Should you invest in... financials?

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The Independent Online
THE FINANCIALS sector, covering banks, life assurance companies, general insurers and a few quoted fund managers and stockbrokers, is perceived to have outperformed significantly over the last two years, and stand on the threshold of a golden age, when an increasingly affluent and savings conscious public places larger amounts of money in its care.

But the reality is different. Although some financial stocks have outperformed, the picture is far from even. Chris Burvill of Investec Guinness Flight says: "The notion is that they have all been through a great bull market, which is more or less true for banks and fund management companies. Others, mostly life assurance companies, have underperformed. Even general insurers haven't done particularly well."

The market may be expanding, but it is also getting tougher, with companies under increasing pressure to cut costs and preserve margins. Tim Rees of Clerical Medical says: "From the point of view of stock selection, it is a fiercely competitive market, in the banking and insurance."

And Ian Brown of Norwich Union Investment Management says: "Those banks with big branch networks will be at the biggest disadvantage."

The major development among the financials in recent weeks has been Lloyds TSB's offer for the mutual life assurer Scottish Widows, sparking a new round of speculation about how long the remaining mutuals can last. Tim Rees suggests this may be the most profitable area for private investors to concentrate on: "My advice would be to stick with some of the other mutuals because, sooner or later, they are bound to fall by the wayside."

Ian Brown says: "I don't think investors should get too hung up on the idea of the Scottish Widows deal as a great strategic move for Lloyds TSB. Scottish Widows represents less than 10 per cent of the market cap of the merged group. But it does provide is strategic infill at a reasonable price. It makes sense as a development of Lloyds' UK portfolio of brands."

Tim Rees says: "Lloyds TSB has done something most other banks have been trying to do for some time, diversifying from core areas. The more mortgage-orientated banks are dealing with a very mature product and with Scottish Widows, Lloyds TSB is getting a well- established long-term savings business."

This process is being driven, in part, by the fact that bank shares no longer hold the same attractions for investors as a few months ago. Chris Burvill says: "Over the longer term, investors are worried about inflation. Banks' fortunes tend to move in line with long-term interest rates and if they are rising, it is unlikely there will be much enthusiasm for bank shares, though trading conditions would appear reasonable."

Tim Rees says: "The pressure to consider merging, or anything else which improves the cost base of your operation, will grow. You will see much more outsourcing, of administration, IT services, even investment management, so you will have consolidation of functions, if not necessarily of names. As a house, we see opportunities as a result of this consolidation process."

Ian Brown agrees. "There is still a need for consolidation. The route to market through a high street network will be increasingly competitive and less attractive. Future growth will be in phone and Internet banking.

"Companies with branch networks have high cost bases and very fine margins which new competitors can undercut. Standard Life's mortgage operation costs pounds 20m to run, compared with pounds 900m for the Halifax. It doesn't take a genius to see who has a cost advantage."

But this process will take time, because of the size of some organisations. Ian Brown adds: "It is possible to argue the Halifax has a breathing space because it has already built up a big book of business to cross- subsidise its other services. But that lasts only for a limited amount of time and one questions whether it is a good way to build a brand."

Tim Rees says: "One of the ironies is that you have banking services with margin pressures and new entrants such as Standard Life coming in, yet the natural place for them is the savings market, which has more attractive demographics but is, itself, coming under increasing margin pressure."

Chris Burvill adds: "We are not big fans of the mortgage banks. Although they are in a highly profitable business, they will come under increasing pressure. But for the retail banks , trading conditions still look healthy and demand for corporate loans remains strong."Ian Brown says: "Banks need IT expertise, which means the most attractive are Bank of Scotland and Royal Bank of Scotland, which are head and shoulders above the rest in providing banking services for non-banking businesses."

Chris Burvill says: "If you want to benefit from growth in equity markets, then insurance companies are not a bad play. You not only get exposure to the equity markets from the company's underlying portfolio, you also get income from the portfolio and the insurance premiums.

"Unfortunately, the market doesn't tend to agree and the insurers aren't rated as highly as they ought to be. You are starting to get better news, certainly on the general insurance side, with premium rates increasing and some rates on motor business at extremely high levels.

"We reckon CGU, for example, is an extremely undervalued company. Life assurance is more complicated as companies are clearly more highly rated and their business will come under greater pressure, particularly in the light of a more difficult and complex pension market. So we favour composite insurers over the life companies."

Ian Brown says: "Prices are too high for the maths to stack up at present. You may get mergers where both partners can benefit from stripping out costs, but you are unlikely to see anyone coming in and paying a premium price."

There are exceptions, he adds. "Northern Rock has a small branch network and a highly developed mortgage business, but it has been forced out of the savings market by Egg and the like. Putting a savings-rich institution with a competitive mortgage provider like Northern Rock would make sense."

Tim Rees says: "The timing of these things is impossible to determine and depends on managements. Some will be forced to seek a merger because of their regulatory or financial position and others will be more pro- active way, seeking the right deal for their shareholders or policyholders."

Ian Brown says: "The future is branchless banking, so the mortgage banks have a problem. The older high street banks may benefit, because of cost savings in switching to electronic banking. In the long term, it is hard to see a positive endgame for these banks."

Chris Burvill says: "You have to be cautious of the financial sector. We know that financials are highly geared into the market and UK fund managers are always cautious of prospects for the market."