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26 Dec 2020

Financials: Consider the possibilities

Introduction

The financial sector is an important sector in the overall market. Faltering lately, 2021 is setting up to be a recovery year.

The diversity in the financial sector is extreme. Our objective is to find a useful way to navigate the complexity and effectively include this sector in our portfolio.

We will take a look at broad-brush, industry focused and best-of-breed alternatives to identify a useful construct for the portfolio.

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Background

The financial sector is among the top sectors in terms of defining a healthy market. Over the last 10 years its returns have ranged from -17% to 35%. Lagging in 2020, the probability of a snap back in 2021 is better than even.

Source: novelinvestor.com

The Financial Sector is very diverse. The simple definition is that it is made up of companies providing financial services to commercial and retail customers. The range includes asset management, banks, credit services, investment companies, insurance companies, funds, mortgage finance, and real estate firms. Each of these areas has different business models, market sizes, capital requirements, regulatory impact and risk profiles.

Even that does not describe scope as banks include money center, regional, investment and brokerage firms; funds can be closed-end or Exchange Traded Funds; insurance can be diversified, life, property, reinsurance, specialty or brokers.

Investment possibilities

Broad-brush

The simplest approach would be an all-encompassing ETF like the XLF, VFH, FXO, RYF and more. There are differences among these in terms of the number of equities included, the weighting factors, re-balancing frequency, expense ratios and yield.

Looking at the XLF, the top ten holdings account for 53% of the ETF; total holdings are 66 equities. As to performance diversity, the performance in the last year of these ten holdings ranged from -45% (WFC) to +40% (BLK). The XLF itself is down about 8%.

Industry focused

There are ETFs that focus on the industries inside the sector such as regional banks, financial technology stocks, etc., that can provide a bit more focus.

Best of Breed

Rather than a shotgun approach to a sector, we would like to make some informed choices. Usually, we look at the top performing ETFs, pull the top 10 positions, compare the result and settle on the top 5 that are common across the ETFs. That is not really possible with financials given the diversity.

Instead, we will look at the top industry ETFs in those industries we plan to include and settle on 2-5 equities in each that are in the top 10 of those ETFs.

Wild cards

There should always be room for a few wild card companies. These can be those on the leading edge, disruptors or those recovering from significant performance issues

Our Approach

There is more to establishing investment targets for the financial sector than looking solely at the sector. The first step is to take a strategic view and establish what sectors to be in and at what level of participation (weighting). Our article, "A Diversified Portfolio", provides more detail on a process and is recommended reading.

The issue we have with ETFs, similar to mutual funds, is that they include the good and the poor performing equities in their mix as they aim to meet some benchmark. This may provide an excuse when performance is poor but it will also attenuate performance to the upside.

Traditional wisdom holds that diversity is good and low correlation among holdings is good. We think too much diversity will deliver zero or negative Alpha and that correlation in a given sector is a good thing.

If we have a clear thesis for establishing our investment direction, there is no reason to take the other side of the bet. It seems logically unlikely that we can deliver material Alpha when included assets are trending opposite each other. At best, we would get some representation of an average performance while reverting to the mean from both directions.

"Diversification is protection against ignorance. It makes little sense for those who know what they are doing." Warren Buffett

A different thought is that the financial services for retail traders are based on a flawed relationship. The purveyors of services (financial advisors, wealth management services, advisory services, etc.) have a singular mission: retain your business and collect 1-2% regardless of performance. To that end, being able to defend their actions with comparisons to benchmarks, other service providers, alignment with conventional wisdom, etc., becomes the chief toolset.

Overall, we think a hybrid of selecting best of breed and including some wild card equities will outperform the other alternatives to investing in a given sector.

Recommendation

The underlying driver for our recommendation is delivering Alpha for our 10Alpha Program (TaP^©) so this is an aggressive approach. Check out our article "HPI™ 10alpha Program (TaP) Introduction".

Sector weighting

The historical weight of the financial sector in the S&P has declined year on year since 2015 from 16.5% to 9.7%. As the S&P is market capitalization weighted (see our article, "Insights on Indexes"), a way to think of this is that the sector has lost value to other sectors, leaving it in a better position for recovery than those sectors that have gained. This is simply the theory of mean reversion in practice.

