Financial Stocks: Here's Where The Easy Money Ends

Sluggish earnings and deregulation could sting

You can sense it from analysts' recent downward revisions of earnings prospects for even financial juggernauts such as Morgan Stanley Dean Witter (MWD) and Goldman Sachs (GS). And you can see it in the dwindling list of initial public offerings, as well as an alarming increase in bad loans. After several years of record-breaking earnings growth, Wall Street is facing rough times.

To be sure, key ingredients remain in place for financial services to do better than the economy as a whole over the long term. A growing legion of individual investors continues to flock to the stock market. And in several years, banks, brokers, and asset managers will surely benefit from a wave of retiring baby boomers.

But in 2001, financial stocks hold big risks for investors. Despite the prospect of lower interest rates--normally a boon for financial stocks--sluggish earnings growth combined with deregulation have triggered a shakeout. Since the passage of the Gramm-Leach-Bliley Financial Services Modernization Act in November, 1999, banks, insurers, asset managers, and brokers have been free to compete in one another's territories for the first time since the Depression. So, executives are bracing themselves for lower margins partly as a result of the increased competition. "It will be a little bloody for some of these businesses," Bank One Corp. Chairman and CEO James Dimon told executives at a recent Securities Industry Assn. meeting. "I don't think the advice business will go away. But it may come cheaper."

As the Darwinian struggle plays out, the consensus among analysts is that the growth of securities firms' profits will trail the anticipated 10.6% rise in 2001 earnings of companies in the Standard & Poor's 500-stock index for the first time in two years. Brokers' and asset managers' earnings may decelerate to a tepid 7% increase in the coming year, vs. a cracking estimated 27% rise in 2000, according to First Call Corp. Indeed, investment banks such as Morgan Stanley Dean Witter & Co. and Bear Stearns Cos. Inc. (BSC) could soon post their first quarterly earnings declines since they were battered by the Russian currency crisis in the last quarter of 1998.

FOLLOW THE MONEY. Banks wallowing in credit woes such as First Union Corp. (FTU) and Bank of America Corp. (BAC) could be even worse off. For now, though, First Call says analysts are estimating bank earnings will rise by 11%. That leaves the industry's least exciting players--insurance companies--as potentially its best earners with profits jumping 21% in 2001.

Investors with iron nerves should be able to find some winners even in sluggish sectors. Investment pros' advice: Follow the money. That means investing in brokers, banks, and insurance companies that are raking in retail assets from the rich--and avoiding those weighed down by widening credit spreads and vanishing advisory fees.

Asset-based businesses such as retail securities firms or money managers with stable revenue and earnings streams stand the best chance of surviving the war for assets, say analysts. Firms with a focus on high-net-worth clients or strong distribution systems are best placed to beat the competition, says Bear Stearns analyst Amy Butte. That's why Charles Schwab Corp. (SCH) looks alluring to many. Following its purchase of U.S. Trust, it is raking in more assets from wealthy customers. Butte also likes two outfits often mentioned as potential takeover targets--securities firm Legg Mason Inc. (LM) and asset manager Neuberger Berman Inc. (NEU)

Given that some brokers' stocks have already taken substantial hits, bargains are popping up. Some analysts like Morgan Stanley Dean Witter and Goldman, Sachs & Co. for that reason. And expectations for Lehman Brothers Inc. (LEH) have sunk so low that it's a candidate for a strong bounce. Indeed, the stock surged 10%, to 68, on Dec. 11 after Goldman Sachs suggested its stock price had fallen too low.

Firms that dominate a niche may perform better than the sector as a whole. Tom Goggins, portfolio manager of John Hancock Financial Industries Fund, which is up 25.2% this year, likes State Street Corp. (STT) and Northern Trust Corp. (NTRS) because they are less reliant on loans and have strong fee-based global custody and estate planning franchises. But his real favorites are commercial property/casualty insurers that have been only recently able to raise premiums for the first time in years. "We think the property-and-casualty stocks have the potential to continue their run because we believe there will be a continuing hardening of the cycle," says Goggins. "Price increases are sticking." Among his top choices: Ace Ltd. (ACL) and Everest Re Group Ltd. (RE)

The tectonic shifts now reshaping the financial-services industry will create lots of opportunities, says Lanny Thorndike, chief investment officer of Century Capital Management Inc., whose financials-heavy Century Shares Trust is up 33.81% through Dec. 8. "This is a good opportunity to participate in the change agents," he says. Thorndike likes Bank of New York (BK) and insurer American International Group (AIG) partly because both companies are leading the pack in building up global franchises.

Risk takers who believe that big is beautiful may want to look at new megabanks. Merrill Lynch & Co. financial-services industry analyst Judah Kraushaar's first choice is Chase Manhattan Corp. (CMB) He thinks that with more corporations asking for credit lines from securities firms, investment banking is becoming more of a balance-sheet game. Through its merger with J.P. Morgan (JPM), Chase could become a trailblazer by combining Chase's clients and balance-sheet strength with Morgan's securities products and global reach. Still, some money managers are cautious about recent financial mergers. They're staying on the sidelines until it's clear that these new marriages will be driven by asset growth--or cost cutting.

If investors choose wisely, it could pay to invest in a broker, bank, or insurer. But they had better tread carefully.

Before it's here, it's on the Bloomberg Terminal.