Diversified Financial Services: Investing Essentials

The diversified financial services industry may sound intimidating and isn't the easiest to define, but the massive benefits its firms can provide reveal how compelling the businesses can be.

Aug 4, 2014 at 9:57AM

Diversified Financial Services By Epsosde
There's a lot of money floating around out there, and these companies control a lot of it. Source: epSos.de. 

The financial services industry has many names -- some pleasant and some are not so pleasant -- but in every day conversation, few use the word "diversified" to describe it.

Yet a dive into the details reveals the massive size, scope, and even diversity of those companies which fall into the diversified financial services sector.

What are diversified financial services?

Investing platform Fidelity defines this category as companies with a "diverse range of financial services and/or with some interest in a wide range of financial services including banking, insurance and capital markets, but with no dominant business line." 

With such a broad definition in mind, one of the interesting things about the industry is defining exactly what companies fall into it. After all, three of the four biggest banks have major presence in both basic banking -- think banking accounts and loans to individuals and companies -- but also capital markets -- trading, investment banking, and the like. And their income is split relatively evenly across the business lines.

And while Wells Fargo doesn't have a massive capital markets division, it calls itself a "diversified financial services company." So taking it at its word, you could place it here too. 


Insurance is another example. For instance, at its core, Warren Buffett's Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), is an insurance company.

In a 2013 letter to shareholders, Buffett included a quote from the 1967 Annual Report, when Berkshire first bought an insurance business, that read (emphasis added), "Our investment in the insurance companies reflects a first major step in our efforts to achieve a more diversified base of earning power."

He went on to say its insurance business is "Berkshire's core operation and the engine that has consistently propelled our expansion since that 1967 report was published."

The insurance business is what has allowed Berkshire Hathaway to become so diverse, as it used both the proceeds of its underwriting operations, and the float -- the difference between what it collects in premiums that will one day be paid out to others -- to invest in a wide and diverse scope of businesses and stocks.

Yet Berkshire Hathaway isn't the only financial services company that has a diverse set of businesses under its umbrella. For example, Leucadia owns an investment bank and writes commercial mortgages, but holds the fourth largest beef processor in the U.S. or another is an insurance firm with three energy operations and owns nearly 20 hotels and resorts.  

All of this is to say, both the industry is diverse as it relates to the firms which make it up, and so too are the individual companies.

How big is the diversified financial services industry?

Since the definition of industry leaves it out to imagination, designating the true scope of it is a tough task.

But having said that, at the time of writing, Berkshire Hathaway and the four big banks mentioned earlier, have a market capitalization of $1.1 trillion.

In total, there are is a wide scope of companies which could be placed into the diversified financial services, and as a result, pegging the exact industry size is easier said than done. However, it is undoubtedly a massive one.

How do diversified financial services work?

When considering buying any stock, it's always critical to properly understand the core foundations of how its business operates and how it delivers returns to shareholders. And this need is even more pronounced in the diversified financial services industry, because there is so much complexity in the industry and the companies which make it up.

But generally speaking, for the banks, they operate like any other bank. Yet they will often laud their ability to "cross-sell" or some variation of that term, which means selling other offerings to bank customers.

And for those with core insurance operations, they will use the float -- mentioned earlier -- to make investments in stocks or bonds, as well as other businesses.

What drives diversified financial services?

Since the companies which make up the diversified financial services sector span so wide, it's tough to say things A, B, or C, are the things to keep an eye on and monitor in their financial reports. However, there are a few worth noting.

For the banks, keep an eye on their risk levels, and whether or not they seem to be overextending themselves into industries or areas they shouldn't be in. While government mandates have clamped down on some of the things they are now able to do, only time will tell if those stipulations remain in place and the banks remain under higher regulatory scrutiny. Being able to offer a wide range of services to customers is a great thing, but as we have seen, reaching too far can be incredibly dangerous.

For those companies which are actively on the hunt to make investments, the ability of their management to make sound decisions with the money it earns is vitally important. Even with great operations, a bad acquisition could have a disastrous result on the firm as a whole depending on its size and scope. And, of course, always monitoring the success and ability of the core businesses, whether insurance or others, which drive the success company is critical.

The bottom line on diversified financial services

Because the sector is so wide and can move in so many different directions, each company which finds itself here must be gauged on a company by company basis.

While the work which goes into it may be a bit more complicated and take more time, examples like Berkshire Hathaway growing its book value from $19 a share in 1965 to $134,973 in 2013 shows how the right investment in the right company can provide returns which are unmatched.

Patrick Morris owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway, Leucadia National, and Wells Fargo. The Motley Fool owns shares of Berkshire Hathaway, Leucadia National, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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