10 Questions With John Hancock's Jim Schmidt

You probably wouldn't guess it, but financial-sector funds lead every other fund flavor over the past five years.

The category's 17.9% annualized gain during that stretch, compared with 15.3% for the S&P 500 , merits our attention. After the average financial-sector fund gained 27% last year, you might be wondering if it's time for the sector to cool. Well, no one runs more money in financial-sector portfolios than Jim Schmidt, manager of the $2.6 billion (FIDAX Quote)John Hancock Financial Industries fund and the $3.2 billion (FRBAX Quote)John Hancock Regional Bank fund, as well as closed-end funds focused on the banking sector.

Talking With: Jim Schmidt

Fund: (FIDAX Quote)John Hancock Financial Industries Fund

Assets: $2.6 billion

1-Year Return: -4.2%/Trails 95% of Peers

5-Year Return: 15.4%/Trails 71% of Peers

Expenses: 5% sales charge/1.4% annual expenses

Top-Three Holdings: American International(AIG Quote), Citigroup(C Quote), Fifth Third Bancorp(FITB Quote)

Sources: Morningstar and jhancock.com. Sales charge is the maximum on Class A shares.

Six interest rate cuts have boosted bank stocks, but a sagging stock market has kept brokerage and asset-manager shares -- and Schmidt's Financial Industries fund -- down. The veteran stock manager admits financial stocks aren't nearly as cheap as they were a year ago, but he argues for more gains in financial stocks, two more rate cuts and a modest market recovery.

1. What's the case for owning financial stocks today?

Schmidt: The case is based on better relative earnings compared to the market. Outside of the brokerage business, our companies' earnings are up while the average company's aren't. Even though financial stocks are up, I wouldn't say they're overvalued. A year ago I might have said they were undervalued, but I'm not sure I can say that today.

Also, I think consolidation activity will continue among the banks. You'll probably see more deals between banks and brokers. The new merger accounting rules are in effect now and, I think, will be good for helping merger activity. Under the new rules you won't have to amortize goodwill created in a merger against earnings. So, you'll be able to do some of these transactions without diluting your earnings.

2. What do you see in terms of consolidation over the next 12 months or so?

Schmidt: It's been quite slow this year, but I think we'll see some pickup. You have resistance on the part of sellers, but both time and higher prices clear that up. The one negative that has held back bank consolidation is that there aren't as many buyers as there used to be. The people that were the real acquirers, like First Union(FTU Quote), Bank One(ONE Quote), Bank of America(BAC Quote), have fallen on leaner times.

The buyers now are BB&T(BBT Quote), Wells Fargo(WFC Quote) and Fifth Third(FITB Quote). They're out there, but there aren't as many of them.

Streaky Financials were the rage in 1997 and 2000, but this year has been tough

Source: Morningstar. Returns through July 19.

Who out there has a solid, if niche, business that could fit nicely within a bigger company?

Schmidt: There are attractive businesses, with good franchises in the banking area, like Commerce Bancshares (CBSH Quote) in Missouri and Cullen/Frost Bankers (CFR Quote) in Texas. They each have good market share and are the last one standing in their area. They'd be good candidates, if the right deal comes along.

3. Many of your companies' earnings hinge on the stock market, so what's your outlook for equities?

Schmidt: It has been an unusually bad period in the market. I don't remember a time in the last 15 years where you could have bought a diversified set of stocks and two years later still been under water. I just don't think a period that bad can last forever.

We'll see the Nasdaq recover. Suppose it even recovers to 2600, that's barely half of where it was at the peak, so I'm not asking for much, but I am just saying a little better market. Then I think some of the things that are being hurt, like securities transactions and IPOs , will start coming back. You'll have more people with a positive experience in the market, but now anyone who has done anything has been hurt in the last year, and it's pretty hard to get people interested in a lot of equity-related products.

4. A recovery should be a salve for brokerages and asset managers, right?

If you are a mutual fund company or brokerage firm, a good equity market is the best thing for you.

When interest rates get cut, on average the brokers are the best group of all. If you look over history and you take every time the Fed cuts rates, the financials tend to beat the market two-thirds of the time, and the brokerage stocks are the best group of all. But then, usually, lower rates means a better stock market, too, and it hasn't this time. You need a better market for brokerages to go up. The market doesn't have to go back to where it was. In other words Nasdaq has gone from 5000 to 2000; it doesn't need to go back to 5,000, but it needs to go up.

How about asset managers?

Schmidt: The story here is similar to the brokers, but I think that the negative on asset managers is that the recovery is going to be a little bit slower. In three months we could see just as many mergers as we saw a year ago, [driving brokerage earnings up through advisory fees]. But it's very unlikely that the mutual fund balances will be back in three months to where they were a year ago.

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5. What's your interest-rate outlook?

