When you look at financial stocks, you see glaring positives and glaring negatives. If you want to talk about them, talk to Jim Schmidt.

The average financial services sector fund has quietly averaged a 12.3% annual gain over the past five years, trouncing the S&P 500 and trailing only health care funds over that stretch. But what now? The terrorist attacks on Sept. 11 struck the world's financial center. To spur the economy, the

Federal Reserve

has slashed interest rates, a strategy that usually boosts profits and stock prices for financial shops. But the stocks haven't rallied and rates can't go down forever.

To sort it all out, we huddled with Jim Schmidt, manager of the $2.9 billion

(FRBFX) - Get Report

John Hancock Regional Bank fund and the $2 billion

(FIDAX) - Get Report

John Hancock Financial Industries fund, among others. No fund manager runs as much money in the financial sector, which has been his racket since the 1980s. After a tough year, where is he investing his shareholders' money now? Are brokerages, for instance, a value -- or just cheap? Read on.

1. From where you sit, what's the case for owning financial stocks today?

I think it's based on valuations and better relative earnings performance than other areas. As a whole, financial stocks are trading at about two-thirds of the market's

price-to-earnings multiple. The valuations of financials are good in part because the earnings have plunged so much for companies in other sectors. I think to some extent some of the financials can benefit from lower interest rates, but I don't want to overstress that argument because that's more of a minor deal than people think. And I still think we'll see many years of merger activity ahead of us. That's been slow lately, but I think it will come more to the forefront next year.

2. Some might counter that argument by saying interest rates can't keep going down much longer and rising rates tend to hurt financials. Then there's the terrorist attacks on the financial center of the world. What's your response?

Well, you'd normally assume that with the Fed cutting rates aggressively, the financials would have a great year. They've done OK compared to the rest of the market but haven't really performed as well as you'd hope. To some extent, that makes us less vulnerable to the rate increases that will eventually follow. If financials had already had a big run, then I might say you want to be out of financials before rates start rising next year, but I think they really haven't had their move. They're really not at high valuation levels, even now. So, I think you don't have to be as nervous about a rate increase next year as you might normally be.

What factors held the stocks back?

Well, I think it's concern about the economy. In the case of the brokerage stocks, it's the softness in trading activity in the stock market. With the bank stocks, it's concerns about loan losses. I think those things are worrisome enough that they prevented a big run in the financial stocks. And merger activity has been slow and that's one of the drivers of interest in the financial industry.

3. What effects have the terrorist attacks had on the financial sector?

The odd effect on the insurance companies and the property casualty industry is that there will be $20 billion to $30 billion paid out because of the attacks but the stocks have done OK because the outlook for premium increases is much better than it was before. The market has almost taken the view that it's worth suffering the claims losses for those increases. I'm not sure I totally buy that, but that's been the market response.

The brokerage stocks have been hurt because business is lousy. There were no IPOs at all in September, and that's extraordinary. Merger-and-acquisition advisory is way down, retail commission volume is very poor, the bond business has been a little better, but most aspects of the brokerage business have been very slow. That business goes away quickly, but it can come back very quickly. I think in the brokerage stocks, it's worth taking a shot at it. You're buying them when business is slow and you could see much better earnings comparisons. I think this is about as bad as it gets.

Now, let's contrast that with the asset management business, where business has been slow but is going to take some time to recover. The trading volume within a few months could be back higher than where it was at during the summer, but I doubt asset levels at most money management firms are going to be back higher than where they were during the summer any time soon because they have a lot to recover. So I think it's early for the asset management stocks.

As for banks, they're sort of ambiguous. They won't get severely hurt; the big news from the terrorist attacks for the banks is the slowing economy. Banks' numbers tend to trail the economy, so I expect higher nonperforming assets in the banking industry for the next three quarters maybe. I don't think it will be alarming, though. I think the worst we'll get is a total ratio of 1.4% of the balance sheet, vs. say 3.3% in 1992.

4. As you say, consolidation is a big part of investing in financial stocks. But sellers don't want to sell at today's valuations and buyers might be braver if their stocks weren't low. What do you think has held back consolidation?

Well that's part of it. The sellers are feeling they're not getting a good price. Another problem is the recent distractions. There's so much stuff going on elsewhere that people just aren't focusing on mergers. I guess that'd be part of it. Also, several large mergers, particularly in the banking industry, have run into problems and turned out not to be value-enhancing for shareholders. That has made everyone a little cautious. The pool of buyers is also not as large as it used to be because you used to have some companies in the banking industry that had very acquisitive bents --

First Union, Bank of America, Bank One

-- that did deals all the time. Now they have pulled back because their stocks aren't as highly valued.

