Financials were a port in this year's storm, but what about next year?
FBR Financial Services fund is up more than 48% over the past year, is cautiously optimistic about 2001. He thinks interest rates will be stable, unlike in 1998 and 1999 when rising rates took a bite out of some financial stocks' profits. That's good news for traditional lenders like
and his top holding,
. That said, things might not be as rosy sectorwide. Brokerages and investment banks, for instance, won't be riding high if the past five years' outsize returns aren't repeated and the
IPO market stays sleepy.
To find out Ellison's thoughts on sector-titan
, industry consolidation and what financial stocks he'd hold for five years, read on.
Fund: FBR Financial Services
Managed fund since: December 1996
Assets: $25 million
YTD Return/Percentile Rank (1- Best, 100-Worst)47.2%
Expense Ratio: 1.88%
1. 2000 was a comeback year for financial-sector firms and for the sector itself. What do you think drove the comeback, and what do you see for the sector next year?
Well, I think there's really a tale of two sectors here, in the sense that the group started to get better when it became obvious that the
Fed wasn't going to raise rates any more. That happened maybe April, May, June, something like that. In that context, the really rate-sensitive names have done quite well. The ones that are more market-sensitive, like a
Bank of America
, like a
, they haven't done as well because there're concerns about credit. In that sense it's been a recovery year, but not one that's been broad in industry specifics. Finova's out there struggling, and there're plenty of other names that have had very, very difficult years, driven primarily by credit. And that's a big concern going forward, where the big concern the past two years has been the rising rates.
I think we're entering a period where rates will be stable or falling, and I think the group is going to continue to do better relative to the market in the next couple of years; I'm not sure how much better. But I think the wind has gone from being at our backs to being at our sides, and it will continue to swing around and be at our backs for the next couple of years.
Again, it's hard to tell whether they're going to outperform significantly, but the chances of underperforming significantly are probably close to zero.
2. What parts of the financial sector look best to you going forward?
I like those that are very rate-sensitive and don't have credit exposures. Those would include primarily the thrifts, maybe the mortgage banks -- but those would primarily make residential mortgages and have the bulk of their income coming from the balance sheet, as opposed to coming from fee income or investment banking income. That's really the big distinction: The ones that I think have done well this year are obviously the ones that are quite simple companies. They make traditional mortgages, traditional home equity loans and they fund them with deposits. It's a business that's been around for hundreds, probably thousands of years, and it's quite mundane and simple to run, if it's done conservatively. I think those are the ones that have done well and will probably continue to do well if rates come down a little next year.
What are a few specific names?
The three names in the top of the fund -- Astoria Financial,
Golden West Financial
-- are all traditional mortgage lenders. And they have struggled the last two years with rising rates and the inversion of the
yield curve, and it would appear that that difficult period is behind them and earnings will start to improve, probably in the second half of next year, a bit slowly, but I think if there's a big drop in short-term rates, it will be very beneficial to these guys. They fund short and lend long, and they'll benefit with higher
3. Now the other side of that is a bit more of a dicey outlook maybe for the brokers of the world and the folks that are more tied to the market?
Yes, if you look at the brokers like a
or even somebody like a Bank of America, First Union, Chase, that have big investment banking components to their earnings, that's a little more uncertain. I think they've come off two or three years of exceptional profitability. Really, it peaked in April, May or June of this year and has now cooled down. IPOs are down, and syndication loan deals are down and trading activity has slowed a bit, and I think that's where you're going to see the slowdown.
You've already heard it. I mean, Bank of America has already said they're going to be slower and Chase has already said the fee income related to investment banking activity is going to be down. A lot of these guys have gotten into venture capital the last four or five years, and that's been a huge positive to their earnings in the last year or so.
But if nobody's going into the market ...
Right, so that has slowed and companies have already indicated that. It's not a disaster, but it's going to be something that these guys have to work through, and they've got a lot of high-priced bodies hanging around there that aren't producing like they used to.
4. When we look back at 1997, the sector was particularly hot. A lot of folks that ran diversified growth funds had loaded up to a certain extent on financials because it was kind of a tendency to worship at the church of what's working now. And then when things got rougher in '98, '99, all of those folks took off, and that may have added some momentum to the selling pressure over those couple of years. Do you think that's what happened, and do you think folks in diversified funds might start fishing in your pool now?
