CHAPTER 3

DIVERSIFIED FINANCIALS

The Diversified Financials industry group is the “catchall” of the Financials sector. If it doesn’t fit neatly in the Banking, Insurance or Real Estate groups, it’s labeled a diversified. Although the group is diverse enough to capture pawn shops and nationally recognized statistical rating organizations (NRSRO), the vast majority of the group is made up of capital markets-related and multi-faith conglomerates. Using GICS classifications, the group consists of Capital Markets, Consumer Finance and Diversified Financial Services industries (see Table 3.1).

Table 3.1 Diversified Financials Composition

Source: Thomson Reuters; MSCI, Inc.;1 Russell 2000 and S&P 500 Indexes. As of 12/31/2011.

The group is very top-heavy: The largest 10 Diversified Financials firms account for nearly 60% of the industry group’s weight in the MSCI ACWI. And of this, over half is attributed to the US banks that are not categorized as banks—Citigroup, Bank of America and JP Morgan Chase & Co.

This chapter covers the following sub-industries, delving into the characteristics of each:

• Capital Markets
  • Asset Managers & Custody Banks
  • Investment Banking & Brokers
  • Diversified Investment Banking
• Consumer Finance
• Diversified Financial Services

CAPITAL MARKETS

The Capital Markets industry is home to Asset Managers & Custody Banks, Investment Banking (IB) & Brokers and Diversified Capital Markets sub-industries. These businesses often overlap—e.g., a diversified capital markets firm could run an IB, several asset management companies, a custody bank and even a commercial bank! Breaking the business apart by unit helps determine what drivers will be more important.

All three sub-industries are impacted by trends in capital markets, meaning rising asset prices and increased capital markets activity are generally a boon. The trick is picking which one is most exposed to areas you forecast to do best. For example, if you forecast stocks will go up in the period ahead, perhaps an asset manager would be a suitable investment. If you believe M&A activity will pick up, maybe look into the investment banks. And if you think trading will be robust, you’d probably look at the brokers.

Asset Managers & Custody Banks

Asset managers’ and custody banks’ primary business is safekeeping and managing other people’s money (OPM). Whereas the asset managers typically have a degree of control over client funds, custody banks do not and act more as custodians and order takers.

Both asset managers and custody banks can have varying degrees of exposure. Often, a commercial bank can serve as custody bank and retail bank, or an asset manager may be an asset manager first and private bank second. The degree of exposure will help determine how the company will act in various market environments.

Asset Managers

Asset managers are firms set up to manage investors’ wealth in pursuit of their investment objectives. Most asset managers derive their revenue via a fee based on the amount of client assets under management (AUM).

AUM composition is a telltale sign of how the manager will act in different market conditions. For example, fixed-income managers may outperform equity managers in equity bear markets, and vice versa—though that’s not uniformly true. Many managers manage a combination of equities and fixed income—the degree to which each is exposed will determine how it acts. Same goes for alternative money managers—those focused on private equity, real estate, commodities or even currencies will act differently depending on the underlying asset type’s performance. While there are several classes of assets, a plethora of possibilities, most publicly traded asset managers focus on stocks, bonds or a combination of the two.

When considering asset managers, one of the first things to determine is which asset class you expect will outperform. If you believe equities will outperform, it doesn’t matter if you pick the best performing fixed-income manager—the stock of that firm likely faces significant headwinds. Further analysis should include trends on net flows, style and performance.

As the old adage goes, “A rising tide lifts all boats”—meaning if equities are higher, it is likely most equity-focused asset managers experience a tailwind to AUM growth. This is one reason it is important to pay attention to net flows, or the value of new sales minus redemptions plus net exchanges—a positive number represents a positive flow, and vice versa. Net flows measurement is important because it strips out the impact of market fluctuations and shows how much new business the manager captured during the period.

Style can refer to active versus passive, value versus growth, small versus big, foreign versus domestic or even quantitative versus traditional management styles. As with asset class selection, the manager’s style could very well drive the firm’s relative performance. If you expect large US growth companies to outperform, selecting an asset manager with a similar strategy will give you a leg up if your outlook is correct.

