It's not difficult to understand the "whys" behind the wild swings the financial services industry in general, and the banking sector in particular, have undergone lately. What's troubling is that the ups and downs over the last week or so seem to be bringing momentum investors into the fray.
Volatility personified
Industry leaders including Citigroup (NYSE: C), JPMorgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS) have bounced up and down seemingly daily. The exception to the industry's wild swings in price and trading volumes is Wells Fargo (NYSE: WFC) -- and as we'll see, that's exactly as it should be.
With all the financial news pouring in, it's not surprising investors are reacting, but much of the movement in financial stocks seems more like overreacting, opening the door for short-term momentum investors to take over. Whether on the up- or downside, the financial services industry has been much more volatile than the market as a whole. When the S&P is up, the financial sector is way up by comparison. Unfortunately for investors, the reverse holds true as well.
For investors who believe there are values to be had (a good mid-to-long-term notion, by the way), jumping on and off the momentum bandwagon is no way to generate long-term gains.
The opportunities
Fools everywhere know that incorporating current data into their long-term investment approach is the way to invest; let the daytraders chew their fingernails to the nubs dissecting their up-to-the-second charts. For the banking sector, this means finding institutions that are building revenues based on traditional banking lines, like growing quality loan portfolios and core deposits, and generating consistent noninterest-income streams.
As an industry, revenues from trading activities (in other words, investment performance) will always play a part in results; there's nothing wrong with that. But the result of buying (nearly) pure-play investment management companies like Morgan Stanley or Goldman Sachs (NYSE: GS) is more exposure to the whims of global markets and near-term economic indicators. Morgan Stanley's three business segments -- institutional securities (including investment banking), global wealth management, and asset management -- are dependent on securing and growing investment assets or placing trades. Goldman has similar segments, which are subject to the same inherent risks.
The result is that Morgan Stanley, Goldman, and others of that ilk lack the ability to generate sustainable, long-term revenues via lending activities, in addition to benefiting from investment activity, like Wells and Citi do.
So what's an investor to do?
For sustainable mid-to-long-term growth, look for bank stocks that are strengthening core banking lines and services. Like what? An increase in deposits and loans, recognizing that net interest margins may be squeezed based on the low rate environment we're in, are two key areas to focus on. Also investigate loan-loss allowances: Are they getting larger or smaller? As the quality of a bank's loan portfolio improves, the amount they are required to set aside to meet possible defaults decreases. And that's another sign the institution is heading in the right direction.
Moody's recent credit review and downgrade was an indicator of how well, or poorly, some of the key industry players are doing in strengthening their financial statements, and limiting their exposure to capital markets. Though the downgrades to JPMorgan, Citi, and others didn't negatively impact stock prices, they were indicative of which banks have taken steps to manage shareholder risk.
A prime example
So is there any bank out there that's focused on building its business the right way, with the potential for growth with or without the momentum players? You bet there is: Wells Fargo. Wells' first-quarter growth in net income year over year rose 13% and revenues grew 6%. This and the dividend increase announced in March all point to a bank heading in the right direction. But a closer look at the financials uncovers areas investors should be even more excited about going forward, and speak directly to a return to fundamentals.
During the same first quarter, Wells increased average core deposits 9%, average loans were up 2%, and assets increased 5% over the first quarter of 2011. All the while, the bank's allowance for loan losses dropped 14%. Not only is the bank growing its core banking lines, it's strengthening its loan portfolios as evidenced by the lower loan allowance and a decrease of nearly 30% in net charge-offs. In other words, conducting business like a bank, which is sustainable for the long haul. Forget the momentum swings; as Wells Fargo continues to show us, there are legitimate long-term opportunities.
If you're going to invest in the financial services industry, avoid trying to guess what will happen tomorrow; that's an ulcer waiting to happen. Let the momentum players play that game. Find a strong bank that's growing the right way, and hold on to it.
And you're hardly alone if you have interest in the financial services industry right now, volatility and all. One of the best long-term investors around is on board too, as described in detail in the Fool's free special report "The Stocks Only the Smartest Investors Are Buying."
