Financial companies have borne the brunt of the downturn in the U.S. stock investing market in the last year. For some companies, such as Bear Stearns and Countrywide Financial, the bottom has dropped out all the way to requiring takeovers by competitors in order to avoid bankruptcy. For other companies, such as Lehman Brothers (LEH) or mega-insurer American International Group (AIG), the impact has cut share prices in half, or worse.
Truly, it’s a treacherous and risky time. However, with risk comes opportunity. Smart investors know that superior returns come when they can buy while everyone else is selling. They find a company whose price has dropped too much – more than its financial fundamentals would suggest. Then they buy its stock, and wait for it to come roaring back with huge gains.
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But can an individual investor really learn enough to make these risky, far-sighted investments? One of the mantras of the world’s great investors, like Warren Buffett, is to “invest in what you know.” Buffett’s advice makes sense if you are buying stock in a restaurant, motel, or carmaker.
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However, a regular Joe can’t know enough about a financial company that has complex investments worth tens of billions of dollars in markets across the world. Do you know anything about collateralized debt obligations (CDO)? How about sub-investment-grade tranches of mortgage-backed securities? Or five-year exchange-rate swaps?
The following is a strategy to consider that may help you make some sense out of financial stocks – and perhaps enjoy out-sized investment gains in the next few years.
An individual considering financial stock investing must realize that “financial companies” comprise a much larger group of industries than is commonly supposed. It’s more than Wall Street brokerages and national banks. It’s also insurance companies (which are, in fact, among the world’s smartest investors). And it’s regional banks, credit card issuers, mortgage lenders, mortgage brokers, student loan providers, and so on. Even real estate investment trusts (REITs) are financial operators; they bundle together investments in many buildings, and they collect rent and fees.
The point is that “finance” includes many companies that participate in many parts of the economy. You can invest in all of them in one general category, or you can pick a particular sector that looks especially attractive to you.
Still, you are faced with the tough decision about which investments to make. The solution is to use Exchange-Traded Funds, or ETFs. ETFs are investments in multiple companies that are bundled together and then traded as if they were a single stock. The benefit of using an ETF is that a group of stocks can be purchased simultaneously, but with the efficiency of purchasing just a single share. This saves a tremendous amount of money in transaction fees, and it also allows an investor to achieve greater diversification of his assets with very little effort. In other words, you don’t have to pick the exact right stock; you can pick a good sector instead.
ETFs have been developed for a wide range of investment strategies – including financial services. For example, iShares, which is one of the leading developers of ETFs, has created eight sector-specific financial ETFs. These different ETFs each target a particular part of the financial world – thus giving the investor the opportunity to pick an area that’s been unreasonably downgraded by most investors. Financial ETFs are available from ishares that target just brokerages, insurance, real estate, or banking.
A stock investing individual who wants to make a broad investment in financial services overall, might consider the ETFs offered by Select Sector or State Street (State Street also has some sub-sector financial ETFs, too).
The point is that with an ETF investment, you don’t have to pick a specific company and make a big bet on its ability to fix its financial problems. You don’t have to know what its exposure is to sub-prime mortgages or interest-rate swaps. Instead, if you believe that the financial sector in general will bounce back, or you believe a specific sector will prosper, just put your money in an ETF.
An investor might also consider a covered call investing position for an ETF. For example, a covered call investing position for the Financial Sector SPDR ETF (XLF) for July 2008 with a call option strike price of $22 currently has a potential unchanged return of 4.1% with 3.9% downside protection. So even if the price of XLF is unchanged at stock option expiration, the position will return 4.1%, and as long as the position falls in price less than 3.9% at stock option expiration, the position will be profitable.
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[tags] Bear Stearns, Countrywide Financial, Warren Buffett, collateralized debt obligations, CDO, sub-investment-grade tranches, mortgage-backed securities, exchange-rate swaps, Wall Street, insurance, regional banks, credit card, mortgage lenders, mortgage brokers, student loan, REIT, Exchange-Traded Fund, ETF, iShares, Select Sector, State Street, AIG, American Intl. Group Inc., LEH, Lehman Brothers Hldgs. Inc., XLF, Financial Sector SPDR ETF, covered call investing, covered call investment strategy, investment strategy, iron condor, poweroptions, stock investing, stock option trading, stock options [/tags]