CHAPTER 8

FINANCIALS INVESTING STRATEGIES

This chapter covers various investment strategies specifically for a Financials allocation, building on the knowledge in this book. The strategies include:

While the strategies presented here are by no means comprehensive, they’ll provide a good starting point for constructing a portfolio that can increase your likelihood of outperforming a benchmark. They should also spur some investment strategy ideas of your own. After all, using this framework to discover information few others have discovered yet is what investing is all about.

Also, though these strategies focus solely on Financials, they are meant to be used as part of an overarching strategy for a portfolio managed against a broader benchmark. Some investors may choose to manage a portfolio only of Financials stocks (or any other single sector). But in our view, for individual investors, managing against a broader benchmark increases both risk management and outperformance opportunities.

ADDING VALUE AT THE SECTOR LEVEL

Consistent with the top-down method, investors must first determine when it is appropriate to overweight or underweight the Financials sector relative to a broader portfolio benchmark. Some major factors contributing to this decision, covered in depth in Chapter 1, are shown in Table 8.1. Each driver should be considered not on its own, but in combination with other relevant drivers and also larger macroeconomic conditions. Also, don’t take this table to mean overweight decisions can be driven by the mere number of positive drivers (and the same is true in reverse with underweight decisions). There can be, at any one time, many more meaningful drivers than we have space to list here. And some drivers are just more important than others. Most important, macroeconomic drivers can swamp sector, industry and sub-industry drivers.

Table 8.1 When to Overweight and Underweight the Financials Sector

Implementing Sector Overweights and Underweights

After the decision is made to overweight or underweight the sector, it’s time to implement it. The first step is determining the sector weight relative to your benchmark. The relative bet size should be proportional to your conviction. Mild conviction should translate to a more modest bet against the benchmark. The stronger your conviction, the bigger your bet can be—within reason. A vital rule is to never make a bet so large that if you’re wrong you inflict irreparable damage on your portfolio’s return versus the benchmark.

Next comes determining the actual investments. One method is directly mimicking the sector by buying all the sector’s stocks in direct proportion to your under- or overweight. Obviously, this can be time consuming and costly—particularly for individual investors working with relatively smaller pools of money—depending on the number of stocks. An easier and probably cheaper method of mimicking the sector composition is buying exchange-traded funds (ETF) or mutual funds. The following are some larger Financials ETFs and their stock tickers (again, this list is by no means exhaustive):

• Financial Select Sector SPDR (XLF)
• iShares S&P Global Financials Sector Index Fund (IXG)
• SPDR KBW Bank ETF (KBE)
• SPDR KBW Regional Bank ETF (KRE)
• iShares DJ US Financial Sector (IYF)
• Market Vectors Bank and Brokerage ETF (RKH)
• iShares US Broker Dealers (IAI)
• EGShares Financials GEMS ETF (EFN)
• Vanguard Financials ETF (VFH)

ADDING VALUE AT THE COUNTRY OR INDUSTRY LEVEL

A more advanced strategy is making country- and industry-level bets based on your top-down analysis. Each Financials industry and region falls in and out of favor periodically—no one area outperforms consistently over the long term. Your job is determining how pronounced the degree of leading or lagging will be, when it’s likeliest to happen and whether it’s likely to be profitable enough to make a bet.

Chapters 2–5 should provide a structure for asking relevant questions to assist such decisions. For example, Chapter 2 outlines key variables for identifying trends in regional and diversified banking firms, such as:

• What countries, regions and industries have the best prospects based on financial product penetration rates and spending patterns?
• What will drive regional and diversified bank performance? Loan growth, delinquency trends or both?
• What is the most popular loan category driving demand for credit? Auto? Corporate? Small and medium business? Is that likely to continue?

Once such questions are answered, they should be scrutinized by examining appropriate challenges and opportunities. Ultimately, your decision to overweight or underweight an industry relative to the benchmark should jibe with your high-level portfolio drivers. Note: Always remember past performance is no guarantee of future performance. No set of rules works for all time, and you should always analyze the entire situation before investing. The past is about understanding context and precedent for investing—it’s not a road map for the future.

ADDING VALUE AT THE SECURITY LEVEL

A still more advanced strategy entails investing directly in individual firms. This strategy should be based on your sector, country and industry opinions and was covered in more depth in Chapters 2–5. Never forget, individual stock selection should be driven by higher-level, top-down portfolio themes. For example, if you have a strong conviction that, relative to expectations, loan growth is going to decelerate and credit quality will worsen, you know that is typically a period when Financials stocks tend to underperform (though not always). And if the sector overall underperforms, even the best stock picking in the world means your Financials picks likely lag better-performing sector stocks.

However, in a period when Financials underperforms, if your stock pick does well, your overall sector allocation may perform as well or better than your sector benchmark—which can help your overall relative performance. And certainly, during periods when Financials does perform better than the overall market, if you can add value at the security level, you can improve your portfolio performance on both an absolute and a relative basis.

In Table 8.2, we provide some examples of strategies for top-down security selection—though there are countless others. Further, the stocks named are just a few of those that, as of this writing, are emblematic of the higher-level themes we’re trying to capture based on the hypothesis. As you become more familiar with specific Financials firms and their industries, you can eventually develop your own strategies. Always be vigilant for firm-specific issues that could cause a stock to act differently than you would expect in the context of your broader strategy.

Table 8.2 Examples of Top-Down Security Selection