, keep in mind their businesses are highly correlated with the overall markets.
Consumer finance companies include payment processors Visa (NYSE: V ) and MasterCard. These companies collect fees from merchants with every swipe of your credit or debit card. Potential challenges for payment processors include caps on swipe fees and mobile payment processing. Both Visa and MasterCard are investing heavily in mobile payments, but Google, eBay, a consortium of merchants, predictably Apple, and now Groupon are all getting onboard the disruptive mobile payment revolution. Look for how this will affect traditional payment processing companies in the years ahead.
Get sector exposure the simple way
Many investors shy away from financial services stocks, but owning the sector is part of being a well-diversified investor. Don't have the time or desire to dig into financial services stocks? Consider a sector specific exchange-traded fund (ETF). Sector specific ETFs like the Financial Select Sector SPDR ETF are helpful when you're dabbling in a sector that's not your cup of tea. Roughly 14% of your overall stock portfolio should be allocated to financials, using the MSCI World Sector Weightings as a benchmark.
Build a more cents-able portfolio
Making a bet the wrong way in the stock market could cost you. Instead, develop a diversified strategy for adding all sectors to your portfolio. That way you'll know, regardless of what happens in the market, a portion of your portfolio will triumph.
Want to stay up to date on Bank of America's efforts to boost profitability? Check out our brand-new premium research report. In the report, you'll find everything you need to know, including key opportunities and risks facing the company. You'll even score a year's worth of updates from our analysts. Check out the details here.
Join us for more basic investing information on our microsite for Worldwide Invest Better Day. On the site, we've posted tons of great articles aimed at helping you do just that.