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PART I
INTRODUCTION
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CHAPTER 1
FINANCIALS BASICS
Trends within the Financials sector are often topics of heated debate, and for good reasonânot only is it the largest sector in most broad equity indexes globally, but it revolves around one of the things most hold very dear: money. Money is transferred, multiplied, protected and placed at risk in the Financials sector. The sector is considered the lifeblood of the global economyâand while a properly working Financials sector can be a boon, its going haywire can have unfortunate consequences.
Many of this sectorâs products and services are relatively simple, like making a cash deposit at a bank or using a charge card for your morning cup of coffee. And many are quite complex, like making a leveraged bet in a synthetic collateralized debt obligation. Financial innovation has transformed the sector from its simple roots into an incredibly complex systemâso complex that, at times, it can engender great fear.
Globally, governments are well aware of the complexity and importance of the Financials sector, making it one of the worldâs most highly regulated sectors. From central banks to financial services authorities to consumer protection agenciesâthe governmentâs hand in the Financials sector is a core concern, capable of promoting prosperity or driving disaster in the sector and economy as a whole.
This bookâs intention is not to provide detailed instruction on complex financial structuresâ construction, focus on the 2008 financial panic (as many other books attempt to do) or discuss in detail the impact of myriad proposed and existing regulations, but rather to help readers make better decisions about when to over- or underweight the sector (or the industry positioning within) as part of an overall portfolio strategy. Moreover, we attempt to demystify many of the sectorâs complexities and allow for a better understanding of trends. The aim is not to provide definitive answers, but to help readers learn to think critically about this and, indeed, any other sector.
Global Versus Domestic
In our view, a global approach to investing is superior to a domestic-only approach because it allows for greater diversification and more opportunity. However, for data availability, consistency and reliability reasons, we often use domestic data to demonstrate a point. Most often, we refer to the S&P 500 for domestic trends and either the MSCI World or MSCI All Country World Index (ACWI) for global trends. The S&P 500 is an index of the largest US firms, the MSCI World represents the largest developed world firms and the MSCI ACWI also includes Emerging Markets.
FINANCIALS 101
The Financials sector is quite a bit more diverse than many who are new to analysis might assume. However, at a very high level, there are some overarching defining characteristics. First and foremost, it is, as of this writing, the worldâs largest sector. In addition, the sector tends to be:
- A relatively more volatile sector that tracks closely with broader markets
- More âvalueâ oriented than âgrowthâ
- Neither big nor small
- Sensitive to interest rates
- Not cyclical, yet not defensive
- Heavily regulated
- Highly leveraged and reliant on other peopleâs money (OPM)
The Largest Sector
The Financials sector is the largest in most global and country-specific benchmarks simply because it represents more companies with more assets, income, equity and sales than any other sector.
Balance Sheets
In terms of assets and shareholder equityâtwo main components of any companyâs balance sheetâthe Financials sector accounts for $89 trillion in assets and nearly $7 trillion in equity.1 Thatâs 72% of assets of all firms in the MSCI All Country World Index and 32% of all shareholder equity (see Table 1.1).2 Simply put, the Financials sector dwarfs all others.
Table 1.1 Percent of Assets and Shareholder Equity by Sector
Source: Thomson Reuters; MSCI, Inc.,3 as of 12/31/2010.
| MSCI ACWI Sector | Assets | Equity |
| Financials | 72% | 32% |
| Industrials | 5% | 9% |
| Consumer Discretionary | 4% | 9% |
| Energy | 4% | 14% |
| Utilities | 3% | 6% |
| Materials | 3% | 8% |
| Telecommunication Services | 2% | 6% |
| Con... |
