When will Financials be Investment worthy again?

by Wayne Ferbert on January 4th, 2012

The Financials sector has definitely been the punching bag for the markets for the last 4 years. The performance has been terrible and some of the largest blue chip stocks in this sector are among the worst performers in the entire S&P500. Add to this mix the steady dose of ‘kick them when they are down’ from the Occupy Wall Street crowd. Ouch!

But every sector that is ‘un-investable’ eventually rebounds and becomes one of the better performers once it does rebound. This is why so many investors believe in sector rotation and regularly rotate money to past under-performers. But when do you do this?

If you have tried to rotate to the Financials sector in either 2010 or 2011, well, you wouldn’t have been that successful. But you could have made a case for it in either year (and many talking heads on CNBC did just that). This is a hard sector to figure out. I have spent my whole career in financial services so I think it is the business model I understand the best.

But in this sector, picking the business winners and picking stock winners are not always the same thing. So much more matters in this space: balance sheets; market confidence; risk management & risk controls. And it is hard for the individual investor to get a good feel for all of these components.

So, all of this begs the question at the beginning: when will this sector be investment worthy again?

An interesting article in the Wall Street Journal today points out an interesting point about the earnings estimates for financials in 2012. Basically, under current S&P 500 earnings estimates, 26% of the growth in these earnings is going to be driven by the top 6 financial firms in the S&P500. This represents a significant rebound in earnings for these financials.

But ask yourself a question: does the performance in the Financials sector in 2011 look like it anticipates this kind of rebound? Or does this price performance imply a more skeptical investment community? Take a look at the Financials ETF, symbol XLF, which follows the sector.

Where you stand on this point should guide your decision on Financials. If you think this earnings growth will come around and be realized, then you probably should like this sector. If not, then you should probably avoid it.

Here is what I think about the sector:
  • It has been very beaten down and definitely has room to recover. And the recovery has the room to be sharp
  • Profit margin as a % of sales will never reach the pre-2007 levels again – meaning multiples probably won’t either
  • Despite the populist uproar, I don’t see a lot of meaningful regulatory reform affecting earnings in the next 12-18 months. After the presidential general election, however, there is certainly potential for a new push to regulate the industry more – and squeeze the profit margins even more.
  • While margins will likely be squeezed, I can still see total earnings in the industry in dollars growing as the industry looks for other ways to expand wallet share and fees. And as the economy improves and balance sheets improve, earnings will grow from these effects as well.

Net/net: It is time to watch the financials very closely. And maybe even dabble in some. But remember Iron Rule #1: Hedge Every Investment. And I would set your hedges in this industry a little tighter than most!

(Full Disclosure: The author has a position in Bank of America (BAC). And some of the author’s clients are invested in Bank of America (BAC).)

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