That's a great observation because it's something that nobody talks about. I think the market has changed in the last two or three years in terms of how the money goes around and around. There was a tremendous amount of redemptive activity out of the industry.
If you look at the guys at
, and the guys at
and the guys at
and, of course, my funds, and I talk to all these guys, there were huge redemptions. For all the reasons that we can talk about, well, rates are going up, and technology was doing great, and they wanted to be in the group, and it's a dinosaur, the industry's going to go out of business and so on and so forth.
And now, of course, now suddenly we're back in favor and the stocks are doing well, but a lot of money hasn't come in yet. So the people that are buying are really, in my view, not the domestic funds that are financial services related, it's really the diversified funds that are buying the stocks now.
There's been some big outflows, and now the money is starting to come back. The question is, will it continue? As I said in the beginning, if rates are going to be flat-to-down in the next couple years, you're probably going to continue to see money trickle in. I don't know to what degree it's going to be good ... it's hard to say ... but I think fundamentals are going to be better, and therefore, the stocks should do better.
But for me to predict whether this stock's going to be up 20% or 30% or up 2%, it's hard to say. But it's clear the wind is turning from our face around to our back, driven by rates, and that's a big part of this industry -- rates and credit are the two lynchpins of this industry, and we're going through a positive rate change right now, and we're entering a negative credit change right now and those two forces are playing off each other -- that's why you see something like Fannie Mae making new highs and Bank of America doing nothing.
5. A couple of names that a lot of folks have made a lot of money off of in the past few years and that get a lot of attention that we haven't talked about are Schwab (SCH) and Citigroup. What do you see for those two?
I like Citigroup better than Schwab. I like Citigroup because they're very diversified; they have a very traditional lending business in the consumer side.
Schwab tends to be a little bit less diversified, a little more sensitive to trading activity, a little more sensitive to mutual fund sales, a little more sensitive to client asset accounts. I don't own Schwab. I do own Citigroup.
It seems that Citigroup is far and away the blue-chip play.
I think it is in terms of the overall business. I think we're at a point right now where the overall business is OK. Hopefully, spreads will improve a little bit, but you're going to lose a bit on the investment banking side, a bit on the trading, a little on the loan fee side. So all cylinders aren't clicking there for them, but I think it's sort of like the
of the financial services business, they'll make it up in other areas.
It's not a one-horse company, and they have enough going on there, and they have international exposure, which is good and bad. If Japan is going into a recession, it's bad for them because they have exposure in Japan, but then you could argue that they have some other plays that are doing better. It's just a much more diversified company, and I feel it's pretty well-run.
You've just got to stay with it. Right now, people don't really want to own Bank of America or Chase or First Union or Citigroup. But when that group comes back into favor, when rates start to fall and people realize that the Fed's actions are going to have a positive impact on the economy, everybody's going to want to own these names. And Citigroup is going to be at the top of everybody's list, because it's big and it's liquid and they get into everything.
6. Do you see consolidation picking up across the financial-services industry, a la Citigroup?
Well, I think consolidation is always going to be part of the industry.
Why, because it's a scale business?
Not necessarily. I'm not a big believer that bigger is better here. I believe that the incremental steps that the industry has made over the last four or five or 10 years have been generally good. I mean, I think Citigroup is a better company now than it was four or five years ago, not so much because it's more diversified, but because they have better use of technology, they have better information about what's going on in the company. But I don't necessarily think that bigger is better. The smaller companies are just as well-run and just as profitable as the bigger ones. The question really is about competing with one another, meaning that these guys, if they can buy the business and run it a little better, that's fine. But I don't think everybody's going to be like Citigroup. There's no need for that.
There's enough business for everybody. Citigroup's going to get its piece of the business, some little thrift in Tennessee is going to get its piece of the business, and they can both be equally as profitable. So I think consolidation will continue just because there are too many companies out there and consolidation can add value. It can be destructive, as we saw, for example, with the First Union deals or the Bank One deals.
