Two Ways to Play Financials

On February 27, the day the Dow Jones industrial average fell 416 points, Thomas K. Brown wrote: "One of my favorite Warren Buffett quotes is, 'We simply attempt to be fearful when others are greedy, and to be greedy only when others are fearful.' " Brown went on to add: "Given the level of investor panic lately, I'm feeling very greedy regarding subprime lenders and am especially greedy over subprime mortgage lenders."

The gutsy declaration on Bankstocks.com is vintage Tom Brown. He is chief executive of a New York hedge fund that specializes in financial stocks, and that between its inception in April 2000 and the end of last year produced net returns totaling 227%. Readers of this column may remember Tom Brown as the guy who selected the best performer on my list last year of stocks to buy (see My 10 Stocks for 2006). The company was First Marblehead (symbol FMD). Brown trimmed his holdings last year, but he still owns and loves the student-loan specialist. Now he has a couple of new ideas. They are risky investments and represent one of two approaches to investing in financial stocks.

Aggressive picks

Brown got into hedge funds after a distinguished decade spent analyzing banks for a top Wall Street firm. He worked at Julian Robertson's Tiger fund, then launched his own hedge fund, called Second Curve Partners, seven years ago.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Second Curve is as aggressive as it can be. At the end of last year, its $700 million in assets was concentrated in just 14 stocks (in addition to several others that Brown shorted in hopes their prices would go down). He uses leverage, too. For every $1,000 he invests in a stock, $500 is borrowed. And he revels in buying companies when other investors detest them. Thus, the Buffett quote and the paean that followed to a San Diego-based company he owns called Accredited Home Lenders Holding (LEND).

Accredited fell from $50 at the end of 2005 to $22 on February 27, the day of Brown's posting. "Could it go lower?" wrote Brown. "Of course." And fall it did. By March 14, the stock was in $4 territory.

The company lends money to what are euphemistically called subprime borrowers -- that is, families with weak credit -- so they can buy homes. The subprime market suffered as short-term interest rates rose, and monthly payments on adjustable mortgages with enticingly low initial rates ratcheted upward, forcing borrowers into delinquency or default. Meanwhile, New Century Financial, the second-largest subprime lender, announced it was the target of a criminal probe, and the New York Stock Exchange moved to delist its shares.

This is an environment in which Brown thrives. His specialty is finding good companies in beaten-up sectors. His enthusiasm for Accredited, which has not waned, is based on its management's skill at underwriting -- that is, assessing risk and keeping defaults and delinquencies down. It's the best in the business, says Brown. And, he says, Accredited keeps its costs down, uses conservative accounting and "has plenty of liquidity."

Another subprime lender Brown likes is CompuCredit (CCRT), which has also been hammered this year, down from $40 to $26 through mid March. At Second Curve's annual partners meeting, CompuCredit -- which focuses not on mortgages but on credit cards, auto financing, "payday" loans (microlending at high rates) and debt collection -- was the star. Brown believes it is a well-run, underappreciated company in a sector that includes visible bad actors.

[page break]

Enamored of CompuCredit myself, I used Brown's selection as one of my stock choices for 2007 (see My 10 Stocks for 2007). Will he (and I) be embarrassingly wrong or brilliantly correct? We'll see. Brown certainly has an impressive track record, and he's done particularly well buying stocks everyone else hates. First Marblehead collapsed by two-thirds between February and September of 2005, in part because of a scandal involving top management. Brown scooped up shares at the bottom, and the stock tripled over the next year.

Financial funds

A less exciting but sensible way to invest in financial stocks is to own broadly diversified portfolios of companies in banking, consumer lending, investment management and insurance, among the sector's many subdivisions. Financial stocks are now the single largest sector in Standard & Poor's 500-stock index (a good proxy for the entire U.S. stock market) and represent 22% of the SP 500's value.

The biggest business in the world is managing all the wealth that's being generated by the modern global economy. In recent years, that has been a very good business indeed, and despite the doom and gloom that have become staples of financial commentary, a very stable business as well.

Look at the 42 mutual funds with three-year records that specialize in financial-services stocks. Their average return to March 1 over the period was 9.8%, versus 9% for the SP 500. As a group, they also beat the SP over the past five, ten, 15 and 20 years, and in 14 of the past 19 calendar years. Also impressive: Even the bottom quarter of the financial-funds universe -- the runts of the litter -- produced annualized three-year returns averaging 5.5%.

Steady winners

The consistency of the sector is awe inspiring. Fidelity Select Financial Services (FIDSX) returned 9.2%, 9.9%, 10.9% and 15.4% over the past three, five, ten and 15 years, all at risk levels that are roughly the same as the SP 500 -- which, I might add, it has whipped in total return over each of these time periods.

The fund was inaugurated in 1981 and has an expense ratio that's a shade below 1%. Turnover is mild (the average holding is about two years), and the stock list is pretty conventional, with the exception of a huge chunk of AIG International, the world's largest insurer, which represents nearly 10% of assets. The five largest U.S. commercial banks -- Bank of America, JPMorgan Chase, Citigroup, Wachovia and Wells Fargo -- are all represented in the top ten holdings.

Another plain-vanilla financial-services portfolio to consider is Vanguard Financials (VFH), an exchange-traded fund. This ETF strictly weights its holdings according to a Morgan Stanley index. Its track record is far shorter than the Fidelity fund's, but recent returns are roughly the same. The expense ratio is a mere 0.25%, but you have to pay brokerage fees to get into and out of the security, which trades just like a stock.

In addition to the big banks, the ETF, which currently has a dividend yield of 2%, owns insurers AIG and Metropolitan Life, plus mortgage-funding providers Fannie Mae and Freddie Mac and investment bankers Goldman Sachs, Merrill Lynch and Morgan Stanley. There's not a subprime lender in sight.

The Fidelity and the Vanguard portfolios are both plodders, finishing in the middle of the pack among financial funds but giving investors a broad exposure to companies that make money off money and don't assume a lot of risk. Your own portfolio needs a fund like this -- unless you want to own a bundle of individual financial stocks. If you do, you might begin with Allstate (ALL) and Bank of America (BAC), both recommended by Prudent Speculator, an investing newsletter with an impressive track record, plus perhaps one of Brown's favorites, Capital One Financial (COF), a smart consumer-credit and banking operator.

Get greedy

More exciting than the plain-vanilla funds and also very enticing is Mutual Financial Services (TFSIX), part of the Mutual Series family. It has earned above-average returns among financial-services funds in eight of the nine calendar years since its 1997 start-up. The Class A shares carry a 5.75% sales charge, but the no-load Z class (TEFAX) is available to those who invested in other Mutual Series funds before their sale to Franklin Templeton. Mutual Financial's managers have a penchant for European stocks; only four of the portfolio's top 20 holdings are U.S.-based. Among the few U.S. stocks are White Mountains Insurance Group, a property-and-casualty insurer that is also a holding of Buffett's Berkshire Hathaway, and First Community Bancorp, a solid commercial bank based in San Diego, with a 2.4% yield.

Stocks like First Community have been languishing recently -- or worse. I'm no market timer, but if you don't own enough financial services, this may be a good time to jump in. Others are certainly fearful, so get greedy.

James K. Glassman is a senior fellow at the American Enterprise Institute and editor in chief of its magazine, The American. Of the stocks mentioned, he owns ComputCredit, Capital One and Allstate.