Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Warren Buffett, the world’s most famous investor, once said: “Never invest in a business you can’t understand”.

That logic has kept a lot of investors clear of the financial sector, which is home to plenty of complex business models and unnerving jargon.

Its case hasn’t been helped by a bad decade topped off with a painful 2020. However, this is one sector which could benefit greatly from reopening economies and buoyed consumer confidence. Its fortunes may just be about to change for the better.

In order to understand how and where to invest in the sector, it’s important first to understand how it works.

Making sense of banks

The key to understanding this sector is understanding banks. Their business models underpin how many other financial companies operate.

A bank’s profitability depends on two things. First is something known as ‘net interest margin’ (NIM). This reflects the difference between the money a bank borrows at a lower interest rate - through customer deposits such as current accounts - and the money it lends at a higher interest rate - through mortgages, loans, overdrafts, etc.

The greater the difference between the two, or the larger the ‘spread’ between them, the greater the NIM.

A bank will also earn money through fees and charges on accounts. Its overall profitability will be a combination of NIM, plus this non-interest income.

It’s a simple enough model, but it can easily run into obstacles along the way.

Banks are typical ‘cyclical’ companies, meaning their performance tends to reflect the overall health of the economy - they do well when times are good, and badly when they’re not.

There are two main reasons for this. The first reflects the overall state of loaning conditions for banks. In a healthy economy, conditions are ripe. Consumers and companies are more likely to be looking for loans - be that to expand their businesses, buy a house, and so on - while the likelihood that borrowers fail to repay those loans decreases.

The second reason is more closely tied to banks’ NIM.

What banks ideally want is something that resembles the ‘yield curve’ of a healthy economy. The yield curve reflects the difference on the yield available between short-term and long-term bonds.

In a healthy economy, in which interest rates aren’t low and people are confident in the present, shorter-term bonds offer a lower yield; long-term bonds, which are seen as riskier because of their greater time commitment, should offer a higher yield to compensate for that risk.

Banks’ NIM relies on a similar relationship between short and long dated loans. The maturities on their assets (e.g. mortgages) tend to be longer dated than those on liabilities (e.g. customer deposits) - they ‘lend long, borrow short’. The larger the spread between the two - i.e. the healthier looking the yield curve - the better for the bank.

A healthier economy should equal a healthier looking yield curve. That could mean the ideal spread for financials’ NIM.

For insurers, the relationship is similar. Insurers tend to hold a lot of safe debt to back their policies. As interest rates rise, the yields on that debt follows suit. For asset managers, the money they make is linked to the charges on their assets under management. In other words, the more money they hold, and the more transactions customers make, the better.

Cheap valuations

There’s another reason why financials look interesting right now: they’re cheap.

Banks tarnished the industry’s reputation during the financial crisis, and the subsequently low interest rate decade has kept them firmly in the lurch.

That’s had a powerful effect on valuations. The price to earnings (P/E) ratio (a measure which compares the sector’s share price compared to its per-share earnings) for global financials stands at 16.4 compared to 28.4 on the MSCI World Index. The price to book (P/B) value stands at 1.21 compared with 2.94 - a lower P/B may be an indicator of value.

The sector is also home to many of the UK’s big dividend payers. Others, like the oil companies and British American Tobacco, pose ESG risks that may worry income seekers. While many banks were forced to cancel payments last year when COVID struck, most have since resumed.

Where to look

For all the complicated work going on behind the scenes, many financial names are very familiar. Banks like Lloyds, Barclays and NatWest suffered last year and while their share prices have rallied to positive vaccine news, most are still down on where they started 2020, suggesting there could still be room to climb.

Bank dividends remain low - most are yielding around 1-1.5% - but that’s no real surprise given they’ve been advised to resume payments cautiously. Those yields could start to rise as we emerge from the crisis.

Another bank to consider is HSBC. Like many, it had a tough 2020. Its international arms were also affected by US-China tensions and political instability in Hong Kong. But this international exposure does differentiate it from the others. Areas like Asia and Emerging Markets, with their expanding middle classes, represent serious growth opportunities for financials in these regions.

Consider too disruptors like Metro Bank. Metro was set up in 2010 and has already cemented its place as a key high street bank. While faring better than some last year, its share price has nevertheless fallen again off the back of its 2020 results. Given its relative youth, it may look riskier - it has run close to the mark with its capital ratio before, and has received some attention from the Reddit/GameStop investors - but this could be another good value opportunity.

Beyond the banks, there are plenty of insurers and asset managers with similarly appealing valuations and more eye-catching dividends.

Aviva and Legal & General are both offering attractive forward dividend yields over 5%. Prudential, while offering a lower dividend yield, has made a series of structural changes which could stand it in good stead as we emerge from the pandemic. The latter has also benefitted from diversifying into other areas. Losses in Prudential’s US insurance business last year were offset by its investment arm, PGIM.

Asset managers are also offering impressive dividend yields at low prices. Schroders has benefitted from an upturn in investor activity and currently offers a solid forward yield of 3.3%. M&G, meanwhile, is offering an eye-catching 9%. This may look like a trap - especially given M&G has been paying dividends for fewer than two years - but payments have proved stable in that time.

Finally, think about delving beyond the usual FTSE names and into the UK’s nascent fintech scene. Over 2020, the UK accounted for just under half of Europe’s fintech investment, according to Innovate Finance.

Investing in fintech is quite a different experience from holding traditional financials. Many resemble growth technology stocks far more than the ‘old economy’ financials, and most remain unprofitable.

But there could be some real potential in names like Funding Circle, a platform that allows investors to loan to small businesses, and AIM stock CPP Group, which serves a number of well-known companies like AXA and Vodafone, and has begun expanding into Emerging Markets like India and Mexico.

Glossary:

Price to book (P/B): The price-to-book is a financial ratio used to compare a company's current market price to its book value – the value of a company’s assets.
Price to earnings (P/E): A valuation ratio of a company's current share price compared to its per-share earnings.

Important information: Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. When you are thinking about investing in shares, it’s generally a good idea to consider holding them alongside other investments in a diversified portfolio of assets. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.

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