Who else would you talk to?
Regarding financial stocks, that is. For the first time in a couple of years, money managers are starting to see good things for the sector. That's the domain of Jim Schmidt, who runs $6.5 billion in financial-sector funds. He saw the bank merger and acquisition wave coming way ahead of others and launched the
(FRBAX)John Hancock Regional Bank fund back in 1985. Since then he's added the
(FIDAX)John Hancock Financial Industries fund in expectation of broader cross-industry consolidation, a la
Citigroup(C).
It won't take much to send these unloved stocks up, and Schmidt says now might be the time to get involved. For the next 10 Questions, Schmidt walks us through his likes, his dislikes, likely M&A players, his interest-rate outlook and how to tell a good merger from a bomb.
Jim Schmidt |  |
Fund
(FIDAX)John Hancock Financial Industries |
Co- Managers
Thomas C. Goggins, Thomas Finucane |
Managing Fund Since
March 14, 1996 |
Asset Size
$2.5 billion |
YTD Return/ % Rank in Category
14.6% / Top 14% |
1-Year Return/Rank in Category
10.3% / Top 9% |
Load
5% (class A shares) |
Top Holdings
Marsh & McLennan (MMC) American Express (AXP) Citigroup (C) |
| Source: Morningstar. Returns through July 27. Holdings through July 24. |
1. What slivers of the financial sector look good to you these days? Schmidt: The sectors we've done best with recently are the brokerage and asset-management companies. As the market comes back a bit, I think it's made people think that there's more life to the IPO and the investment-banking business than they might have thought a couple of months ago.
Second, there's been some merger activity involving both people on the mutual funds side and on the brokerage side, most recently with
UBS (UBS) buying
PaineWebber (PWJ), and I think that's caused people to focus on the remaining players.
We think we'll see consolidation among many financials, and certainly there will be a strong trend toward banks acquiring brokerage firms. Most of the publicly traded brokerages will wind up being owned by banks. Favorites here:
Lehman Brothers(LEH) and
Schwab(SCH).
We still believe in the bank story; the commercial banks are very inexpensive. There will eventually be resumption of some merger activity among the banks, and here I'll pick
Comerica(CMA) and
Commerce Bancshares(CBSH).
Finally, we think there are opportunities in insurance. A growing area is some of the investment-oriented insurance products like variable life and annuities and, let's see, in insurance we'll go with
Protective Life(PL).
2. On the flip side, what are some areas in financials that don't look so hot right now? Schmidt: One area we've been a little wary of is the savings and loans. We own a lot of commercial banks, but we feel as interest rates have risen, all the financial stocks have sold off. The commercial banks we think will largely be able to keep returning good earnings, even with higher rates, because most banks have approximately balanced rate sensitivity. Both sides of the balance sheet re-price as rates change with about equal liquidity, and it doesn't really hurt them as rates go higher. That's not so much true of the savings and loans.
Also, regarding some of the finance companies for subprime lenders, while times are fairly good now, we think there may be credit problems ahead.
3. You've said that financial stocks anticipate rate stabilization by a couple of months by starting to perform well again. What do you see happening with interest rates? Schmidt: We think the financials bottomed in March and with the economy looking a little weaker here, I think that the stage is set perhaps for no other increase, or maybe just one more hike later this summer, so I think we're getting close to the end.
Part of the wild card is what the stock market itself does, that if we were to see the
Nasdaq coming back a little bit here, if we were to see a continuation of the Nasdaq move back, returning to the days when it was above 5000, then I think the Fed might once again feel they need to rein in speculation a little bit.
4. What is your second-half outlook for financial stocks? Schmidt: Very good. They've been out of favor, so they're expensive. I think we're heading into a period where interest rates, which have hurt investor interest in the stocks, may help us as opposed to hurting us.
Then the merger activity will start to pick up somewhat, in the banking area -- there's very little activity now -- but I think, among commercial banks ... so I think that activity will pick up as time goes on.
5. What's the state of cross-industry consolidation look like to you? Schmidt: The Gramm-Leach Act has been in effect since March and it repeals key sections of Glass-Stegall Act [the 1934 law that placed curbs on mergers across different financial industries] and the bank-holding company act, thereby permitting the establishment of financial holding companies that are in banking, insurance and brokerage. This is really the first time that this has been possible.
So we think there will be further affiliations between banks and brokers and additional deals between banks and insurance.
But we also think that Gramm-Leach promotes European acquisitions of U.S. companies. I think it will be easier for the Europeans to build equivalent franchises in the U.S. to what they have in Europe. To some extent, we've seen already several acquisitions of banks or insurers from Europe, buying sizable financial institutions in the U.S.
