Investing in Financials

Investing in financials is complex. These companies are often called “black boxes”: the flow of money cannot be followed clearly and there will always be unanswered questions.

This sector comprises companies dedicated to banking services, investment management, consumer finance, capital markets and insurance. It is worth noting that the Real Estate sector previously formed part of this sector but was separated to become an independent sector.

MSCI

The Financials sector (Financials), according to the MSCI GICS structure, is assigned code 40.

The Financials sector is organised into three main industry groups:

1. Banks (Code 4010)

This group includes financial institutions that operate mainly through deposits and commercial and retail lending.

• Diversified Banks (40101010): Large banks with national presence that offer a diverse range of financial services.

  • Example: JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, HSBC, Barclays, BNP Paribas, Santander, UBS, etc.

• Regional Banks (40101015): Commercial and savings banks that operate in limited geographic regions and focus on retail banking and deposit-funded mortgage lending.

  • Example: US Bancorp, PNC, Truist, Fifth Third, KeyCorp, Regions Financial, M&T Bank, etc.

2. Financial Services (Code 4020)

This is the most diverse group and includes everything from holdings to payment platforms.

• Financial Services (402010): Covers diversified financial services, Multi-Sector Holdings (companies with non-controlling stakes in three or more sectors), specialised finance and commercial and residential mortgage finance. It also includes Transaction and Payment Processing Services, such as digital payment processors and mobile wallets.

  • Example: Berkshire Hathaway, Visa, Mastercard, American Express, Fiserv, Global Payments, Adyen, Block (Square), etc.

• Consumer Finance (40202010): Providers of personal credit, credit cards and peer-to-peer (P2P) lending services.

  • Example: American Express, Discover, Synchrony, Capital One, SoFi, LendingClub, etc.

• Capital Markets (402030): Includes asset management and custody banks, investment banking and brokerage, and Stock Exchanges and Financial Data (such as risk rating agencies and securities or cryptocurrency exchange platforms).

  • Example: BlackRock, State Street, Charles Schwab, Morgan Stanley, Goldman Sachs, S&P Global, Moody’s, CME Group, Nasdaq, ICE, Coinbase, etc.

• Mortgage REITs (40204010): Real estate investment trusts that originate or purchase mortgage loans and mortgage-backed securities.

  • Example: Annaly Capital, AGNC Investment, Two Harbors, Starwood Property Trust, etc.

3. Insurance (Code 4030)

This group brings together entities that manage risk and offer financial protection.

• Insurance Brokers (40301010): Insurance and reinsurance brokerage firms.

  • Example: Marsh & McLennan, Aon, Willis Towers Watson, Arthur J. Gallagher, etc.

• Life and Health Insurance (40301020): Companies that mainly offer life, disability or supplemental health insurance.

  • Example: MetLife, Prudential Financial, Aflac, Manulife, Sun Life, Prudential plc, etc.

• Multi-line Insurance (40301030): Companies with diversified interests in life, health and property and casualty insurance.

  • Example: Allianz, Zurich, AXA, Generali, etc.

• Property and Casualty Insurance (40301040): Providers of insurance for physical assets and liability.

  • Example: Chubb, Travelers, Allstate, Progressive, The Hartford, Berkshire Hathaway (GEICO), etc.

• Reinsurance (40301050): Companies that provide insurance services to other insurance companies.

  • Example: Munich Re, Swiss Re, Hannover Re, Everest Re, etc.

Characteristics

• The typical business model is based on the spread: raising funds at one rate (e.g. reference rates such as Fed funds or Euribor) and deploying them at a higher rate (for example, raising at 3% and lending at 6%).

• It is the most leveraged industry in the economy and very cycle-sensitive; some subsectors are more resilient.

• Most businesses are highly complex: balance sheets are often hard to interpret and valuations uncertain despite regulation. It is advisable to have prior experience in fundamental analysis before investing in the sector. A solid MOAT is especially important to sustain attractive returns over the long term.

Key metrics

Banks

Bank analysis differs from other companies. The core metrics are Net Interest Margin (NIM), Debt/Equity, book value, EPS, ROE and ROA. The model is based on the spread between funding and lending.

This is one of the subsectors where alignment of the management team with shareholders matters most, to limit opaque risks. It is highly cyclical and the most leveraged in the market; in a crisis it is important to monitor non-performing loans and compliance with capital ratios (e.g. Tier 1).

Metrics to track:

• Debt/Equity: up to 5–6x can be acceptable; above that, risk increases.
• Maturity mismatch: many institutions lend long and fund short; that mismatch implies liquidity and rate risk.
• Loans/Deposits: a ratio around 1:1 is generally considered prudent.
• Compare NIM, ROE and ROA with historical trend and with competitors.
• Prioritise banks with a clear niche or competitive advantage and check that management is aligned with shareholders.

Insurers

For insurers the key metrics are float, the combined ratio, EPS, book value, ROE and ROA.

The model has two legs: (1) Underwriting business, based on premiums —the combined ratio measures the margin on this part— and (2) Reinvestment of float: premium collection generates liquidity that is invested in fixed income or equities to earn additional return. It is usually a less cyclical subsector than banking, because policy payouts are more stable.

Price to Book (P/B)

Price to Book (P/B) relates market capitalisation to book value (equity):

It is widely used for financial companies with no growth (together with the ROE / P/B relationship), because a large part of assets and liabilities is valued at market price (mark-to-market).

For non-financial companies, P/B can be useful when the value of equity clearly exceeds the value of cash flow or earnings generation (e.g. certain real estate assets or collections).

Limitation: in many companies the value lies in future earnings growth, not in current equity.

Common valuation multiples

For financials the reference profitability metric for multiples is ROE (ROIC for non-financial companies).

P/E depends on margins (operating or net interest margin), net margins and EPS growth.

With MOAT and growth, guidance by EPS growth:

Without a clear MOAT or without growth, guidance by ROE and P/B:

TOP company example

• Visa