Investors tend to prefer to invest in firms that have done well over time. If an asset manager has a strong performance record, it is much easier to attract new clients. An industry standard for tracking performance is to measure performance relative to similar investments. Typically, a higher rating supports net flows, and vice versa. However, all investors should be aware past performance is no guarantee of future returns, and while a strong track record could help attract client funds, focusing on a manager’s strategy moving forward relative to your outlook is equally important.

Distribution is also important for an asset manager. Often managers offer their product through a third-party channel, which can help in gathering assets but pinches margins. It also puts the manager at risk if any one channel controls a significant portion of its flows. If a major brokerage firm controls 50% of a manager’s flow, the manager could lose some of its autonomy.

Another thing to consider is the manager’s customer base. Is the manager a mutual fund catering to retail investors, a separate account manager focused on serving institutional investors or a hedge fund serving the affluent? Understanding the end market’s trends can also help in your selection.

A core revenue source for asset managers is typically management fees, followed perhaps by performance fees and other miscellaneous revenues. These fees are usually based on a percentage of AUM and vary depending on investment objective. Table 3.3 illustrates the average fee charged by the mutual fund industry in 2010.

Table 3.3 Fund Expense Ratios for Selected Investment Objectives

Source: Investment Company Institute, 2011 Investment Company Fact Book: A Review of Trends and Activity in the Investment Company Industry (51st ed.) (accessed March 28, 2012).

Since most revenue is generated through a fee based on AUM, AUM is the driving force behind asset manager valuations. The amount, growth rate and characteristics of AUM will help in determining an asset manager’s value. Actively managed AUM usually demands a higher multiple than passive AUM, and equity AUM has a higher value than fixed or short-term AUM. Understanding all of these will give you a leg up in investing in this sub-industry.

Custody Banks

As of this writing, there are only three custody banks in the MSCI ACWI—Bank of NY Mellon, Northern Trust and State Street. All are financial holding companies consisting of commercial banking and trust subsidiaries. While the commercial banking subsidiaries will act similar to other commercial banks, the trust companies offer unique services over and above what a commercial bank can offer. These companies also own asset management subsidiaries and other financial operations.

Custodial services include safekeeping, recordkeeping, pricing, shareholder services, trade settlement, reporting, trust services, cash management, risk and performance analytical services, operations outsourcing, securities lending . . . the list goes on and on. Like asset managers, custody banks derive their revenue from OPM, but rather than AUM, custody banks refer to assets under custody (AUC). A big difference between AUM and AUC is custodians do not manage AUC—rather, they hold them for safekeeping and perhaps processing or reporting purposes. As a result, fees on AUC are typically much, much lower than those on AUM.

Two core drivers of custody banking are asset values and interest rates. A considerable portion of revenue is derived from a fee based on AUC—as AUC increases, so do fees. Additionally, several custodian bank services are driven by NIM, such as securities lending, and as the yield curve steepens, margins follow. Furthermore, due to custodial services, custody banks tend to be less credit sensitive than commercial banks but less impacted by trends in capital markets than asset managers or investment banks.

Investment Banking & Brokerage

Investment banks and brokers are very sensitive to capital markets activity. In general, they both tend to do well as markets and corporate sentiment are improving with expectations for higher asset values, improved margins and increased activity.

Investment Banks

In their purest form, investment banking activities include underwriting securities and advisory services. However, when most investors think about an investment bank now, the names Goldman Sachs and Morgan Stanley likely come to mind. It is true these financial companies operate some of the world’s largest and most successful investment banks. However, traditional investment banking is a small part of what they do. In 2011, traditional investment banking net revenue accounted for 15% and 13% of these companies’ total net revenue, respectively.3 In addition to investment banking, asset management and commercial banking, they also offer client trading, brokerage and security services, and they run proprietary trading desks and make principal investments . . . this is not a sub-industry for the lighthearted.

Securities underwriting is the business of raising capital from investors on behalf of a client issuing securities. These securities are typically either equity-like or debt-like. Sometimes the investment bank managing the issue will underwrite the entire deal, and sometimes the managing bank will enlist a group of banks, or a syndicate, to fund the securities.