But as far as full-blown mergers between banks and insurance companies, that has been slow to get going. We think over time we'll see deals in this area, too. I think there's a little less deal activity than there would be if the stocks performed better.
6. What are a couple of companies on the acquiring warpath? Schmidt: Likely acquirers are companies that have high multiples and can do it more easily in the banking area, such as Citigroup; of course, we know the proclivities of Sandy Weill [Citigroup Chairman and CEO] to make opportunistic acquisitions, and Citigroup also has a high multiple.
Wells Fargo (WFC) has made a bunch of smaller acquisitions this year, and they're in a good position to continue doing that. And probably
First Star Bancorp(FSSB), as well.
I think on the brokerage side you'll see strategic acquisitions, possibly some of the national firms buying some of the regional brokers, like we did with PaineWebber buying
J.C. Bradford.
Some potential European acquirers may be an
ABN-Amro(ABN) or UBS.
On the insurance side, I think
AIG (AIG) is certainly in the best position. There are very few insurance companies really in a position to make acquisitions, but probably AIG would be the best example, to some extent
Berkshire Hathaway (BRK.A), as well.
7. Can you name a few likely acquisition targets? Schmidt: I think some of the best targets are companies that just represent good value and are in a spot where I think there might be several interested in them, and sooner or later they're going to find the right deal.
For example in the banking area, you could have a Commerce Bancshares, where they have their last surviving bank of any size in Missouri and the last independent bank, real good asset quality. I think they'd be an attractive fill-in target for several people. Another example of that might be
Summit Bancorp(SUB) in New Jersey, in the banking area.
And then on the brokerage side, I think we'll see some deals involving first of all the firms that offer an underwriting capability, like Lehman and also perhaps some of the firms with regional distribution --
Tucker Anthony(TA) would be a good example of that.
On the insurance side,
Lincoln National(LNC) would be a good acquisition target.
8. With all this potential merger activity in the near future, there are potential pitfalls for investors if the deals don't work out as planned. What should investors look for as guidance as to whether a merger is working or not? Schmidt: You've raised a very tough issue, because some of the smartest minds in the financial business have been tripped up on some of these mergers. We're going to see this when you start merging, say, banks with a brokerage firm where the culture is quite a bit different, where there may be dramatically different types of personalities in the two firms. And there's no simple formula for knowing what's going to work. I think you have to start to see as the merger gets put into place: Does it seem to be one that's going where's there's a big loss of customers and employees, or does it not seem to be that?
A couple of things you might watch for as clues: First, look for managements that are proven in doing mergers successfully. The Wells Fargo-
Norwest, I think you had a CEO who's done some deals before and they've worked. First Star has done several mergers and they've worked well. At Citigroup, Sandy Weil has done some, so you go somewhat by management reputation.
Number two, I think mergers that depend on enormous cost savings to make them work are going to be a little more vulnerable than those that don't. So if the pricing of the merger is such that the acquiring firm needs to claim a lot of expense savings to make the deal not dilutive, then that greatly increases the risk of something going wrong because it means getting rid of a lot of people, a lot commotion and a lot of customer dislocations caused by all that process.
When there's less of that going on and it becomes a little simpler -- it's simply adding the two companies together and there aren't a lot of staffing changes -- then I think there's less chance of an error. So, to recap: The size of the staff reduction, the size of the expense savings and the reputations of the managements are the big tip-offs.
Other than that, you somewhat have to wait until afterwards and just monitor it, because some mergers sounded good on papers and they bombed, and vice-versa.
9. If you had to pick three stocks and hold them for five years, what would they be? Schmidt: I'll go with Commerce Bancshares. I'll pick
Merrill Lynch(MER), among the brokers, because I think things are falling into place well there. In insurance, I'm going to go with
AFLAC(AFL).
10. What's the last stock you purchased for the portfolio, and what's the last stock you bought personally? Schmidt: Actually, it's something within the last couple of days, which we're not supposed to talk about it, but I'll go back a few weeks.
AXA Financial(AXF), the old Equitable, DLJ and Alliance Capital. I think AXA doesn't get full credit for the value of their different pieces. All those sectors, if it had been different companies, I think those sectors would have done better than the stock has unified.
Personally, it may be surprising, but I haven't done a personal trade in a long time. We have very strict compliance rules here that greatly inhibit our ability to trade, to a point where it's kind of cumbersome; I just own our funds.
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