How to invest in finance

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Important information: The value of investments and the income from them can go down as well as up, so you can get back less than you invest.

Warren Buffett, the world’s most famous investor, once said, “Never invest in a business you can’t understand.”

This logic has kept many investors away from the financial sector, which is home to many complex business models and bewildering jargon.

His case was not helped by a bad decade capped by a painful 2020. However, it is a sector that could benefit greatly from the reopening of economies and consumer confidence. His fortunes may be about to change for the better.

In order to understand how and where to invest in the industry, it is important to first understand how it works.

Give meaning to banks

The key to understanding this industry is to understand banking. Their business models underpin the number of other financial companies that operate.

The profitability of a bank depends on two things. The first is what is known as the “net interest margin” (NIM). This reflects the difference between the money a bank borrows at a lower interest rate – through customer deposits such as checking accounts – and the money it lends at a higher interest rate – via mortgages, loans, overdrafts, etc.

The greater the difference between the two, or the greater the “spread” between them, the greater the NIM.

A bank will also earn money from the fees and charges on the accounts. Its overall profitability will be a combination of NIMs plus that non-interest income.

It’s a fairly straightforward model, but it can easily run into some obstacles along the way.

Banks are typical “cyclical” businesses, which means that their performance tends to reflect the overall health of the economy – they do well when times are good, and do badly when they don’t.

There are two main reasons for this. The first reflects the general state of loan conditions for banks. In a healthy economy, the conditions are right. Consumers and businesses are more likely to seek loans – whether it’s to expand their business, buy a home, etc. – while the probability that borrowers will not repay these loans decreases.

The second reason is more closely related to the NIMs of banks.

What banks ideally want is something that looks like the “yield curve” of a healthy economy. The yield curve reflects the difference in yield available between short and long term bonds.

In a healthy economy, where interest rates are not low and people are confident about the present, short-term bonds pay less; long-term bonds, considered riskier because of their greater time commitment, should offer a higher yield to offset this risk.

The NIM of banks is based on a similar relationship between short and long term loans. The maturities of their assets (eg mortgages) tend to be longer than those of liabilities (eg customer deposits) – they “lend long, borrow short”. The larger the gap between the two, that is, the healthier the yield curve, the better for the bank.

A healthier economy should equal a healthier yield curve. This could mean the ideal spread for the financials NIM.

For insurers, the relationship is similar. Insurers tend to hold a lot of secure debt to back up their policies. As interest rates rise, the yields on that debt follow suit. For asset managers, the money they earn is tied to the charges on their assets under management. In other words, the more money they hold and the more transactions customers make, the better.

Cheap valuations

There’s another reason financials look good right now: they’re cheap.

The banks tarnished the industry’s reputation during the financial crisis, and the decade of low interest rates that followed kept them firmly in embarrassment.

This had a powerful effect on the ratings. The price-to-earnings (P / E) ratio (a measure that compares the industry’s share price to its earnings per share) for global financials stands at 16.4 vs. 28.4 on the index MSCI World. The value of the price to reserve (P / B) is 1.21 versus 2.94 – a lower P / B can be an indicator of value.

The area is also home to many of the UK’s major dividend payers. Others, like the oil companies and British American Tobacco, present ESG risks that may worry income seekers. While many banks were forced to cancel payments last year when COVID hit, most have since resumed.

Where to look

Despite all the complicated work that goes on behind the scenes, there are many financial names that are very familiar. Banks like Lloyds, Barclays and NatWest suffered last year and while their stock prices rallied with positive vaccine news, most are still down from their 2020 starting point, suggesting there may still be room for maneuver.

Bank dividends remain low – most yielding around 1 to 1.5% – but this is not much of a surprise given that they have been advised to resume payments with caution. These yields could start to rise as we come out of the crisis.

Another bank to consider is HSBC. Like many, she has had a difficult 2020. Its international arms have also been affected by US-Chinese tensions and political instability in Hong Kong. But this international exhibition sets it apart from others. Areas like Asia and emerging markets, with their expanding middle classes, represent serious growth opportunities for financials in these regions.

Think too much of disruptors as Metro Bank. Metro was established in 2010 and has already consolidated its place as the main bank on Main Street. Although he is doing better than some last year, his share price has nevertheless fallen again following his 2020 results. Given his relative youth, he may seem riskier – he has already grazed the mark with its capital ratio and has received some attention from Reddit / GameStop investors – but it could be another value opportunity.

Beyond banks, there are plenty of insurers and asset managers with equally attractive valuations and more eye-catching dividends.

Aviva and Legal and general both offer attractive term dividend yields above 5%. Careful, while offering a lower dividend yield, has made a series of structural changes that could be useful in coming out of the pandemic. The latter has also benefited from diversification into other areas. The losses in Prudential’s US insurance business last year were offset by its investment arm, PGIM.

Asset managers also offer impressive dividend yields at low prices. Schroders benefited from a pickup in investor activity and is currently offering a strong forward yield of 3.3%. M&G, meanwhile, offers an eye-catcher of 9%. It may sound like a trap – especially since M&G has been paying dividends for less than two years – but payouts have proven to be stable during that time.

Finally, consider going beyond the usual names of FTSE and the UK’s burgeoning fintech scene. In 2020, the UK accounted for just under half of European fintech investments, according to Innovate Finance.

Investing in fintech is quite a different experience than owning traditional financial stocks. Many look a lot more like growth tech stocks than “old economy” financials, and most remain unprofitable.

But there might be real potential in names like Fundraising circle, a platform that allows investors to lend to small businesses, and AIM stock CPP Group, which serves a number of well-known companies like AXA and Vodafone, and began to expand into emerging markets like India and Mexico.

Glossary:

Price to book (P / B): The price-to-book is a financial ratio used to compare a company’s current market price to its book value – the value of a company’s assets.
Profit price (P / E): A valuation ratio of a company’s current share price to its earnings per share.

Important information: Reference to specific securities should not be construed as a recommendation to buy or sell such securities and is included for illustration purposes only. When considering investing in stocks, it is usually a good idea to consider holding them along with other investments in a diversified portfolio of assets. Foreign investments will be affected by fluctuations in exchange rates. Investments in emerging markets can be more volatile than in other more developed markets. Investors should note that the views expressed may no longer be relevant and may already have been the subject of action. This information does not constitute a personal recommendation for any particular investment. If you are unsure of the suitability of an investment, you should speak to a Fidelity advisor or authorized financial advisor of your choice.

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