Understanding the Basics of Financial Sector Stocks
Proper research is a must before any investment. For financial stocks, it all starts with financial terms and a market overview.
Published May 12, 2024.
You'll need to understand financial terms to assess whether a stock is a potentially good investment. The financial jargon can make this process frustrating, so let's break down key terms and shed some light on financial sector basics, so you can conduct research properly.
Note: The information in this blog is purely educational and should NOT be considered advice.
What Are Financial Sector Stocks?
The financial sector encompasses many institutions offering commercial and retail financial services. This sector facilitates the flow of capital and liquidity in the market.
Financial sector stocks represent shares of financial institutions and companies. They constitute a significant portion of market capitalization.
Moreover, financial stocks often provide attractive dividends to shareholders, reflecting the sector's typically stable cash flows and mature business models.
Brokerage Firms
Brokerage firms are one-stop shops and resource hubs for investors. Through them, investors can buy and sell instruments such as stocks and bonds on domestic and international markets. These firms can also offer investment advice and additional services.
Financial Sector Sub-Divisions
Investment Banking
These firms specialize in complex financial transactions for corporations, governments, and other entities. They underwrite new debt and equity securities for corporations, assist with mergers and acquisitions, and provide guidance on corporate restructuring.
Examples include:
- JP Morgan (JPM)
- Goldman Sachs (GS)
- Morgan Stanley (MS)
- Citigroup (C)
Commercial Banking
Commercial banks' primary functions include accepting deposits, offering checking and savings accounts, and providing loans for various purposes such as mortgages, auto loans, and business financing.
Examples include:
- Bank of America (BAC)
- American Express Bank (AXP)
- Citibank (C)
Asset Management
These companies manage investments and portfolios of assets for individual clients, institutional investors, or both. They make investment decisions on behalf of their clients and employ diverse investment strategies involving stocks, bonds, real estate, and other asset classes.
Examples include:
- BlackRock (BLK)
- UBS Group AG (UBS)
- Credit Suisse (CS)
Insurance Companies
Insurance companies offer financial protection against various risks, including property damage, liability, and loss of life. As much as they secure businesses, insurance policies are often seen by clients as proof of professionalism.
Examples:
- Allianz SE (ALV)
- MetLife (MET)
- UnitedHealth Group (UNH)
Fintech Companies
Fintech companies leverage technology to streamline, innovate, and democratize access to financial services. From revolutionizing payments and banking to new platforms, fintech aims to reshape how consumers and businesses manage their financial lives.
Examples:
- Stripe
- Revolut
- Klarna
Financial Market Terms
Market Capitalization
Market capitalization shows a company's aggregate value, calculated by multiplying the current share price with the total number of outstanding shares. If a company has 10,000 outstanding shares and a share price of $100, its total market cap is $1,000,000.
This metric is crucial for investors, especially in the financial sector, as it indicates a company's size, investor perception, and market position.
Companies with larger market caps are often considered less volatile, whereas smaller cap companies offer more growth but could come with increased risk.
Hedge Funds
Hedge funds are private investment partnerships that pool funds together and use aggressive and complex investment strategies to generate potentially high returns. These strategies allow them to aim for positive returns in rising and falling markets but often require a higher minimum investment.
Hedge funds are usually available to accredited or institutional investors.
Private Equity
Private equity firms aim to acquire underperforming or undervalued companies that they believe have potential for improvement. By injecting capital, managerial expertise, or operational improvements, they seek to increase the value of these companies for potential sale or public offering.
Mutual Funds
Mutual funds are sometimes considered an essential component of many trading accounts. They are typically confused with exchange-traded funds (ETFs) but aren’t the same.
These funds pool money to invest in various securities and provide an accessible way for individual investors to diversify. Handled by professional fund managers, they strive to deliver returns as outlined to their investors.
Exchange-Traded Funds (ETFs)
ETFs combine the diversification benefits of mutual funds with the relative ease of stock trading. This allows investors to buy and sell shares throughout the trading day.
ETFs often have lower expenses than mutual funds, making them a cost-effective option for entering specific sectors, indices, or investment strategies.
Financial Sector Trading Terms
Sector Rotation
Sector rotation is a strategy in which investors switch their investments from one industry to another, aiming to profit from upcoming changes in the economy or market cycles.
This approach is based on the fact that not all sectors of the economy perform well simultaneously. By anticipating which sectors will thrive or underperform, investors can potentially enhance returns and mitigate risks.
P/E Ratio
The P/E ratio is a critical tool for assessing a stock's value and comparing it to other stocks or the broader market.
A high P/E ratio may indicate high expectations for future growth, while a low P/E could suggest a stock is undervalued or facing challenges. The average P/E ratio is around 20 to 25.
Earnings per Share (EPS)
EPS directly reflects a company's profitability on a per-share basis. It shows the portion of a company’s profit allocated to each share of stock.
EPS is a key driver of stock prices and often affects dividend payouts and investment decisions. However, there’s no fixed answer for a good EPS, so it’s best to compare a stock to its competitors and see how it matches.
Dividend Yield
The dividend yield shows the income generated from an investment relative to its stock price. For example, a stock share worth $100 with a 2% dividend yield pays its shareholders $2 yearly per share.
A higher dividend yield can be attractive, especially in stable industries, but investors should also consider their overall investment strategy and whether these payments are sustainable. In some cases, a high dividend yield is less attractive than a lower dividend yield with high stock price growth.
Financial Sector Market Overview
Financial sector stocks are sensitive to fluctuations in interest rates and broader economic cycles since they are directly related to lending, borrowing, and investing activities.
When interest rates rise, the cost of borrowing increases. This can reduce consumer demand for loans and potentially squeeze the profit margins of banks and lending institutions.
Lower interest rates stimulate borrowing and investment, so they are typically good for financial institutions.
Impact of Financial Regulations
The financial sector is one of the most heavily regulated industries. Financial regulations maintain market integrity, protect consumers, and ensure the financial system's stability. They also impact how companies operate, manage risk, and interact with customers.
Navigating these regulations is vital for companies within the sector. Regulatory changes can introduce challenges and opportunities, forcing firms to adapt their practices and strategies.
Market Indexes and Financial Markets Health
Market indexes, such as the S&P 500 and Dow Jones Industrial Average, aggregate the performance of selected stocks to provide a “snapshot” of the market's overall health and trends.
These indexes are particularly important for tracking the performance of financial sector stocks. They offer insights into how this critical sector is performing relative to the broader economy, helping investors make informed decisions by reflecting on both the optimism and pessimism in the market.
Next Steps
Researching financial stocks doesn't have to be frustrating. With key terms and a better understanding, it's much easier to look at the main indicators and the market before investing.
The best way forward is to start exploring companies, compare different investments, and remember that detailed research and diversification are pillars of a healthy financial portfolio.
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