Schmidt: I think we'll see at least one more cut, maybe two. Only if the economy were really in the dumps would you see more, but I don't think that will be the case. If they do two more 0.25% cuts, then I think there's no need to do anything because the economy will slowly recover. So, we don't have much more to go in downward rates, but I don't think it's like a "V" in rates and then they head back up. I think, for maybe six months to a year, there won't be any changes in the fed funds rate .

6. Before this year the Financial Industries fund was keeping pace with more diversified financial funds, but it's had a rocky 2001. What happened?

Schmidt: One thing is that we have a fair chunk of brokerage stocks and asset managers, and they've had a poor year. And then we had more of the large-cap financial names among our big holdings in the beginning of the year, like American Express(AXP Quote), Merrill Lynch (MER Quote) and American International Group(AIG Quote). And this year has been more of a small-cap year. I'd say in 2000 the Financial Industries fund did well because we had those bigger names, but this year some of these big caps like AIG haven't had a bad year, the stocks just haven't performed as well as many of the smaller names.

7. You invest in the fund companies, but you also work at one. With cash flows to funds well off last year's record pace, it looks like the number of funds might shrink. Do you think that will happen?

Schmidt: I think so, and I'm surprised there hasn't been more in a way. Mediocre funds that have assets but a middling track record don't have a very bright future as far as distribution. Someone will buy them just to take the assets and no expenses. You know, [at] a lot of large-cap growth funds, you can manage $1 billion or $10 billion with the same staff. You don't need any extra people.

8. Let's play some word association. I'll name some companies, and you can give us your opinion and let us know if the fund owns shares. Let's start with Citigroup(C Quote).

Schmidt: I like it and we own it. They've done a good job of integrating complex businesses together, and it has been one of the more successful mergers.

Washington Mutual(WM Quote)? The bank's shares are up 96% over the past year.

Schmidt: One of our favorites. It's a big holding with good management that's really benefited from lower rates and been a good story. One negative is the potential for them to do acquisitions. They're in a good position to buy someone, so you might open the paper and find out that Washington Mutual bought someone and the stock is down two points, and that's a risk you have to live with.

Bonny Year for the Banks Schmidt's bank fund shows that financial industry's strength over the past year
	1-Year Return	Percentile Rank vs. Peers (1=Best, 100=Worst)
(FRBAX Quote)John Hancock Regional Bank	38.3%	17%
(FIDAX Quote)John Hancock Financial Industries	4.2	95
S&P 500	-17.1	N/A
Source: Morningstar. Returns and rankings through July 19.

Merrill Lynch?

Schmidt: Merrill Lynch we still like, although brokerage stocks, including Merrill, have hurt us. When I say we still like it, it's because they've continued to be able to gather assets this year even in a tough environment and I'm assuming there will be a recovery in investment banking later in the year. If I am wrong on the market coming back, then we won't do so well with Merrill.

Charles Schwab(SCH Quote)?

Schmidt: They're not quite as positive because their business is slow. Investment banking can almost turn on a dime, and Merrill is one of that business's leaders; Schwab's business is individual trading, and that's just down. Schwab is good in electronic brokerage, but that may never get back to quite where it was at the beginning of last year.

Does the fund own Schwab?

Schmidt: Schwab is a small holding, much smaller than it used to be.

Smaller every day?

Schmidt: Yeah, I guess so. We've been net sellers. Everyone has less Schwab than they used to, but we've been net sellers.

Stilwell Financial(SV Quote), which owns Janus?

Schmidt: We don't own Stilwell. That's a good example of the dynamic I was talking about. Things might get better for Stilwell's inflows later in the year, but it's going to take a long time to rebuild their assets to where they were at the peak last year.

9. Cash flows into funds tend to chase performance and often miss the boat. Did most of the funds' recent flows come this year, even though financials were a safe harbor in 2000?

Schmidt: It's a surprising thing they were still in negative outflow. It's not a lot, but it's surprising that [they] were in negative flow at all, particularly the bank funds that had a very good year and a good long-term record. I guess people don't get as excited about financial stocks when they do well as maybe some other groups. And I don't know if I can fully explain it, but [can] say in all past downturns, once financial stocks started doing better, we started to see positive flows. This time it really hasn't happened.

10. If you had to pick three companies today -- based on their management, their products and their current valuation, what three would you choose for a five-year holding period?

Schmidt: I'll go with Cullen/Frost in Texas. I like the management, one of the sizable independent banks left down there, and, I think, over many years that will do real well. Then I'll choose Aflac(AFL Quote) -- but this year [it] hasn't really been a favorite, but we'll stay with it. In the brokerage business, I'm going to go with Lehman Brothers(LEH Quote). Lehman tends to sell cheaper than the other firms, but they've done a very good job. They've traditionally been thought of as a bond trading house, and that gets a lower multiple, but they've made a lot of inroads in investment banking and they're strong over in Europe. And maybe Lehman will get taken over -- I don't know for sure, but it's a possibility, too.