I think consolidation will happen, but you can have bad periods of consolidation, you can have good periods of consolidation. And right now, I think we've come through a period where we've had reasonably good consolidation -- Citicorp buys
, Chase and
get together, those are reasonably good deals.
But a year from now, Citicorp may do some deal where it could be a bad deal. So it's not like all these deals work. Generally, though, the industry needs to consolidate. We need to have bigger players. Consolidation has been good for the industry since I've been watching it, since '83, because it's created a better, more consistent, more predictable pricing umbrella under the industry. There was a time when I was in this business, there were so many banks that on the corner one guy would give a mortgage at 6% and the other guy would give a CD at 7%. It was just ludicrous because of too many competitors.
And no one makes any money.
Right. Nobody makes any money, and the industry becomes weak, and the regulators wonder why there's so much weakness. Well, the regulators need to have a certain amount of consolidation, a certain number of people that have market share, that have enough market share to control enough of the markets so they're rational. The bigger plays tend to be rational players, and that's probably the most important thing about consolidation.
7. This is a crapshoot, but who are the potential acquirers and potential targets?
In terms of the acquirers, obviously the bigger companies are the acquirers, whether it be Chase or First Union or Bank of America or Citigroup. The real question is, what do these guys want?
The last three years, they wanted brokers. If they decide they want a funding base, then you're probably going to look at all the regional banks and the thrifts, because that's where all the deposits are. If they decide they want mutual fund assets then you're going to go for the mutual fund guys. I would suspect that it's uncertain about where the next big consolidation phase is going to take place.
But right now, I think the biggest problem in the industry is the funding side. If you look at the top four or five companies in terms of assets, or whatever you want to look at -- assets or equity or deposits or whatever -- they all have all the pieces they would want. They have the investment bank, they have the mutual fund assets, they have the venture capital stuff, they have lending. But what they've done a lot in the last two to three years is borrowed a lot of money to make loans and fund these businesses.
So the deposit side, or the funding side, is where they're the weakest right now. Obviously they've grown a lot, and it's been tough to get deposits in this market environment because everybody's been buying Internet stocks. So, to make a bet, probably the next phase would be for them to secure more retail funding sources, which would drive you toward the smaller regional banks, and the smaller to midsize thrifts. That's just a guess on my part.
8. One pie-in-the-sky merger that people have discussed as possible is Schwab and Merrill. They've slowly been getting closer to one another's models -- Schwab with the U.S. Trust acquisition and a more traditional route, and Merrill doing more business online. Do you think there's anything there, or is that just something people talk about?
The pattern has been that similar companies have not typically bought each other. They're trying to say I want to buy somebody that's going to complement me as opposed to somebody that's going to be like me. So, it's just conjecture, I've heard about it, but my sense has always been, why would Merrill buy something that's just like them? Why wouldn't they want to buy something that would add something, a new product line?
9. If you had to pick three stocks today to buy and hold for five years, what would you buy?
Wow. Let's see. I think I would buy safe. I'd buy the big guy, Citigroup. After that, I'd probably buy, even at these levels, Astoria, and
MetLife's a big insurance company, the industry is in transition, and there's a tremendous amount of cost savings and business rationalization going on in it right now. There's going to be a lot more of these companies going public.
MetLife has the earnings and the capital, and they're going to be able to continue to make strides in terms of profitability and market share. If you've got to buy something that long term, you've got to buy the big names because they're going to give you very little downside.
10. What's the most recent new name added to the fund, and what's the most recent name added to your portfolio?
I haven't added anything lately. Boy. What have I added? Well, I haven't bought anything personally, I've bought more of the fund recently.
I guess my recent purchases have been things like
MTG MGIC Investment
. MTG is a mortgage insurer. I've added some of that, primarily because mortgage rates have come down and I suspect volumes are going to be pretty good next year; even if it's not straight volume, there'll be a fair amount of refinancing that takes place and that's good for them. And credit quality there continues to be pretty good. With Wachovia, I was just trying to add traditional banking businesses and trying not to buy companies that are sensitive to investment banking activity or trading or venture capital.
Most of the names I really like are in the fund and are maximum positions. I mean, I can't buy any more of them, so I haven't been able to buy into the names that I would have wanted to continue to buy.