Sector Report by Jamie Biswas, 27 November 2020
The financial institutions sector provides a unique proposition. The industry is very mature and developed in the US and Europe but rapidly growing in developing markets. The industry is constantly evolving due to regulatory changes whilst simultaneously being disrupted by the emergence of fintechs. The Covid-19 pandemic has had a massive impact on stock prices within the sector, which has underperformed the overall market over the last few months. Whether the sector provides a great value investing opportunity or not is unclear, but there are great ETFs available to gain exposure to industry.
OVERVIEW OF SECTOR
The main sub-sectors within financial institutions include:
- Insurance Firms
- Financial Technology Firms (Fintech)
Their main business models are outlined below:
Banks – Includes both retail and investment banks. Retail banks mainly generate profits through borrowing money from households in return for interest and subsequently lending the money out at a higher rate of interest, earning a spread. Common retail banks in the UK include NatWest, Lloyds and Santander. Common retail banks in the US include JPMorgan Chase, Bank of America Corp, Wells Fargo and Citigroup.
Investment banks generate profits through multiple avenues. The Sales and Trading division makes money through facilitating the buying and selling of various financial products. The advisory division of an investment bank will generate revenue through fees on providing advice on corporate actions such as mergers, acquisitions and capital raises. Key investment banks include J.P. Morgan, Goldman Sachs and Citigroup.
Insurance Firms – Their business model is centred around providing protection against financial loss. They charge an annual fee to consumers in return for this cover. The nature of the business model means revenues are fairly consistent. Some well-known insurance firms are Aviva, Prudential Financial and Berkshire Hathaway.
Fintech – Fintech is an emerging industry that uses technology to improve activities in finance. The use of smartphones for mobile banking, investing, borrowing services, and cryptocurrency are examples of technologies aiming to make financial services more accessible to the general public. Some large fintech companies include Ant Financial, Stripe and Adyen.
Previous Price Action of Sector Index:
Historically the financials sector has performed roughly in line with the broader market, with annualised returns of 10.52% over the last 10 years. The sector has performed poorly this calander year, as can be seen below. Since Januray, the sector has declined 10.37%, using the S&P 500 Financials Index as a benchmark. The S&P 500 Financials comprises those companies included in the S&P 500 that are classified as members of the GICS financials sector. The index contains 65 companies, with the largest constitutents by weighting being Berkshire Hathaway, JP Morgan Chase, Bank of America Corp and Wells Fargo & Co. The full factsheet regarding the index can be found here.
FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS
The sector has a very large customer base due to the services banks provide being almost essential. For the developed markets, there is little scope for the customer base to increase over time. The developing markets contrast this, with banking becoming much more widespread in certain countries. The industry as a whole is very mature and so growth of banks is fairly slow but stable. The market share among banks has remained fairly stable over time, and I see this continuing into the future. There are many very large banks which together control a large proportion of the market but fintech companies are challenging this. The six largest banks in the US are listed below.
|JPMorgan Chase||$2.82 trillion|
|Bank of America Corp||$2.16 trillion|
|Wells Fargo||$1.80 trillion|
|U.S. Bancorp||$536.29 billion|
|Truist Bank||$494.00 billion|
Regulation has become a large factor which drives the value of banks. Tighter regulations restrict profits and therefore reduce the market’s value of banks. Recently in the UK there have been some trends in regulation centred around:
- Increasing risk sensitivity
- Increasing transparency
- Increasing cross-border regulation
As a result of these changes, banks are being perceived as lower risk investments but with less potential for growth. These trends have also been observed in the US and Europe.
Similar to banks, the insurance industry is well established. However, over the last few years there has been a high level of consolidation. The growing rate of consolidation in the sector is being attributed to several competing pressures facing the industry, including: increasing competition, ongoing cost pressures, inefficient legacy technology, mounting regulatory requirements, and poor financial performance. Large insurance players are aware that they cannot achieve their strategic objectives through organic growth alone. They are looking to M&A and partnerships as their path to achieving their strategic objectives of scale and sustainable long-term growth. However, mergers in the insurance industry have brought many challenges and obstacles. Newly merged companies have to grapple with operating in a new range of markets and countries, complying with multiple sets of regulations, and rationalising their various legacy and cloud-based technology systems. A staggering 70% of M&As in the sector are unable to deliver the expected operational synergies. This is a critical component to the success of mergers, and failure to achieve the optimum level of integration between merged companies can lead to costly operational impediments. The six largest insurance firms in the US are listed below.
|Insurance Firm||Total Assets|
|Prudential Financial||$896.55 billion|
|Berkshire Hathaway||$817.73 billion|
|Lincoln Financial Group||$334.76 billion|
|New York Life||$330.81 billion|
The Fintech sector is rearranging to become a real contender in the consumer banking industry, and that process of consolidation starts with joining forces to turn into a more integrated sector. This reorganisation seems especially needed in the payments sector, where the M&A has grown exponentially in the last three years. Although there is still a lot of deal making expected to happen in the next few years, this reshuffle has ended up with four noticeable key players that will be likely to concentrate the sector even further. Europe looks like the region where most of this deal making will be taking place, as it is still the most fragmented market of all. Dutch and Italian market leaders, Adyen and Nexi respectively, are expected to lead the M&A activity in the Europe for the next few years. The six largest fintechs in the US are listed below.
