Fisher Investments on Financials
Characteristics of financial industry:
1. A relatively volatile sectors that is highly correlated with broader markets
– high beta that is second only to IT industry
2. Sensitive to interest rates
– financial firms are heavily exposed to financial assets and they are typically leveraged
– highly negatively correlated with 10 year yield except certain periods like financial crisis
– tend to underperform in rising interest rates
3. Neither cyclical nor defensive
– relative performance in both bull and bear market tend to be similar
– best not to allow market cycle to dictate financial stocks unless it’s a financial crisis
4. Heavily regulated
– decisions made by regulators can greatly impact the sector
5. Highly leveraged and reliant on other people’s money
– have a lot of liabilities relative to equity (gearing)… Asset to equity ratio
6. Value oriented rather than growth
-low earning growth, high dividend, lower PE ratio
7. Largest sector in most countries
8. Knowledge based sector
9. Performance is event driven … Mid 1980s S&L crisis… Asian contagion and tech boom in 2000…
>>Bank<<
Introduction:
– Role is to borrow from customer deposits (liabilities) and make loans (assets) and earn from spread
– Managing balance sheet is important especially on aligning liabilities with assets, capital buffers with growth and appropriate risk
– Required reserve ratio (rrr): the amount from deposits that banks have to retain as reserves
Money multiplication:
– banks multiply money by using deposits to loan out or invest. The ability to multiply heavily depend on the rrr
How banks make money:
1. Net interest income:
Total interest earned from earning assets – interest cost associated
Measured by Net interest margin (NIM)
(Net interest income / earning assets) x100%
Factors affecting NIM:
-Yield curve
-Supply and demand for credit
(Dd for credit borrowing > Ss, NIM increase)
-Earning assets composition
(Riskier assets such as aggressive construction lead to higher yield)
-Funding sources
(Non interest deposit >> cheaper >> higher NIM)
2. Non interest income
Service charges, trading accounts, fiduciary activities, investment banking etc
Performance evaluation:
1. Efficiency ratio
> how much cost is associated with every unit of operating revenue
2. Credit quality
> risk of loan defaulting
> affected by loan composition, higher yield loan >> higher risk of default especially during bad economy
(Commercial loan vs construction loan)
Can be measured by average loan to value, average debt to income on loan
3. Non Performing Loans (NPL) ratio
(Non performing loans/ total loans)
4. NPL coverage ratio
Loan loss reserve/ non performing loans
Factors affecting banks
1. Economic conditions
Interest rates, residential real estate, employment trend will affect supply and demand for credit and credit quality
2. Bank regulation
Heavily influenced by political noise
3. Basel committee
4. Liquidity
Business of borrowing short and lending out long, the banking system is built upon trust
> interbank lending rates
> measured by loan to debt ratio
>>Asset Management<<
-role is to safe keep and manage other peoples money
-revenue: fee based on assets under management (AUM), performance fees, miscellaneous fees
Factors affecting performance:
– choice of asset class by asset management play a big part in determining its success (e.g. bull market for equity but at the same time bear for bond will mean equity focus fund will outperform fixed income fund)
> active vs passive, choice of sector to focus
> method of product distribution to customer, usually via third party
> manager’s customer base (retail or institution)
> stable pool of talent
>>Investment Banks<<
-role is to underwrite securities and provide advisory services (traditional roles)
-currently investment banks like Goldmam Sachs act more like a universal banks, offer a wide range of services such as client trading and commercial banking
Performance of underwriting and advisory generally depends on markets and corporate sentiments
>>Brokerage Firm<<
-role is to provide securities distribution and trading, financial planning, research, asset management
-revenue: fee based services or transaction based like commission
Performance based on market sentiment, income of investors (high income >> more money to invest), trading volume, rising asset prices
>>Consumer Finance<<
– role is to provide credit to consumers
– credit cards, student lending, auto loans, home equity loans, personal loans
– difference btw banks and consumer finance firms are:
1. Method of funding; They do not take in deposits but funded by issuing bonds and asset backed securities which make funding more costly
2. Not subjected to heavy regulations, unlike banks
3. Higher risk lending than banks
Performance affected by:
– regulation
– interest rates
– probability of debt default by consumers
– unemployment rate
– consumer expenditure level
>>Insurance industry<<
– involved in transferring risk
– using the law of larger numbers, insurance collect premium income from the masses to cover losses of the few.
