The past three years have been a disaster for Nasdaq. Prices have plunged. Trading volume is off. From a record high of 5,048 on March 10, 2000, the Nasdaq composite has dropped to around 1,300.
One sector, however, has bucked the trend: Financial stocks. As a group, financial stocks have shot straight up, going in the opposite direction of the broader market.
Nasdaq's bank and insurance stocks have been on the rise since March 2000, the same month the broader market began its steep descent. In the past three years, the Nasdaq Bank Index has risen 57 percent. The Nasdaq Insurance Index, meanwhile, has gone up 37 percent.
On the flip side, during the same period, the Nasdaq Composite Index has lost three-quarters, or $4.75 trillion, of its value.
Nasdaq desks that specialize in financial stocks are obviously pleased. "The sector is strong and relatively healthy," said Jay Suskind, head trader at Ryan, Beck, one of the larger brokerages to trade financials. "The small and mid-cap names have done very well for the past two to three years."
In the aggregate, desks are doing better with these names than the broad market. Trading volume in the ten biggest financial names rose 30.6 percent in 2001, and 11.8 percent in 2002. Overall, Nasdaq share volume grew only 6.4 percent in 2001 and declined 7.9 percent in 2002.
Special Focus
Ryan, Beck is one of about a dozen specialist and regional market makers that focus on financial stocks. Others are Keefe, Bruyette & Woods; Sandler O'Neill & Partners; Stifel, Nicolaus; Hoefer & Arnett; McConnell, Budd & Romano; Sterne Agee & Leach; Howe Barnes Investments and Fox-Pitt, Kelton.
All of these are small or mid-sized houses. All are likely to stay that way. Despite the large number of financial stocks, the sector is still a niche by most measures. About 750 of Nasdaq's 3,600 common stocks are regional banks, thrifts, insurance companies and specialty shops.
By dollar volume, financial stocks comprise only a small percentage of all trading. That wasn't true in the early days of Nasdaq. In the 1970s and 1980s, such financials as AIG, GEICO and California Federal appeared regularly on the most active lists.
At its inception in 1985, the Nasdaq Financial Index, which consists of the 100 largest financial stocks, made up 13 percent of all dollar volume.
The group's comeback reflects, of course, the deflation of Nasdaq trading volumes. In 2000, Nasdaq dollar volume hit $20 trillion. So far this year, it is running at a $6 trillion rate. That takes the market back to where it was in 1998.
Leading the regional banking sector upwards is a combination of events, according to traders and analysts. These include low interest rates, a strong housing market, stock buyback programs and the flight from Enron-type problems at money center banks. Another factor, of course, is the flight from technology.
One analyst boils it down to earnings. "The industry has been producing double digit earnings-per-share gains in each of the past 14 years except one," said Robert Albertson, chief strategist at Sandler O'Neill. "Investors paid extraordinary prices for technology stocks on the theory of growth – growth that wasn't there. So now they're backing away from that false assumption. It is very natural you would see this sector outperform."
The performance of Nasdaq's smaller insurance sector has been choppier. In 2000, insurance shares benefited with the flight from tech stocks, according to the Insurance Information Institute. In 2001, the industry ran into trouble with a slowing economy, the effects of under-pricing in prior years, catastrophic losses and other factors. Conditions were similar last year, but profitability jumped sharply.
Smaller Insurers
The smaller insurers, those more likely to trade on Nasdaq, are gaining the most, according to a new study by Conning & Co., an asset manager that specializes in insurance stocks.
Between 1996 and 2000, small insurers increased their premiums by 24.7 percent, nearly twice the 12.8 percent growth achieved by their larger counterparts.
As a result, small insurers' market share grew from about 19 percent to 21 percent over the period.
So who's buying these stocks? Retail accounts have traditionally been dominant because most of the stocks are illiquid. Institutions find it too troublesome to build positions large enough to affect their performance figures. It is also too costly to dedicate an analyst to the sector.
Cincinnati Financial (CINF), for example, one of the larger Nasdaq financial stocks, has a market cap of $6 billion and traded between 200,000 and 600,000 shares per day in January. PeopleSoft (PSFT), a software publisher with a similar market cap, traded between four million and 16 million shares per day that month.
PeopleSoft is owned by 1,213 institutions, representing 76 percent of the total shares outstanding. Cincinnati Financial is owned by 673 institutions, representing just 45 percent of the shares outstanding.
Better Educated
Much of the buying of regional bank shares over the past few years has been by the banks themselves. The practice helps to support their share prices. That's a plus for those stocks that trade sporadically.
