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Financial Sector Funds May Be the Best Way to Play Merger Game

Ian McDonald

Money managers and analysts say the recent financial services firms' shopping spree should continue -- helping the surging sector stay on the comeback trail.

Does that mean investors should rush out and buy a sector fund that taps into the frenzy? No, and yes. Analysts say it's never a good idea to bet on a stock or sector simply because of acquisition hopes. For one thing, no suitors may emerge; for another, the merger may not work.

"It's pretty hard to guess what the next takeout will be. You can wait forever and never get asked to the dance," says Bruce Olson, who runs institutional portfolios for Milwaukee-based Strong Funds.

That said, buying a financial sector fund may not be a bad thing, even if it's for the wrong reason. Wall Street pros say a variety of factors -- an improving interest rate outlook, stellar performance by the industry leaders and, yes, industry consolidation -- means there may be plenty more growth for financial sector funds.

"The long-term [outlook] still looks really good for the whole industry. Investing in market leaders is a good idea because they're going to the ones who profit. For the most part the products are pretty basic, people need bank accounts and mutual funds. There's more money out that that needs to be invested for retirement," says Alyssa Sibley, a Morningstar financial-services stock analyst and former portfolio manager.

A spate of mergers has drawn attention to financial stocks and financial sector funds, which were weighed down by rising rates and investors' tech obsession in 1998 and 1999. The deals have given financial stocks a boost.

Financial Health After a tough 1998 and 1999, mergers and stable interest rates have helped financial sector funds come back to life.

Source: Morningstar and Baseline.

Over the past 90 days Swiss bank UBS has acquired U.S. brokerage PaineWebber(PWJ Quote), Credit Suisse First Boston has agreed to buy Donaldson Lufkin & Jenrette, Citigroup (C Quote) has gobbled up Associates First Capital. On Monday Goldman Sachs announced plans to swallow privately held clearing shop Spear Leeds & Kellogg and Tuesday news reports indicate Dresdner Bank is in talks to buy U.S. investment bank Wasserstein Perella. The moves underscore firms' drive to boost their customer and asset bases and a steady fee income that can buoy behemoths when the stock market cools off.

"I think we'll see more consolidation because these companies are realizing that they need to bulk up and get the highest percentage of their income from recurring fees," says Sibley. "The bull market has been going strong for years and they need to be prepared for it to slow down." Her favorite brokerage picks are Merrill Lynch (MER Quote), Goldman Sachs (GS Quote) and Morgan Stanley Dean Witter (MWD Quote).

"It's just a drive for economies of scale because bigger is better in this business. I see [consolidation] continuing over the next 12 months," says Olson, who favors big leaders like Citigroup.

Most pros point to brokerages and asset managers, where much of the sector's growth has come this year, as potential merger players.

"There's been a lot of action, especially in the brokerage sector as well as the asset managers," says Tom Finucane, co-manager of (FIDAX Quote)John Hancock Financial Industries fund. "Banks and insurance companies are not as adept at gathering and keeping assets. People look to the future and those with the best chance at surviving are brokers and asset managers."

But predicting the next merger isn't a cinch. Steep run-ups for J.P. Morgan (JPM Quote), Bear Stearns Companies (BSC Quote) and Lehman Brothers (LEH Quote) -- up 36%, 70.3% and 89%, respectively this year -- indicate that investors believe merger rumblings swirling around those companies. But some pros wonder if there are many or any companies both big enough and aggressive enough to acquire these shops that are getting more expensive by the day.

"Who is big enough and powerful enough to buy those three companies? There aren't many. I don't see a lot of logical buyers at these prices," says Hancock's Finucane.

Morningstar's Sibley wonders if American Express(AXP Quote) might use an acquisition to bolster its online brokerage effort and could see market maker Knight Trading Group looking like an attractive buy. After the Credit Suisse-DLJ deal was announced, Dave Ellison, manager of (FBRFX Quote)FBR Financial Services fund thought a laundry list of smaller shops like Raymond James(RJF Quote), TD Waterhouse(TWE Quote), Wit Soundview(WITC Quote) and AG Edwards (AGE Quote) might be looking for larger partners.

Hancock's Finucane says he could see broader deals as banks, brokers and insurers combine, a la Citigroup, to offer a full menu of products and services under one roof.

"Banks are looking to get into aggressive businesses like brokerages and others are looking to get into banking," he says. "American Express, Charles Schwab(SCH Quote) and AXA Financial (AXF Quote)are probably looking to add to what they've got. They're also looking to do more on the banking side. Merrill Lynch is pushing there, too," he says. Conversely, he also sees big banks such as Chase, Wells Fargo and Bank of America pushing to expand their nonbanking businesses, potentially paving the way for big deals down the road.

"It's probably not going to happen today, but someday it will," he says.

In the meantime he and others advise investors to tune out the sexy merger speculation and focus on big global leaders. It is a scale business that might bloom as long as interest rates don't go higher -- rising interest rates typically pinch financial firms' profits.

"Just pick good businesses growing at a steady clip. Either the market realizes that or one of their competitors does and takes them out. Those companies with good market shares and business plans make the most sense," Finucane says. He thinks banks and insurers look undervalued right now, unlike brokerages and asset managers. FleetBoston Financial(FLT Quote) is one bank that's growth potential might currently be underestimated.

For many investors a financial sector fund might be a good route, since it will offer cheap and broad access to the sector's behemoths and its smaller players.