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Industry Analysis: Diversified Financial Services
The Financial Services (Diversified) Industry consists of a collection of companies that offer a wide variety of products and services. Asset managers and credit card companies are the two largest groups within the industry, but after that, little commonality exists. Banking, commercial lending, insurance, student loan origination, pawn brokerage, tax preparation, and aircraft leasing are just a few of the other businesses. Thus, given such a span of operating models and market segments, it is important not to paint the industry with too narrow an investment brush.
For decades, conservative investors flocked to these companies, attracted by their steady revenue and income performances and the protection against volatility and above-average dividend yields that their stocks provided. However, more recently, poor management decisions (e.g., those involving sub-prime loans, derivatives) that significantly raised operating risk, and the near-total collapse of the global financial system, limited the industry's investment suitability to those who are more venturesome. Moreover, the U.S. government and overseas regulators have stepped in to play a prominent role, closely examining and controlling day-to-day business administration of certain companies.
Asset managers represent the largest share of business in our presentation of the Financial Services Industry. These entities offer mutual and hedge fund products, as well as wealth management and consulting services. Fierce competition exists between these firms, since they offer similar products and services to virtually the same institutions and individuals. Barriers to market entry are modest, and the size of operations, notwithstanding the advantage of scale in winning new accounts, is not particularly important for success. Indeed, asset managers might control just a few million dollars or hundreds of billions.
Generally, the greater the Assets Under Management, the greater the Revenues and Net Profit produced. Revenues are made up of management and transaction fees. The cost of trading, portfolio manager and support staff salaries, and advertising expense largely determine the level of profitability. These companies often invest in foreign assets and both their portfolio and operating performances are, thus, subject to currency risk.
The stock market typically leads the global economic cycle. When specific business indicators begin turning positive, investment fund inflows usually rise, with management fees following close behind. Extended up-cycles can produce record results at asset managers. But during a downturn, institutions and individuals will siphon funds from their accounts to lock-in gains or avoid losses. In especially challenging periods, they will draw funds to meet every-day expenses. Through the cycle, sector rotation occurs, according to the degree of risk investors wish to assume.
Aside from the economy, an asset manager's performance, against that of the broad market indexes and peers, will affect fund inflows and outflows. Additionally, management fees can facilitate or hinder fund expansion and impact net-profit optimization.
Credit Card Issuers
The credit card business is the other main sector within the Financial Services Industry. This sector can be further divided into two segments. In one, companies offer credit and charge card services to consumers and commercial businesses. The other segment includes those that handle electronic transactions and payment processing.
Naturally, the performance of the sector is closely tied to the health of the global economy. In our grouping, there are just a few large players, with substantial market share, but investors should note that they have to compete against a good number of second-tier card issuers. Advertisement spending across several media to promote brand awareness can be quite heavy. These companies must determine what amount of marketing outlays will maximize revenue and income potential.
The spread between the cost of available funds and the rate charged to customers is crucial to profitability. A narrow spread will heighten the pressure to contain, for example, marketing, administrative, professional fees, and travel expenses. Too, in a weak economy, loan defaults will rise and force higher net charge-offs. Raising the bar for issuers is government regulation. At times, card company practices may be seen as overly aggressive, prompting politicians and state and federal agencies to tighten lending standards and possibly choke off business. The performance and fortunes of transaction facilitators change in tandem with those of the card companies.
As for the rest of the industry, we include a myriad of companies, some cyclical, some counter-cyclical. In this group, investors will find banks, commercial lenders, insurance and risk management companies, pawn brokers, student loan providers, financial planners and, among others, tax advisors.
For the most part, the stocks represented here track the performance of the overall economy, but there are exceptions. Some do better during stressful periods. Notably, in a contraction, when discretionary funds are hard to come by, credit-challenged consumers may turn to pawn shops for short-term loans to pay pressing debts, e.g., mortgages, medical bills. Also, when jobs are hard to find, providers of student loans benefit, as many people return to school or enroll in training centers to improve their work skills.