Underwriting securities is a lucrative business: In 2011, investment banks globally earned $16 billion in equity-related and $2 billion in debt-related underwriting gross fee income. Fees are typically calculated as a percent of dollar volume underwritten—e.g., in 2011, global equities underwriting dollar volume was $442 billion. The $16 billion in fee income corresponds to an average 3.57% fee. Debt underwriting volume was $758 billion and averaged a 0.27% fee.4

To an investment bank, advisory services can mean many things. The most common advisory service, in both number of deals and dollar volume, is company takeovers, which accounted for 55% of reported “deals” in 2011.5 Other types of advisory services include advising on mergers, spin-offs and asset sales.

Figure 3.1 Global M&A Activity 1999–2011

Source: Bloomberg Finance L.P., as of 12/31/2011.

An increase in underwriting activity is clearly a good thing for the investment banks, as are increased M&A and other advisory activity, but keep in mind how exposed the investment bank is to this type of activity. Correctly forecasting a spike in these activities could give you a leg up when investing in Financials.

Client Execution (FICC)

FICC is a common acronym for fixed income, currencies and commodities. This business usually refers to client-driven trading operations in these markets. The investment banks act as broker, agent, market maker or even simply facilitator of client trades in these markets. Since many of these markets are found OTC (over the counter), unlike most equities, the nature of FICC can be a bit opaque at times. These markets can be defined as liquid, less liquid or custom.

Liquid markets, such as the US Treasury market, are high-volume markets, and investment banks typically charge a small fee or spread to facilitate a transaction. Less liquid markets are more difficult to navigate, so the banks make higher spreads. Custom transactions can be client-driven and usually tailor-made to address a client’s specific needs—these are typically illiquid investments and not intended to have a secondary market. Investment banks can simply facilitate the transaction—they may make a market in the security, or perhaps they own an inventory, and perhaps they will take the other side of the transaction. Being able to play all sides allows the investment banks to appropriately manage their risk . . . and make money.

Principal Investments/Trading

Since investment banks can take the “other side of the trade” and maintain an inventory, they often run proprietary trading desks where they use their own money to invest, trade and otherwise turn a profit. The banks also often make long-term proprietary investments. These can be strategic in nature, such as creating a joint venture with a Chinese bank to gain Chinese influence, or simply investments similar to individual investors’.

These investing activities were brought into the lime light when the Dodd-Frank Act introduced the Volcker Rule. In its purest form, the Volcker Rule attempts to reduce or eliminate US banks’ ability to take on proprietary investments. The idea behind the rule is it is unfair, and perhaps unsafe, to allow banks to benefit from FDIC insurance on deposits (which provides stable and cheap funding for the banks), just to turn around and invest in a “risky” investment. If the “risky” investment goes sour and bankrupts the bank, FDIC insurance kicks in and indemnifies depositors up to certain limits. Moreover, there is a belief if the firm were deemed too big to fail, the US government would ultimately be forced to bail it out at the expense of US taxpayers.

Definitions are the key—how does one define proprietary trades or principal investments, or how does an investment become classified as “risky”? These questions are a big part of the Volcker Rule’s implementation delay and will likely create some confusion even after they are answered.

The Volcker Rule does, however, allow for market making and hedging—which often blur the line with proprietary trading. In a market-making operation, the bank facilitates trades and provides liquidity. The bank acts as the market and matches buyers with sellers—and sometimes, when there is no match, it steps in and takes the other side of the trade to allow an orderly market. When this happens, the bank takes a risk for a short time.

A proprietary trade could look very similar to market-making operations—the bank may intentionally place a trade (buy or sell) in an effort to close the trade out at a profit—but the intent is different. The Volcker Rule attempts to limit or eliminate proprietary trading—but one wonders how it can be reasonably distinguished from market-making operations and therefore reliably enforced.

Additionally, the Volcker Rule allows firms to hedge risks. However, just as we found out from JP Morgan Chase & Co in May 2012, hedges do not always work. Hedges are usually offsetting positions intended to reduce risk. But they’re not always linked to the risks (or assets) being hedged—making it difficult to delineate between a hedge and a proprietary trade.

