Tuesday, July 15, 2008 0 comments ++[ CLICK TO COMMENT ]++

One Big Risk With Investing in Financials

One of the big risks cited by some for the financial services industry is the possibility that a structural change may be occuring (to the detriment of financials.) Financials have been above-GDP-growth earnings from the late 90's to the early 2000's. FT Alphaville refers to a Deutche Bank report illustrating the above-GDP-growth profits and asks whether profits are reverting to the mean (ironically they also point out that a lot of problems with CDOs were because the mean-reverting assumption built into the CDO models turned out to be wrong.)

I brought up this point a few months ago when I mentioned an article from The Economist dealing with the same point. Are we seeing a negative structural change for financials? Will their revenue (relative to GDP) decline in the future? Will their profits (relative to GDP) decline permanently? If you are investing in financials (or thinking about it), and are a long term investor, this is an important point. If future profitability is lower, the earnings multiple (or whatever method you use to value businesses) will be lower in the future. The profit margin from the past will be higher than what's in store in the future.

I don't have a strong opinion either way, yet. Clearly a lot of the profits booked in the early 2000's were either bogus or were unsustainably high. But I'm not too sure about the structural change argument. The world has changed quite significantly over time. Just like how the internet industry is a big chunk of the economy, the financial services industry is larger now. For instance, very few people invested in stocks, bonds, or whatever, 20 years ago, whereas practically everyone under the age of 40 invests one way or another (even if they are not stockpickers, they invest in passive mutual funds.) A huge chunk of commerce (especially the retail side) is conducted using credit cards rather than cash these days. Businesses also can do things now due to advances in financial services that they had difficulty doing before (for example, hedging currencies (even for a medium size business) is quite affordable and easy to do now.) So the verdict is still out on the future of the financial services.

Having said that, if you are investing with a contrarian, turnaround, tactic in mind then the future change in the industry may not matter as much. If you invest in severely beaten up stocks, the upside is large even if future profitability isn't as good as it was in the past. The market is pricing many financials as if they are close to or almost insolvent. All it takes to make money is for mark-to-market losses to reverse (assuming they do.)


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