"Banks have become better educated about the benefits of buyback programs," said Marc Arnett, head trader at San Francisco specialty shop Hoefer & Arnett. "Our business has increased a lot working with banks on buybacks."
Traders say the typical bank stock buyer is either a large retail account or a small institution.
"There are specialized institutional accounts that play in this arena," said Greg LeMasters, head trader at the St. Louis-based Stifel, Nicolaus. "Just not many of them. Occasionally when a stock gets hot, momentum-type or growth-type funds will dabble. But they aren't the bread and butter. They're not there day in and day out."
LeMasters adds that buyers of bank shares appreciate the earnings stability that the issuers offer.
Regional banking is a fairly conservative industry without the wild swings in earnings of many Nasdaq stocks. "Most won't go up three-fold," the trader said. "But earnings don't drop 30 or 40 or 50 percent in a trough either."
Still, institutional investors have noticed the run-up of the past few years. As a group, the big boys bought $3.76 billion more of regional bank shares than they sold in the third quarter of last year.
That's 3.1 percent more than in the previous quarter, according to data compiled by Philadelphia investor relations firm Gregory FCA Communications. It also works out to 13.2 percent on an annual basis.
Some of the biggest buyers were Fort Washington Investment Advisors, Farallon Capital Management and PDR Services. The study took into account 502 regional bank and thrift stocks and was compiled from investors'13-F filings.
Successful Investor
One of the more successful investors in small-cap financials is FBR Investment Services, the asset management arm of brokerage Friedman, Billings Ramsey.
FBR's Small Cap Financial "A" Fund, with assets under management of $335 million, has racked up returns of between 19 percent and 32 percent annually for the past three years. Holdings include Washington Federal (WFSL), Hawthorne Federal (HTHR) and Quaker City Bancorp (QCBC).
Accommodating investors of either stripe can be tricky, market makers say. Not many of these names even trade in the quantities of a CINF. Many trade in the 5,000 to 15,000 shares-per-day range. Patience is mandatory, pros say.
"We've had one order on the books for months," lamented Mary Parker, head trader at McConnell, Budd & Romano, a small New Jersey shop that focuses on Northeast banks. "It sounds crazy, but it can take a long time. Some stocks are more liquid, of course, and those are the ones in which we try and keep ourselves active. If you're trading them, you cannot have zero movement. Otherwise you don't make money."
Most desks that specialize in these often-obscure names stay close to the institutions and individuals that own them. The ability to match the ultimate buyer with the ultimate seller is often essential to get a trade done.
"At Keefe, we are very attuned to the investing community for bank stocks," said Eric Savitch, head trader at Keefe, Bruyette. "So we have a pretty good shot of finding both sides of the trade on an illiquid issue."
Savitch adds that some of the smallest stocks are the results of conversions. When mutual institutions, those owned by depositors, go public they usually sell a large chunk of shares to their depositors.
"We're very much in touch with that core group of investors," the trader said. "Opening up that business has been a big push of ours since 9/11. We've ramped it up significantly."
Keefe, primarily an institutional shop, has two or three brokers handling retail. It plans to expand that effort, said Savitch.
Keefe was one of the three stock brokerages based in the World Trade Center to suffer the greatest loss of life on September 11. Sandler O'Neill, sadly and ironically, was one of the others. The two rank among the top specialty houses in financial stocks. On September 11, both firms lost all the trading pros on their desks. Keefe and Sandler have since rebuilt, but both are still reporting significantly lower volume than in their pre-9/11 days.
For LeMasters, of Stifel, Nicolaus, a firm which also trades many non-financial stocks, illiquid bank stocks are no different than illiquid technology stocks. They trade the same.
"A financial is really no different than any other micro- or mid-cap," he said. "It mostly comes down to liquidity. Financials are just not as volatile. That's because you don't have the quick-money types – the hedge funds or the momentum type players -jumping in and out at a minute's notice."
Will the good times continue? There are signs the bull market in financials is tired. Both the Nasdaq Bank Index and the Nasdaq Insurance Index are off their peaks and traders say volume is starting to slow.
Analysts at Fox-Pitt believe the run-up in small and mid-cap names is kaput and that investors should put their money in the larger issues. Interest rates are too low and credit problems are likely to crop up in the middle market and consumer sectors.
"Mid- and small-cap banks will have a tough row to hoe in 2003," Fox-Pitt's Brian Harvey noted in a recent report. If so, it was a nice run.
