Financial stocks still looking good

By Elmer L. (Al) Meszaros, CFA, Partner

“Money never disappears, it just finds a new parking space—so own as many parking spaces as possible.”

That pithy advice was offered by Dick Kovacevich, CEO of Wells Fargo & Company, to a meeting of professional investors in Cleveland.

His suggestion was also a simple, yet effective rationale for incorporating financial service company stocks into our clients’ managed portfolios. Financial services companies—including banks, insurance, investment, mortgage, and real estate firms—are the “gatekeepers” of American commerce. They derive fees whenever money changes hands and represent nearly 22% of the U.S. economy.

Legendary “Pony Express”

Many financial service companies have long histories of profitable operations and stability. Some of our holdings, such as National City, Fifth Third Bank, and U.S. Bancorp, were founded more than 150 years ago. Wells Fargo was founded in 1852 and used the legendary “Pony Express.” Many prospered from the Agricultural Age to the Civil War era, through the Industrial Age into the Information Age.

Their growth continued through wars, depressions, booms and busts. Despite significant bank failures in the 1930’s, most survived.

Today, many well-run financial service companies are growing slightly faster than the economy. In fact, financial service companies currently represent 21% of the value of the S&P 500 and 36% of the Barra Value Index.

Midwest Investment Management currently invests a significant portion of our clients’ assets in financial service stocks because we like their ability to deliver steady growth in earnings and dividends, despite fluctuations in interest rates.

On average, the dividends of financial service companies have grown substantially faster than the S&P 500 Index in recent years (see chart below).

This superior growth in earnings and dividends has been reflected in superior shareholder returns, as shown below.

Any risks?

Not all financial service companies are good investments, however. In fact, dozens of poorly managed financial companies have disappeared over the years. Risks can result from:

1. Excessive debt leverage;
2. Excessive exposure to interest rate changes;
3. Poor asset quality;
4. Poor execution.

Currently, some people believe that rising interest rates will produce a negative effect on financial service stocks. We hold a different view. We believe the stocks of many bank and insurance companies could actually benefit from rising interest rates because it would improve their asset yields, offsetting the burden of rising interest rates.

How we judge financial stocks

Strategies are usually not unique, so execution defines the winners. First, we look for asset quality. This means the company should own a diversified portfolio of good quality loans and investments. Revenue growth—the ability to grow the business—is indispensable. Expense control is a necessity. The ability to consistently expand revenues faster than expenses is the mark of a potential winner. Skill in integrating acquisitions is important. Last, but not least, we look for quality management reflected by solid execution of growing revenues, earnings, and dividends.

Springboard for growth

A well-run financial company is an annuity-like business with 80% to 90% of revenues fairly predictable at the beginning of each year. This stability provides an advantageous springboard for growth. Thus, a company like Wells Fargo that can grow its earnings 10% to 12% annually with a 3% dividend yield produces compounded growth of invested value at 13% to 15% per year.

This means you could double your money every five or six years—not bad!