I think time cheers all those problems. You have some companies now that have done several acquisitions that have turned out OK, so they can probably continue to do them. You'll build up a new group of acquisitive banks and it won't be First Union or Bank of America, it'll be banks like

BB & T

that will fill that role.

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5. Merrill Lynch just reported its results and, as usual, everyone's wondering if it's an acquisition target. Does Merrill need to join another company and will it do so?

Well, I think they're prepared to go it alone. If you asked management I'm sure they wouldn't say they need a partner or are for sale.

We've seen a lot of the major investment banks go from total obscurity to having some success by adding a partner like J.P. Morgan pairing with Chase. If any of the unaffiliated brokers like Merrill Lynch could get a well-heeled banking partner, they might have interest in a merger like that. I'm not saying they feel they desperately have to, but the issue of capital and what it takes to play in the major leagues of investment banking has come to the forefront and it must make Merrill Lynch at least consider that possibility.

6. What's your outlook on the economy and interest rates?

I'm looking for a sharp downturn in the fourth quarter and maybe a recovery in the first quarter. First quarter may be zero GDP growth, but there will be a recovery under way in the second half of the quarter. Then I'm looking for say 3% GDP growth for the second quarter of 2002. And interest rates, I'll think we'll see maybe 50 basis points in cuts by the Fed, and hopefully that'll start to take hold and they won't need to do more than that because there will be a recovery visible after that.

7. Let's do a brief survey of the different financial industries, in order of their representation in the fund. With each, name a couple of companies that stand out to you as having solid growth prospects and skilled management.

In the banking area, we still like the stocks even though there will be some quarters of higher nonperforming assets. I still own them despite that because they're relatively inexpensive. You have to buy the stocks that don't have real credit problems. Three or four years ago you figured no matter how bad a bank's lending policy is, most of the customers are going to repay them anyway because the economy's booming but that's less true now. Our favorite banks would be

Fifth Third

, BB & T who I mentioned before, and

Northern Trust

, which gets its revenue not just from conventional banking but from trust and investment management, and that stock has been hit pretty hard lately, so I think it's an opportunistic time to look at it.

How about the second-biggest part of the fund, insurance stocks?

I'd be a little weary of the property casualty companies because they've had a good bounce here. We still have

AIG

but that's the only one of the pure property casualty stocks we own. Then I think you can look at insurance brokers like

Marsh & McLennan

that will benefit from price increases but don't have to pay the claims.

The brokerages?

Here I lean a little more to the institutional side of the businesses, opposed to retail. The trading volume has been pretty high among the institutions but the retail will take longer to bounce back. The big blow-off with the tech stocks tended to hurt the individual more. I'd also say investment banking can come back quicker than retail, so I might look at

Goldman Sachs

and

Lehman Brothers

.

How about asset management? Fund companies charge their fees based on average quarterly balances, so it will take a sustained rally for fee income to get back where it was.

That's why we're not too heavy in asset management. One you can look at is

Legg Mason

, which is both a broker with asset management too. They also have Western Asset Management which is good in the bond business. Another interesting name is Black Rock, which is a bond shop.

8. Big losses and cash flows to stock funds this year might lead to fewer funds, but that might be Darwinian and good for investors, right?

Yes, you'd get better funds afterward. We probably had more funds than we needed. I hate to say that, being in the business, but it's natural -- sort of like in the

Godfather

when they said we need to go through one of these purges every few years and kill each other so that we don't have so many... I can't remember the line. I think we do too many funds to be economic and you'll see some purging. And maybe that'll help expense ratios some. It won't hurt individual investors any, and at least it will give you a more rational menu of funds to pick from.

9. This year the fund has trailed behind its peers on a relative basis. What went wrong?

All year we've had a fairly large exposure in the brokerage stocks and that's been a weak move. I'd also say we had some pretty big holdings in some big-cap names and it has been a small-cap year. If you look at the biggest financials, AIG had a mediocre year,

American Express

has been very poor and

Merrill Lynch

has been weak. Fifth Third, one of our big holdings, is down 8%. I'd say it's a combination of big-cap holdings and the brokerage stocks.

10. There's a sense that in five or 10 years today might look like a good buying opportunity, but divining what to buy has never been more difficult. As you look at the companies on your radar screen, what are three you would be most confident in buying today and holding for at least five years?

I'm going to go with BB & T, based in North Carolina. They've made a lot of acquisitions but they've been disciplined about it. They're kind of cheap and they don't pay up. They have good credit quality and the stock is still down noticeably from its highs in the summer.

If I want to go with a broker, I'll take Goldman Sachs. With the vagaries of the market day to day, you never know when Goldman's going to have an up quarter or a down quarter, but over several years they are the pre-eminent investment banking firm. I think they have the best people and get the best share of most of the new deals. And then, I'm going to go with another bank -- Fifth Third. It's a very high-performing bank with credit quality and one of the best management teams.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.