Depending on your strategic view, over- or under-weighting this sector for 2021 may lead to some Alpha from the sector. Based on our thesis that 2021 will be the year of recovery in financials, we plan to target 10% portfolio weight initially and re-evaluate each quarter. For comparison, we were essentially out of financials, other than FinTech, for 2020.

It is important to note that this sector is unlikely to out-perform the tech sector unless value investing comes back into play. The Robin Hood effect over the past year leaves that possibility suspect.

Industry weighting

Looking at the included industries, we want to focus on diversified banks (JPM, BAC, C, WFC), capital markets (GS, MS), asset management (BLK), credit services (AXP, MA, V, PYPL, SQ) and insurance (BRK-B). Your choices and rationales may differ but in the end getting to 10-12 best of breed stocks in the sector that cover the best industries begins to reduce the workload in companies to follow.

Using our Trader Performance Coach (TPC^®) software you can create custom 'sectors' to set targets, automatically allocate among sectors and track portfolio weightings for each across all accounts and brokers

In order of growth potential for our chosen assets we see the order as follows along with portfolio weight allocations:

• credit services: 5%
• asset management: 2%
• capital markets: 2%
• banks: 1%
• insurance: 0%

One of our unwritten rules is to have no less than 2% in a given sector. In a large portfolio, doing anything less causes too many equities in the portfolio to effectively manage. In a small portfolio, more will be spent on commissions (options) than makes sense.

The sub-sector to watch closely is banks as 2021 may set up differently in a material way from 2020. If interest rates rise and come into play and/or the Fed's openness to inflation brings that to fruition, trading off between banks, capital markets and asset management will be helpful.

Equity weighting

Equity weighting within the sector/industry is about identifying the potential for higher growth balanced with base level performance.

Banks (1%)

WFC significantly under performed at -45% for the year with the other 3 equities ranging from -10% to -24%. Given the issues over the past few years for WFC this is not surprising. If we choose to expand the allocation above 1%, WFC will be the first equity to receive funding.

JPM was the best performer followed closely by BAC, then C. JPM generally trades at a premium, largely due to Jamie Dimon. May not be this year, but he will retire sooner than the 5 years he quotes each year.

BAC and C look to be the ones to work with for now as being stable and set to benefit from any changes in monetary policy.

So, we'll aim for 0.5% in each of BAC and C.

Capital Markets (2%)

GS and MS are very different in their business models. As a consequence, feeding them both seems prudent. If we must choose, it would be GS as MS has moved substantially toward lower reward low risk operations.

Initially, we will balance at 1% in each of GS and MS.

Asset Management (2%)

BLK is simply a juggernaut. PEG at 2.1, reasonable PE at 23, BLK adds upside potential on a reliable basis.

Credit Services (2%)

Likely the industry to look for out-performance possibilities. PYPL and SQ provide growth potential while there are many smaller players growing their capabilities.

SQ is the clear growth winner and is doing more innovation than PYPL. MA would be a more conservative option that is performing better than V.

Initially we will put 1.5% in SQ and 0.5% in PYPL.

Insurance (0%)

Berkshire continues to perform. Leadership is transitioning from Buffett and Munger to the 'younger' guys. One to keep an eye on but not included in the starter list for 2021.

TPC lets you set targets, track portfolio weightings and do the allocations for each equity across all accounts and brokers

Getting it done

So, we now have a plan and it is about execution. There is no rush to get to the planned numbers. The end of the year will be volatile just because: volatile up, volatile down, you choose.

The beginning of next year will be volatile given the Georgia runoff elections, confirmation that COVID vaccines may be working, stress on whether our political elite will finally come to the aid of the American people with COVID financial relief, concern that Trump will camp out in the White House, further concern that there may be some irrational rioting over virtually anything from BLM to LGBTQ(rst?), renaming Army bases, tearing down of confederate leader statues, socialist bs that everyone should be as wealthy as Bezos or Bezos should be as poor as everyone else, etc., etc. Let the drama drive you.

The first quarter looks to be interesting at best.

And, given the run up in the markets, there is significant potential for a reversion to 3500 on the S&P, just over a 5% correction. If not that, then maybe 3400 for 8%.

So, consider moving to cash through the end of January while watching the tea leaves.