Brokerage

Within the Capital Markets industry, a brokerage firm is typically engaged in many components of the investment process, including securities distribution and trading, financial planning, asset management, custodial services, research and even commercial banking and insurance services. Some brokerages are stand-alone companies, but many are part of larger conglomerates—determining the degree of exposure to revenue sources is important.

There are two core types of brokerages: full service and discount. They typically offer similar services, but as the names imply, discount brokers offer less expensive choices, while full-service brokers may offer more products and services. Most often, discount brokers offer much of their product online with very little personal interaction. Full-service brokers may tout a more “personal touch.”

The broader trends for both are very similar. As investors have more money to invest, brokers benefit through rising asset prices, more investors or by increased savings rates. Additionally, brokers can benefit from stealing market share from competitors.

Brokers can charge fees or spreads or collect commissions on investment products. Some brokers focus on fee-based services, which can add a degree of stability to revenue since the fee is typically a set percentage of managed money. Others are more transaction based, charging a commission on each purchase or sale, which makes revenue more volatile—but if trading volumes pick up, it could be a boon.

Since brokers typically offer myriad products and services, many economic factors can have varying impacts based on exposure—specific to the industry, daily average trades, net new client assets and the number of new accounts.

As with the Asset Management sub-industry, Brokers benefits from rising asset prices. As asset prices improve, investors have more money to invest and brokers collect more revenue accordingly. Also similar to asset management, the sub-industry is less subject to credit quality. Although some brokers will offer lending services and can at times invest in securities, most are less exposed to credit losses than a commercial bank, investment bank or consumer lending company—this makes Brokers a bit less exposed to credit losses than Banks, but typically more than Asset Managers.

Diversified Capital Markets

Diversified Capital Markets is a sub-industry encompassing firms with a significant presence in multiple capital market activities. These firms act according to their exposures and are a good way of getting broad capital markets exposure.

The vast majority of the sub-industry is composed of three firms: Credit Suisse, Deutsche Bank and UBS. These firms are large financial conglomerates offering commercial, private and investment banking, as well as asset management and other financial services.

CONSUMER FINANCE

Consumer Finance is a small part of the Financials sector, but as with other Diversified Financials firms, many larger companies take part in the business of consumer finance.

This industry is in the business of providing credit to consumers. Consumer finance includes credit cards, student lending, auto loans, home equity loans, lines of credit and personal loans. This credit can typically be divided into revolving and non-revolving.

Revolving credit refers to credit cards or lines of credit and accounts for 32% of outstanding US consumer credit.6 With revolving credit, the borrower can borrow up to a limit or pay down the loan at any time. In fact, the debt could last indefinitely if the borrower and lender so choose. The remaining 68% of consumer debt is considered non-revolving credit—loans that can be drawn down only once and have scheduled repayment—e.g., a typical auto loan.7

Although Consumer Finance is an industry unto itself, in the US, the Banking industry holds most of the outstanding consumer loans, followed by finance firms and last the government (mainly through student lending). (See Figure 3.2.) Since consumer lending is offered through multiple sub-industries, understanding trends here can help investors understand the consumer loan portion of a company’s overall loan portfolio.

Figure 3.2 Holders of US Consumer Credit 2011

Source: US Federal Reserve, Flow of Funds Accounts of the United States: Flows and Outstandings Third Quarter 2011 (accessed 03/27/2012).

The investable universe in this industry is rather limited: There are fewer than 100 Consumer Finance firms with a market capitalization greater than $100 million globally.9 These firms range from credit card companies to student lenders to payday loan companies to pawnshops. While the type of consumer credit offered varies, they all provide either revolving or non-revolving credit to consumers.

Aside from regulation and interest rates, both of which can impact profitability and viability, a core driver for consumer lenders is obviously consumers. Are consumers borrowing more or less? How is their ability to service debt payments? Do consumers have jobs? Consumer health is core to the industry—it drives credit loss and loan growth.

As a lending-based industry, the quality of loans is a critical component of return, and a core determinant of loan quality is employment. As consumers can’t find or keep jobs, delinquency rates tend to (though not always) move higher and consumer lending companies need to provision for potential losses. And as covered in Chapter 2, provisioning reduces profitability. Accordingly, the relationship between the US employment rate and 30-day credit card delinquencies is very strong.10 (See Figure 3.3.)