FUNDAMENTAL QUANTITATIVE ANALYSIS
Listed below is key financial information and metrics for sub-sectors within financial institutions. Data for fintech companies hasn’t been included due to the relatively new nature of the industry and broad scope of what is defined as ‘fintech’. This combination of factors means that aggregate data for fintech companies is not representative of the individual firms within the sub-sector. The previously defined sub-sector ‘Banks’ has been further split into ‘Investment Banks’ and ‘Commercial Banks’.
All data is from 2020 and therefore some indicators have been affected by Covid-19 to a certain extent – and so must be taken with a pinch of salt.
|Leverage Ratio (TTM)||Quick Ratio||Interest Coverage (TTM)||Total Debt to Equity (TTM)|
|Price/Earnings||Price/Free Cash Flow||Price/Book|
Banks: Covid-19 has indirectly had significant effects on banks across the world. In times of low economic output and demand, central banks cut interest rates in order to stimulate the economy and prevent recession. This reduces the margin banks can make when lending to households and firms, leading to lower profits for retail banks. The pandemic has also reduced revenues within investment banks as uncertainty has reduced deal flow, leading to lower advisory fees. In these circumstances, diversification of revenues is essential. The large international banks such as Bank of America or Citigroup tend to be well-diversified across investment banking, wholesale and consumer lending as well as asset and wealth management. But many smaller banks are less diversified and so more at risk.
Insurance Companies: Covid-19 has forced insurers to adopt remote and digital ways of working, so it is undoubtedly set to drive a wider acceleration of technology adoption across the industry. This is a trend that has already been seen across the industry for years but the pandemic is speeding it up. For example, insurers in China have started to adopt blockchain technology to share information between health providers and insurers. Insurers have also started to adopt AI and intelligent automation as well as the use of IoT and Big Data technologies, in order to speed up and streamline certain processes such as pricing, underwriting, claims handling and fraud management.
Fintechs: The Covid-19 pandemic is accelerating the importance of digitisation. The use of ATMs and cash has significantly fallen; bank branches are closed or operating on reduced hours, and footfalls may not return to their previous levels for the foreseeable future. Fintechs are well positioned to survive the pandemic because of their lean operating models and structures. The total cost of operation for a fintech may be as much as 70% lower than a standard retail bank. Their systems are more flexible, and can be scaled at lower cost. These aforementioned factors play strongly to the fintech model and as a result we can expect to see demand and interest in the cloud enabled, agile services they offer across the financial services ecosystem rising strongly over the coming months and years.
Banks – Xtrackers MSCI USA Banks UCITS ETF
|Asset Class Style||Value|
The investment objective of the fund is to track the performance of the underlying asset, which is the MSCI USA Banks 20/35 Capped Index. This ETF offers exposure to US banking institutions, delivering access to a narrow slice of the financial sector that has historically exhibited significant volatility but is capable of turning in big performances over a short period of time. This fund can be useful for establishing a tactical tilt towards financial stocks, and may be an efficient way to go “bargain hunting” after big sell-offs in financial stocks.
|Top 5 Holdings||% of ETF|
|Bank of America Corp||16.83%|
|Wells Fargo & Co||9.77%|
|Truist Financial Corp||5.73%|
Insurance – iShares STOXX Europe 600 Insurance UCITS ETF
|Price (27/11/2020)||€ 27.61|
|Asset Class Style||Growth|
The iShares STOXX Europe 600 Insurance (DE) is an exchange traded fund that aims to track the performance of the STOXX Europe 600 Insurance Index as closely as possible. This ETF gives investors a way to gain exposure to insurance companies, a sub-sector of the financial sector that offers a unique risk/return profile relative to traditional financial exposure. Insurance companies tend to be far less volatile and tend to be more conservative.
|Top 5 Holdings||% of ETF|
|Zurich Insurance Group||11.27%|
Fintech – Invesco Markets PLC KBW NASDAQ Fintech ETF
|Asset Class Style||Growth|
The Invesco KBW NASDAQ Fintech UCITS ETF aims to provide the performance of the KBW NASDAQ Financial Technology Total Return (Net) Index This ETF provides exposure to a variety of US based fintechs focused on aggressive growth.
|Top 5 Holdings||% of ETF|
|Meta Financial Group||3.15%|
|Alliance Data Systems||2.92%|
The three ETFs provided offer a range of options for gaining exposure to the financial institutions sector. There are both value and growth ETFs, therefore catering to different investment philosophies. These ETFs should be held for a medium to long period, (3+ years).