Financial Stocks: Suddenly Sexy

Now that the tech bubble has burst, the old favorites are even more buoyant

Technology stocks, biotech stocks--who needs 'em? These days, there's a better game in town: good old-fashioned financials.

The Standard & Poor's Financials Index has soared 41% since the Nasdaq Composite Index crested on Mar. 10. By comparison, the PSE Technology Index is down 7% during that same period. The AMEX Biotech Index is up just 5%. Says Anna Dopkin, manager of T. Rowe Price's Financial Services Fund: "The day the tech market peaked was the day true value names in financial services started to rally."

The resurgence of bank and brokerage stocks, however, is not just an anti-tech reaction. Could it be, then, that financial stocks are suddenly sexy? In a way. They've got a lot going for them: the pace of takeovers has quickened--not just for brokerages, but for banks and mutual fund companies, too. Earnings are strong and improving, interest rates have leveled off, and nobody believes that the Federal Reserve will edge rates higher. Notes Louise Yamada, managing director of technical research at Salomon Smith Barney: "The underlying feeling, based on our bond work on the 10-year note, [is that] interest rates are going lower."

One financial stock after another, from commercial insurance to fund companies, has hit or is flirting with a 52-week high--Citigroup, MetLife, Merrill Lynch, American Insurance Group, and Amvescap PLC, which runs AIM and Invesco brand funds. Even small brokerage firms, such as Legg Mason and Raymond James Financial, are higher than they've been in a year.

Of course, stocks don't move in straight lines. And with such a big rally, it may well be that some profit-taking will set in. Some analysts say the sector may have already maxed out. Says Mark Constant of Lehman Brothers Inc.: "The premiums suggest that the downside risk could be pretty material."

But the fundamentals are so powerful that, over the long run, financials should continue to outpace the market. Although price-earnings ratios of financial-sector stocks have spiked in recent months, they're still 38% below the S&P 500-stock index. Earnings growth for the group is still strong and improving, says Richard Strauss, analyst for Goldman, Sachs & Co., who expects a 28% return on equity for the brokerage and asset-management industries in 2000, above last year's 25.8% record.

True, declining trading volumes, the evaporation of initial public offering underwriting, and the threat of Internet financial upstarts hit the brokerage stocks early in the year. But with the stock market performing better and IPOs picking up, earnings growth estimates have jumped to 31%, from 21% for the third quarter, and to 10%, from 4% for the fourth quarter, reports First Call Corp./Thomson Financial. Bear Stearns & Co. analyst Amy Butte is raising her profit estimates for Goldman Sachs Group, saying that private-equity investment and fixed-income trading--the most fragile areas of the business--had boosted the firm's bottom line. She expects Goldman to earn $6.45 a share for the full 2000 fiscal year, up from a previous estimate of $6.10.

It's not just improved earnings that's driving the brokerages and fund-company stocks. A spate of long-awaited cross-border and transatlantic mergers, plus rumors of more deals, is lifting stock prices. Overseas companies especially--Allianz of Germany, UniCredito Italiano, and Old Mutual of South Africa--recognize a sweet deal that gives them entree to the world's most lucrative market. UBS AG's bid for PaineWebber in July and Credit Suisse Group's takeout of Donaldson, Lufkin & Jenrette last month have got people buzzing about who's next. "It's musical chairs right now," says Steven Eisman, financials analyst with CIBC World Markets. "The game is who will be next." Boutique firms, such as J.P. Morgan & Co. and Lehman Brothers, are up for grabs, say analysts, because their businesses aren't diversified enough to go it alone.

LOW EXPECTATIONS. Survivors may look a lot like Alliance Capital Management--large global firms with retail and institutional strengths. Alliance, a mutual-fund growth shop majority-owned by French insurer AXA, bought Sanford C. Bernstein, a value investor and well-respected research firm, for $3.5 billion in June. Building either business from scratch would have been "daunting," says Alliance Chairman Dave Williams. "The established players are hard to displace." A merger was the only real alternative.

Mutual-fund firms are up for grabs, too. Companies with a narrow array of offerings--T. Rowe Price, John Nuveen, and Eaton Vance, for instance--are prime targets, analysts say, and their stock prices are rising on takeover speculation. Once again, European banks are key players because they will "pay a higher price for mediocre managers just to get a foothold in the U.S. market," says Maitland Lammert, an analyst at Edward Jones. Furthermore, overseas companies can afford to pay rich prices for U.S. assets, Lammert says, because European investors are easier to please. "They can earn 11% on the acquisition and still satisfy investors," she says.

Even the battered insurance sector is sharing in the financial renaissance. Shares of Metropolitan Life Insurance and John Hancock Mutual Life Insurance have gained up to 70% this year after announcing or completing plans to "demutualize" (a process which changes a mutual company owned by policyholders into a stock company). This occurred at a time when sentiment toward insurance stocks was at an all-time low, explains Lammert, with these stocks trading at a discount to their book values despite the S&P's AA rating. Moreover, commercial property-and-casualty companies are profitable again after almost a decade of declining premiums and costly catastrophes. "They were doing a lot of underwriting at prices that didn't cover costs," Lammert says. "Some of the weaker players, such as Reliance, really got burned." Financier Saul Steinberg's near-bankrupt Reliance posted a second-quarter net loss of $504.5 million, more than triple last year's loss. But market leaders such as AIG refused to underwrite businesses without rate increases, and other insurance companies followed their lead. Says Lammert: "It's what started the move in the share prices."

Some large regional banks are on the mend, too. Commerce Bancshares of Kansas City, Mo., for example, has done particularly well, more than doubling its wealth-management and estate business to $17 billion in four years. In the second quarter, the bank had its 17th consecutive quarter of double-digit earnings-per-share growth. Says James Catudal of Fidelity Advisor Financial Services Fund: "A lot of banks have to change their strategy to focus on investment banking or some other securities business because that's where the revenue is." And with 8,000 Federal Deposit Insurance Corp.-insured banks in the U.S., Catudal says consolidation is inevitable, and could further boost bank stocks.

What hasn't rallied so far are the online brokers. In large part, that's a result of the sharp fall-off in day trading, but--more important--it's proof that, in the end, earnings count. Companies such as E*Trade Group Inc. and Ameritrade Inc. haven't reached that watermark.

If the economy comes in for a soft landing, as appears likely, and interest rates remain stable, financial-services companies will be making lots of money, and their stocks will stay strong.