The financial sector is both exciting and scary for investors. On the one hand, you have solid banks that are at the heart of our capitalist system. They are a sign of trust, stability and growth. On the other hand, think of all the exotic financial strategies like mortgage-backed securities, options, and swaps. They realize that even those who made these products don’t always understand the complex monster they created.

To simplify things a bit, you can break financial data into three different subsectors:

Asset manager: Companies that manage / invest money for others. This group includes mutual funds, hedge funds, real asset managers and ETF managers. Asset managers typically operate in tune with the overall market. It is very rare for an asset manager’s stock price to rise during a bear market.

Banks: You can divide this group into global and regional banks. You can also look at investment banking, commercial banking, or the credit side as individual industries. In the end, it all comes down to deposits and loans. This group benefits from higher interest rates as the spread between lending rates and deposit rates is often to their advantage.

insurance: This final financial segment includes life, property and casualty insurance, reinsurance, specialty insurance and brokerage. Insurance companies need strong asset management skills to align their revenues with potential damage costs. It is also easier for them to manage their assets during periods of higher interest rates.

Subsectors (industries)

Greatest strengths

Financial data is a real investment option for dividend investors. There are many strong banks, financial firms, and insurance companies that share assets with their shareholders. Remember not to fall for a strategy that you do not fully understand.

Asset managers will do very well during the bull market. There is also an interesting shift from mutual funds to ETF products. Leading companies in ETFs or financial advisory services will lead this industry going forward.

Second, I have to admit that Canadian banks are unique. The Big Six operate an oligopoly that is not only heavily regulated but also protected by the Canadian government. In other words, they can leverage their core business in Canada to generate significant cash flows and use that money to grow beyond those limits. That way, they can get a return of around 4% and have an annualized dividend growth rate of 5% to 8% over decades. The dividend growth policy will be suspended due to the pandemic but will resume shortly thereafter once it is under control.

After all, I’m not a big fan of the insurance industry. I find them too dependent on external factors (disasters, interest rates, etc.). This is an industry that I prefer to ignore in my portfolio and focus on my strengths. This is the strong knowledge that in my past the banking industry was a private banker.

Biggest weaknesses

I think 2008 showed us how financial services can go from “too big to fail” to “the biggest bankruptcy in history”. Most companies in this sector will try to instill trust. Unfortunately, trust sometimes turns into blind faith. Be a better investor and do a thorough research of each company.

In general, interest rates and stock markets will determine whether this sector does well or not. At regional banks, when interest rates are low, the interest rate differential (the difference between interest payments on deposits and the amount of loans) will decrease. In other words, its edge becomes thinner. Insurance companies also face a similar problem. Since they have to invest premium payments to make more money to cover future claims and make a profit, it doesn’t help to have an entire asset class (bonds) with mediocre returns.

When the market goes sideways, many money managers will struggle. If you’re wondering why the market has been so volatile over the past 15 years, it’s in part because of hedge funds and options, as well as other “wild” trading strategies. Since institutional investors can take short positions or take massive positions through options, they could also get into big trouble. Margin calls occur when the market suddenly falls and fund managers do not have enough liquidity to cover the minimum value. You are then forced to sell and drive the market towards new lows.

How to make the most of it

First, understand your investment. Financial firms often generate income from complex strategies. If you don’t understand how a life insurance company makes money (and how it needs to protect their premiums), go ahead and look for another sector that you understand the business of.

If a market panic breaks out, Canadian banks are likely to be hit and offer you the most reliable dividends in the industry. Chasing leaders with a diversified business model is better than a one-trick pony. Most leaders will achieve unmatched economies of scale that are hard to compete with. BlackRock (ETFs) and Visa & Mastercard (payment networks) have such competitive advantages. You can also choose between special dividend payers like Lazard (LAZ) and the CME Group (CME).

Favorite selection

Visa (V)

  • Market capitalization: 460B
  • Yield: 0.60%
Source: Visa website

Business model

Visa is not a financial company; it is a technology stock. V is the most efficient networker in the most important network there is: money. As explained to a 12 year old, Visa’s job is to ensure that money flows from your wallet to someone else without you taking a single penny out of your wallet. Visa dominates the electronic payments market with about half of the total market. The company has more than 3 billion cards in use with over 44 million merchants worldwide. Its systems can process over 65,000 transactions per second.

Investment thesis

Visa went public shortly before the 2008 market crash. V was a unique opportunity for investors as its stock traded around $ 11 in the middle of that financial storm. Today the stock is priced at around $ 200 / share and will continue to rise for at least another decade. The magic behind V is to build the widest, most secure network to transfer money from one place to another. The company is an important partner for large financial institutions around the world. Everyone pays a commission for every transaction. Since there is a clear trend towards electronic payments, Visa has already built its network to enjoy this strong tailwind. Visa is the largest provider in an industry where size matters. The ability to track (and create) trends in money transfer will be vital in the future.

National Bank of Canada (NA.TO) (NTIOF)

  • Market Capitalization: 28B
  • Yield: 3.40%
Source: National Bank website

Business model

The National Bank of Canada is the sixth largest Canadian bank. The bank provides integrated financial services, primarily in the province of Quebec and the city of Toronto. The operating segments include private and commercial banks, asset management and a financial market group. NA’s smaller size is paying off right now as the bank built a strong wealth management brand faster with Private Banking 1859 and built a highly profitable financial markets business.

Investment thesis

NA has focused on capital markets and wealth management to support its growth. Private Banking 1859 has become a serious player in this area. The bank even opened private banking branches only in western Canada for additional growth in that market. Because NA is heavily concentrated in Quebec, lending contracts for investment and insurance companies were created under Power Corp. (POW) completed. The offices are currently undergoing a major transformation with new concepts and improved technology to serve customers. While waiting for the results, it seems wise to invest in digital capabilities to reach millennials and improve efficiency. The stock has outperformed the Big 5 for the past decade as it posted strong results. Recently, NA is looking for additional growth vectors by investing in emerging markets such as Cambodia (ABA Bank) and the United States through Credigy. Can it be more successful than BNS for international reasons?

I recently checked the last quarter of Canadian banks on my YouTube channel. You can see the rating about the National Bank below.

Disclaimer: I am long V and NA.TO.

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