There’s nothing like rate cuts to wake up bank stocks. So imagine how happy investors in financial mutual funds were while the Federal Reserve sliced away at interest rates in 2001.
Here’s why: Low rates help bank stocks because the rates make it easier for financial companies to boost profits. First, a decrease in rates gets borrowers interested in taking out new loans. And the more loans a bank floats, the more interest it collects from borrowers–income that fattens its bottom line. Lower rates also make the raw material banks depend on–cash–cheaper to get.
Long-time bank analyst and Portfolio Manager Raymond C. Stewart, who manages money for his firm RASARA Strategies Inc. in Briarcliff Manor, New York, says bank stocks typically rally almost immediately after the Fed cuts rates. That’s good news given that Fed Chairman Alan Greenspan had already taken a buzz saw to rates six times when he struck once more in August. The cuts have decreased the Fed funds rate from 6.5% to 3.5%.
The next few years could be big for bankers, and not just because of interest rates. Since the ’90s, U.S. laws governing the mergers of financial companies have loosened. As a result, the banking industry has undergone a major round of consolidation. Now that banks are allowed to own branches and operations across state borders, the industry’s biggest players–Citigroup, JP Morgan Chase, NationsBank, and others–have prowled about for banks to buy. By absorbing smaller banks, the big fish can get a leg up on new markets and trim their costs. “There are about 8,500 banking companies out there now,” reports Stewart. “Some experts say for the industry to run at peak efficiency, we should be down to about 6,000 banks in five to 10 years, so there’s a ways to go.”
Be aware of one caveat: A slowdown in the nation’s economy could well raise the number of corporate defaults and bankruptcies, which in turn could eat into bank profits. Stewart says he’s not too worried, however. That’s because the banking industry has been resilient enough to grow earnings an average of 9% a year since 1975.
To get in on the action, we suggest that you consider a financial mutual fund, an investment that will spread your money into as many as a few dozen stocks benefiting from good news in the industry. To dig up the best of the lot, we turned to Morningstar Inc., the Chicago firm that monitors mutual funds of all types, to sift through the 100 financial funds the company covers. To see how the funds perform through good times and bad, we ranked them by their three-year average annual total return as of June 30, 2001. We then narrowed our scope to funds focusing on banking, weeding out portfolios that might stray too far afield into insurance or brokerage stocks. We also focused on funds with relatively low initial investment requirements and those that offer first-time investors an automatic investment program with a minimal outlay to start. Finally, we whittled