Figure 3.3 US Credit Card Delinquencies and Unemployment

Source: Bloomberg Finance L.P., US Bureau of Labor Statistics, as of 12/31/2011.

Beyond employment, consumer spending and savings trends impact the industry by shifting aggregate demand for consumer credit. When consumers spend, it’s often done via credit. Furthermore, if savings rates are high, spending could be crimped and the demand for credit decline.

Consumer Finance firms are not mortgage lenders—this is a key distinguishing factor. Banks are typically heavily exposed to real estate lending, which exposes them to trends therein. If you want exposure to the lending environment but do not want exposure to real estate, the Consumer Finance industry is a pretty good way to go. However, be careful—while Consumer Finance firms do not typically offer mortgages, often the parent company or the holding company has a banking subsidiary. Make sure you understand the parent company’s total exposure whenever you invest in the Financials sector.

Consumer Finance firms aren’t depository institutions, meaning they do not typically accept deposits. Instead, they rely on other funding sources, like issuing bonds or asset-backed securities, to fund lending initiatives. Relative to banks, this puts them at a funding disadvantage since they don’t have access to relatively cheap deposit funding. But this also means they are not under the umbrella of the bank regulators and don’t have to abide by “bank” regulations—although regulation post-2009 is heading that way.

Debt Service and Financial Obligation Ratios

In the US, the Federal Reserve provides debt service and financial obligations ratios (see Figure 3.4). The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal income. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance and property tax payments to the debt service ratio. Both are intended to gauge a household’s exposure and ability to make good on debt obligations.

Figure 3.4 Financial Obligation and Debt Service Ratio

Source: US Federal Reserve, “Household Debt Service and Financial Obligations Ratios,” as of 12/31/2011 (accessed March 28, 2012).

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Since Consumer Finance is often “higher risk” lending—non-secured credit cards or loans secured with depreciating assets (like automobiles)—the industry typically charges higher interest rates on loans. This allows Consumer Finance firms to get away with higher net interest margins—but considering increased risk brings with it increased expected credit losses, the trade-off overall seems fair.

DIVERSIFIED FINANCIAL SERVICES

The Diversified Financial Services industry is home to the Multi-Sector Holdings, Other Diversified Financials and Specialized Finance sub-industries. Collectively, it accounts for roughly half the Diversified Financials industry group in the MSCI World Index.11 This industry may include firms like stock exchanges, nationally recognized statistical rating organizations (NRSROs) and specialty lenders, but the vast majority of the industry is represented by the US banks that are not banks—JP Morgan Chase and Co., Bank of America and Citigroup. These three firms alone account for 1.2% of the MSCI World Index, 30% of the Diversified Financials Industry group and 88% of the Diversified Financial Services industry.12 These three Diversified Financials firms derive their revenue and income from a diversified pool of businesses, encompassing most of the business lines in the Financials sector.

If you think large cap will outperform, this sub-industry may be appropriate—it doesn’t get much larger in the Financials sector—or in most others, for that matter. The average market cap of the Diversified Financial Services sub-industry is the second largest in the MSCI World Index, second to only the Energy sector’s Integrated Oil and Gas sub-industry.15

Notes

1. MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.

2. State Street, Bank of New York Mellon, and Northern Trust Company 2011 10-Ks.

3. Goldman Sachs and Morgan Stanley Company 2011 10-Ks.

4. Bloomberg Finance L.P., as of 12/31/2011.

5. Ibid.

6. US Federal Reserve, “Consumer Credit” (January 2012), www.federalreserve.gov/releases/g19/current/default.htm (accessed March 28, 2012).

7. Ibid.

8. SLM Corporation 2010 Annual Report.

9. See note 4.

10. Bloomberg Finance L.P.; US Bureau of Labor Statistics, as of 12/31/2011.

11. Thomson Reuters; MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. As of 12/31/2011.

12. Ibid.

13. Company 10-Ks, as of 12/31/2011.

14. US Federal Reserve, “Flow of Funds Accounts of the United States” (March 8, 2012), www.federalreserve.gov/releases/z1/Current/ (accessed March 28, 2012).

15. Thomson Reuters, as of 12/31/2011.