– premium is based on probability and severity of loss
– split into: 1.Life and health insurance 2. Property and casualty insurance
Balance sheet of insurance company
Asset: bonds, stocks, mortgages, policy loans
Property and Casualty firms invest more conservatively because probability of compensating insurer is higher than for life and health insurance firms
Liabilities: insurer coverage
How insurance make money
1. Premiums
> split into earned premium (treated as revenue to company) and unearned premium (portion of premium not yet earned but treated as liability… It will morph into revenue as time goes by). Reason of splitting is because in the event that policy is canceled, unearned premium would be returned to insured
Measurement of premium profitability:
Loss ratio: incurred insured losses/earned premiums
Expense ratio: incurred expense/earned premiums
Combined ratio: (Loss + Expense)/Earned premium
Conclusion: Premium will be used to pay 1. Expenses (amortization of deferred cost, commissions, salaries, legal fees) 2. Pay out on insured loss (largest) 3. Unearned premium
2. Investment income:
Dividends, interest gains
3. Fee income
Asset management services
Note: Insurance compete via pricing of premiums (cannot price too low if not unable to cover losses) and the method of distribution of insurance plans to customers
Drivers for life and health insurance firm:
1. Savings trends
Many insurance product are savings oriented, a rise in savings trend will mean more investment flow into annuities or insurance account
2. Value of assets
Assert value rise >> higher investment and fee income
3. Interest rates
Affects investment income
4. Annuities
Payment at fixed interest rates or variable interest rates which could be risky during period of uncertainty
Drivers for property and casualty insurance firm
1. Economic growth
Higher economic activities >> higher demand for insurance
2. Auto insurance
It’s a big segment in the industry >> a change in demand of automobiles will have an impact on demand for auto insurance
3. Catastrophic loss
Natural disaster
Performance evaluation:
1. Solvency ratio:
Net assets/net premiums written
2. Capital ratio:
Capital as a % of general account assets
3. Net leverage:
Net premium written + net liabilities / policyholder surplus
4. Premium to surplus ratio
>>Real estate industry group<<
Real estate investment trust (REITS)
> an investment fund that is used to purchase primarily commercial properties and mortgages and allow investors access to real estate investment
> typical qualification of REITS:
– company must have most of its assets and income ties to commercial real estates
– distribute most of its earnings to shareholders
Characteristics
1. REITS are value
Normally low growth rates, higher dividend yields, could be below average valuations that are typically preferred by value investors
2. Dividends
Generally higher given that they are required to distribute a large portion of their income to shareholders
3. Supply and demand
Understand the supply and demand trends of underlying property market is critical, the location of the property owned
4. Property prices
High prices >> high valuation of REITS but could also mean dampening demand for property
5. REITS are defensive
Tend to underperform when market rises and outperform when market falls
6. Interest rate sensitive
If interest rates fall >> financing a property is cheaper
If interest rates rise >> make other cash flowing investment more attractive than REITS if it does not increase it’s dividends
Types of REITS
Retail REITS
> leasing properties to retail oriented such as groceries and shopping malls
> core revenue from rental
Office REITS
> own and operate office properties
> typically 7 to 10 years leases
> core revenue from office rents
> trade off issue between occupancy and rent
> most office REITS tend to develop a niche to provide office for certain industry… Providing office to government agencies would be seen as stable
Residential REITS
> focus on residential properties
> prefer mortgages to be difficult to afford and low interest rates.
This allow access to cheap funding and make customers rent instead of buying so to make REITS more profitable as it drives up demand for space in property
Industrial REITS
> logistics, operations such as transport, warehouse, distribution
> driven by industrial activity
Measurements for REITS:
1. Funds from operations (FFO)
Net income (excluding gains or losers from property sales) plus depreciation and amortization and after adjustments for unconsolidated partnerships and joint venture
2. Net asset value (NAV)
Assets minus liabilities (use fair value of assets rather than after deprecation)
3. Net operating income (NOI)
Operating income – operating expense (exclude one time event)
4. Cap Rates
Net operating income/property value
> the profitability level of a property
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