By James Saft
NEW YORK, April 4 (Reuters) - For a business whose main products fetch record prices, the financial services industry sure is firing a lot of people.
That combination may illustrate why finance is a sector you want to own, very possibly for the long haul.
Financial conditions are bank friendly; The stock market is at or near all-time records and demand for risky bonds is high. At the same time, announced layoffs in the financial sector are up 37 percent in the first quarter compared to a year ago, according to consulting firm Challenger, Grey & Christmas.
And while financial sector profits recovered somewhat last year, they are still well below where they were in 2006. However, the median compensation ratio, the percent of revenues paid out to employees, among the 15 largest U.S. banks fell to 49.9 percent by the end of 2012, according to ThomsonReuters First Call data, down from 56.6 percent earlier in the year.
Overall employment in the sector registered a net decline in March, after several years of tepid recovery from the massive falls in 2008 and 2009.
In short, financial services appears to be a shrinking industry, but it is becoming one where net profits are rising, something that benefits shareholders.
Here is a stylized summary of the experience of owning banking shares over the past 15 years or so, to help illustrate the disconnect between financial company shares and shares of other industries: You wake up one morning and the bank in which you own shares reports booming revenues. At the same time, the bank’s compensation outpaces earnings growth. Shares rise, but not as much as they would if the bank made widgets.
Not many days later, you awaken to find your bank has reported a terrible, unexpected loss, generated by trading or securitization or some other oft-occurring 100-year storm. The event crushes your shares despite protests from the CEO that “controls are excellent.”
This example illustrates why investors place a lower value on a dollar of bank earnings compared to other industries. Those earnings may be here today, but gone in a derivatives blow-up tomorrow.
The more reliable earnings are, the higher the price the stock market gives for the company. Banks simply aren’t that predictable.
In large part, that’s because of how banking compensation has encouraged insiders to take big risks and push complicated products to clients. The rewards for employees are big, and shareholders absorb the losses when things go wrong.
That risk profile may be changing, and tighter regulation is playing an important role. While the regulatory system in the United States is still deeply flawed, as evinced by the too-big-to-fail subsidy enjoyed by the largest banks, the general trend is toward stronger oversight, higher capital, and in part as a result, simpler and less risky activities by the banks themselves.
To be sure, tighter regulation crimps profits. Banks will be forced to hold more capital, which will reduce profitability. There is also a real risk that the cost of that capital will rise, at least at first, as many banks all seek to raise equity at the same time.
But on the other side of the equation, tighter regulation will very likely entice banks to offer simpler, less risky products and employ simper strategies when they risk their own money.
The great advantage, from a shareholder’s point of view, is that the organization becomes easier to manage and control, and one which needs fewer employees. Less of the revenue will walk out the door in compensation, and banks will become less prone to self-immolation.
This change at argues for two huge changes that will unlock value for shareholders.
Earnings will become less volatile. Sure, banking will always be cyclical, and banks will always have a difficult time during downturns, but the risks of a London Whale-style blowup should recede slowly over time.
As earnings become more reliable, the multiple that a dollar of bank earnings can command on equity markets will go up. This won’t necessarily be a smooth process, but as banks become less like casinos and more like utilities, investors will slowly become more willing to pay more per dollar of bank earnings. That’s because they will become more convinced that those earnings are more consistent and secure.
There are major risks to this scenario. Financial market memories are notably short, and after a couple of good years it is very possible that regulators ease up and banks and their employees return to risk taking and overpaying themselves.
It is also very possible that it takes longer for investors to get comfortable with the industry and the focus becomes the lower revenues rather than the more predictable profits.
The most likely outcome is a slowly shrinking industry, with perhaps lower revenues but more reliable profits.
It may not be pretty, it certainly won’t be fun for employees, but banking may once again become a good, long-term investment.