Investing in Financial Stocks

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

Top financial stocks for beginners

These are some mature, easy-to-understand financial sector businesses that are smart choices for beginner investors:

• 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. Led by Warren Buffett, Berkshire is the parent company of GEICO, and it also runs an enormous reinsurance operation. Investors in the company gain exposure to its 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 vast 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 over the payment processing industry. But don't make the mistake of thinking Visa doesn't have room to grow. The company currently processes about $12 trillion in annualized payment volume per year, a relatively small slice of the global cashless payment market that the company's management values at $185 trillion -- and growing.

As for financial sector exchange-traded funds (ETFs), the Vanguard Financials ETF (NYSEMKT:VFH) may be the best. The fund confers portfolio exposure to the entire financial sector and for a low 0.1% expense ratio (annual investment fee). The fund provides exposure to a total of 377 different financial sector stocks, weighted according to their market capitalizations. (More of the fund's assets are invested in the larger financial companies.) In addition to the three companies already mentioned, top holdings include Bank of America (NYSE:BAC), Citigroup (NYSE:C), BlackRock (NYSE:BLK), and Morgan Stanley (NYSE:MS).

Types of financial stocks

Several different types of companies make up the financial sector besides just banks. Companies in the financial sector vary widely by function, size, growth potential, and other factors.

Financial stocks can be broken into several categories, including:

• Banks: As previously mentioned, bank stocks make up the bulk of the financial sector. These include commercial banks, such as Wells Fargo (NYSE:WFC), which 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, which serve both commercial and institutional clients.
• Insurance: The second-largest part of the financial sector is the insurance subsector, which includes property and casualty insurers, life and health insurers, specialty insurers, and insurance brokers. Berkshire Hathaway is the largest company in the insurance subsector. This also includes so-called "insurtech" companies, such as Lemonade (NYSE:LMND).
• Financial services: Some companies provide services related to investing and the public markets without being classified as banks or insurers. The ratings agency S&P Global (NYSE:SPGI) and the futures exchange CME Group (NYSE:CME) are two examples of financial service providers.
• Mortgage REITs: Companies that own mortgages and other financial real estate instruments, known as mortgage real estate investment trusts (REITs), are another group in the financial sector.
• Fintech: Financial technology companies, or fintech, are those that leverage technology to create new solutions for the financial industry. Visa, PayPal Holdings (NASDAQ:PYPL), and Block (NYSE:SQ) (formerly known as Square), fit into this category.
• Blockchain and cryptocurrencies: Some companies in the financial sector develop products and services using blockchain technology and conduct businesses related to cryptocurrencies such as Bitcoin (CRYPTO:BTC).
• SPACs: A special purpose acquisition company, or SPAC, is a company with no business operations that exists to take another company public. Also known as "blank check" companies, SPACs are considered part of the financial sector.

Analyzing financial sector investments

Investors can evaluate financial industry investments by using both the standard metrics, such as the price-to-earnings (P/E) ratio, and those that are customized to this sector. For the banking and insurance subsectors of the financial industry, there are some particularly important metrics for investors to consider.

These metrics are especially useful for 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 percentages of shareholders’ equity and total assets, respectively. A 10% ROE and a 1% ROA are widely considered to be the industry benchmarks.
• Net interest margin (NIM): Most banks earn the majority of their profits by simply loaning money and charging interest to customers. The difference between the average interest rate a bank receives and the average rate it pays is known as its net interest margin.
• Efficiency ratio: A bank's efficiency ratio measures how much the bank spends to generate revenue. For example, a 60% efficiency ratio means that a bank spends $60 to generate every $100 in revenue. Lower efficiency ratios are better.
• Net charge-off (NCO) ratio: Calculating this ratio can be useful for comparing asset quality among different institutions since the NCO ratio indicates the annualized percentage of a bank's loans that it ends up writing off as bad debt.
• Price-to-book (P/B) ratio: When valuing bank stocks, the price-to-book-value ratio can be just as useful as the P/E ratio. The P/B ratio is a company's stock price divided by its net asset value. The price-to-tangible-book-value (P/TBV) ratio may be even more useful than the P/B ratio because it excludes assets tough to value such as brand names and goodwill.

Two important metrics for analyzing insurance stocks:

• Combined ratio: To compute this ratio, first add (combine) the amount of money an insurance company pays out in claims to the amount of money the company spends on other business expenses. Divide that amount by the amount the insurance company collects as premium income and verify that the result is less than 100%. A lower combined ratio indicates the insurer is generating greater profit.
• Investment margin: Insurers profit from underwriting policies and also make money by investing the premiums they collect instead of just holding that money to pay any insurance claims. How profitably an insurer invests -- its investment margin -- is important since investment income is often the primary source of profits for an insurance company.

Invest in the financial sector for the long term

Bank stocks have been some of the worst performers during the COVID-19 pandemic. Financial stocks -- especially banks -- can be cyclical, meaning they’re vulnerable to losing value during recessions. When unemployment rises, consumers and businesses often struggle to pay their bills, which can lead to large amounts of bad debt for banks.

Be aware of the risks before investing, and, when conducting your analysis, consider the overall outlook for a financial company, not just one or two metrics. Also remember that financial sector stocks are best suited as long-term investment vehicles.

So many factors can influence financial stock prices in the near term, and many of those factors -- such as weak economic conditions or falling interest rates -- have little to do with the strength of the business itself. If you have an investment time horizon of five years or more, then adding some of the best financial sector stocks to your portfolio is likely a wise choice.