Investing in Financial Stocks

Updated: Jan. 12, 2021, 12:01 p.m.

When most people hear the term "financial sector," they think of banks. While this is certainly the largest part of the financial sector, there are several other types of companies that are included in it as well.

Four great financial stocks for beginners

There are hundreds of stocks in the financial sector, and they have a wide variety of sizes, business dynamics, growth potential, and other factors. However, there are some mature, easy-to-understand businesses that are smart choices for beginners:

  • Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) is not always thought of as a financial sector stock, but it is an insurance company at heart. Warren Buffett-led Berkshire is the parent company of GEICO, and it also runs a massive reinsurance operation. Investors also get exposure to dozens of non-financial subsidiaries Berkshire owns, as well as the company's massive stock portfolio, which happens to own large stakes in several major U.S. banks.
  • JPMorgan Chase (NYSE:JPM) is the largest U.S. bank, and the largest company of any kind in the financial sector. It's tough to make a case against JPMorgan Chase as an investment. The bank consistently posts some of the highest profitability metrics in the industry and has massive operations in both consumer and investment banking.
  • Visa (NYSE:V) operates the world's largest payment network and, along with Mastercard (NYSE:MA), has half of a near duopoly on its industry. But don't make the mistake of thinking Visa doesn't have room to grow. The company currently processes about $9 trillion in payments per year, a small slice of what management estimates to be $185 trillion in global cashless payment volume -- a number that should only increase over time.
  • Vanguard Financials ETF (NYSEMKT:VFH) allows you to invest in the entire financial sector, and at a bare minimum of expense. In addition to the three companies we've already mentioned, you'll get exposure to a total of 428 different financial sector stocks, weighted according to their market capitalizations (so more of the fund's assets are in the larger financial companies). One of the smartest things beginning investors can do is avoid relying too much on any one stock.

Types of financial stocks

Most financial sector companies can fit into one of these main categories:

  • Banks: As mentioned, bank stocks make up the bulk of the financial sector. This includes commercial banks, such as Wells Fargo (NYSE:WFC), which are those that provide deposit accounts and loans to individuals and businesses; investment banks, such as Goldman Sachs (NYSE:GS) which provide services to institutions and high-net-worth investors; and universal banks, such as JPMorgan Chase (NYSE:JPM), which provide a combination of the two.
  • Insurance: The second-largest part of the financial sector is insurance. The financial sector includes property/casualty insurers, life and health insurers, specialty insurers, and insurance brokers. In fact, Berkshire Hathaway (NYSE: BRK.A)(NYSE:BRK.B), which owns several large insurance subsidiaries, is the second-largest company in the financial sector.
  • Financial services: Some companies provide services related to investments and finance but aren't actually banks or insurers themselves. Ratings agency S&P Global (NYSE:SPGI) and futures exchange CME Group (NYSE:CME) are two good examples.
  • Mortgage REITs: Until a few years ago, all real estate stocks were included in the financial sector. Most were subsequently added to the real estate sector, but mortgage real estate investment trusts, which are companies that own mortgages and other financial instruments, remain.
  • Fintech: Financial technology, or "fintech," stocks leverage technology to create new solutions for the financial industry. Think of companies like Visa, PayPal Holdings (NASDAQ:PYPL), and Square (NYSE:SQ).
  • Blockchain and cryptocurrencies: Some companies in the financial sector develop products and services using blockchain technology and conduct businesses related to cryptocurrencies like bitcoin.

Important metrics for analyzing financial stocks

In addition to standard investment metrics, such as the price-to-earnings (P/E) ratio, there are some that are particularly important for financial sector investors to know.

These first six metrics are especially useful when analyzing bank stocks:

  • Return on equity (ROE) and return on assets (ROA): Two of the most widely used metrics to express bank profitability, ROE and ROA are a company's annualized profits expressed as a percentage of their shareholders’ equity and total assets, respectively. A 10% ROE and 1% ROA are widely considered to be the industry benchmarks.
  • Net interest margin (NIM): Although there are other ways banks make money (such as investment banking), most earn the majority of their profits by simply loaning money and charging customers interest. The difference between the interest rates a bank receives and the rates it pays is known as the net interest margin.
  • Efficiency ratio: A bank's efficiency ratio is a metric of how much it spends to generate its revenue. For example, a 60% efficiency ratio means that a bank spent $60 to generate every $100 in revenue. Lower is better.
  • Net charge-off (NCO) ratio: This is an expression of the annualized percentage of a bank's loans that it ends up charging off as bad debts and can be useful for comparing asset quality among different institutions.
  • Price-to-book (P/B): When valuing bank stocks, the price-to-book, or P/B, ratio can be just as useful as the P/E ratio. The P/B is a company's stock price, divided by its net asset value. Better yet, the price-to-tangible book value (P/TBV) ratio excludes tough-to-value assets like brand names or goodwill.

Two important metrics for insurance stocks:

  • Combined ratio: Insurance companies collect premium income and have two main expenses -- money they pay out as claims (the loss ratio) and money spent on other business expenses (the expense ratio). The total of these is the combined ratio. Simply put, a combined ratio of less than 100% indicates that an insurer is running an underwriting profit.
  • Investment margin: In addition to profiting from underwriting policies, insurers also make money by investing the premiums they collect while waiting to pay them out for insurance claims. This is important, as investment income is often the primary source of an insurance company's profits.

Bank stocks and cyclicality

It's important to mention that financial stocks -- especially banks -- can be cyclical, meaning that they are vulnerable to recessions. This is why bank stocks were some of the worst performers during the COVID-19 pandemic. When unemployment rises, consumers and businesses often struggle to pay their bills, and this can lead to big loan losses for banks. So be aware before investing.

Consider the big picture and invest for the long term

When conducting your analysis, it's important to consider the overall picture of a bank or other financial company, not just one or two metrics. And it's not possible to list all of the potential positive or negative characteristics here. For example, if a bank is growing faster than its peers, or if its efficiency is steadily improving, a higher price-to-book valuation could be justified.

And although it applies to all stock market investments, financial sector stocks are best suited as long-term investment vehicles. There's simply too much that can influence their prices over the near term that has little to do with the strength of the business itself (such as weak economic conditions or falling interest rates). However, if you have an investment time horizon of five years or more, it could be a smart move to add some rock-solid financial stocks to your portfolio.

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