Investors have many reasons to seek out the best financial stocks.
You see, every year, untold trillions of dollars flow through the financial sector – banks, insurers, payment processors, brokers and other financial services providers. These firms act as the arteries of the global economy, and they play a part in the everyday lives of billions of people.
Today, we'll take a closer gander at the financial sector, including how it's defined, why investors seek exposure to it, and how to find the best financial stocks to buy.
What are financial stocks?
Generally speaking, financial stocks represent companies whose primary businesses involve providing financial services, such as banking, brokerage services and insurance.
For a more complete answer, we'll look to the Global Industry Classification Standard – a framework used by major index providers to help classify public companies.
According to the GICS, the financial sector "contains companies engaged in banking, financial services, consumer finance, capital markets and insurance activities. It also includes financial exchanges & data and mortgage REITs." (That last industry is mortgage real estate investment trusts, which primarily own mortgages and/or mortgage-backed securities.)
Why do investors buy financial stocks?
Financial stocks are something of an oddball in that they provide services that most people need – savings, checking, credit card processing, auto and mortgage lending – which feels consumer staples-esque in nature.
But the truth is so much more complicated.
In reality, many financial stocks are quite cyclical, waxing and waning with the broader economy. Recessions tend to reduce economic activity, and the typically concurrent rise in unemployment tends to set many consumers back in repayments, sometimes to the point of default.
Financial stocks can also be heavily affected by changes in interest rates; rising rates allow banks to charge more on lending products, for instance, but they can also depress demand for auto loans, mortgages and other products.
That sounds fairly complicated. So … why buy financial stocks?
"Financials make up a significant portion of overall GDP and are extremely important in ensuring the economy functions efficiently," writes Edward Jones. "Playing such an integral role in the lives of consumers, businesses and institutions, we believe financial services companies should be a key component to an investor's portfolio."
But investors would be wise to consider a variety of financial stocks, just given how different the business models, and even the stocks' value propositions, are from one financial industry to the next.
For instance, mega-banks are well capitalized and have a diverse line of revenue streams, providing some level of safety (and often decent dividends). Financial technology companies are a source of growth as younger generations eschew traditional banking models for online banks, payment apps, and the like. Insurance stocks provide relative stability and income and are one of the most direct ways to leverage rising interest rates.
How to find the best financial stocks to buy
Given the variety of reasons you might invest in the sector, we're not going to assume we know exactly what you want out of a financial stock. But we can help you start your search for the best stocks to buy with a basic quality screen.
To get to the following list of financial stocks, we've looked for companies:
- Within the S&P Composite 1500: This index is a combination of the S&P 500, S&P MidCap 400, and S&P SmallCap 600. This screen allows for stocks of different sizes, but it still represents roughly 90% of America's market capitalization, weeding out the smallest stocks.
- With a long-term estimated earnings-per-share growth rate of at least 10%: Financial stocks are cyclical in nature, so you can't realistically expect high growth all the time. But a long-term EPS growth expectation of 10% or more, that considers the possibility of that cyclicality, is a good baseline of potential. (Just remember: Expectations don't guarantee results.)
- With a trailing-12-month return on equity of at least 10%: Return on equity (RoE) is a good way to gauge how well a bank or other financial company generates income from shareholder capital. Generally speaking, 10% is a good benchmark for RoE. Anything above 10% is passable, though 15%-20% is considered good.
- With at least six covering analysts: We'd like to look at stocks that are on Wall Street analysts' radar, which makes it likelier that there's both more reporting and more insights on these companies. The more research we have at our disposal, the more educated a decision we can make.
- With a consensus Buy rating: All of the stocks must have an average broker recommendation of 2.5 or less within S&P Global Market Intelligence's ratings scale. S&P Global Market Intelligence converts analysts ratings into a numerical scale. Anything with a score of 2.5 or less is considered a Buy.
- With a dividend yield of at least 1%: Financials tend to be in the middle of the S&P 500's 11 sectors in terms of yield – dividends can be significant in certain industries, and low or nonexistent in others. Here, we're looking for at least a modest amount of income, so we've set the bar at 1%.
