Building a Model Income Portfolio Sector by Sector Part 4: Financials

by: Clay King

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." -- Henry Ford

In the fourth article in our series on building a model income portfolio by sector, we turn to financials. Banking, insurance, brokerage, and REITS are the primary investment choices in this sector. The S&P 500 sector weightings are shown in the table below.

Sector Weights
Consumer Discretionary 10.7%
Consumer Staples 10.7%
Energy 12.6%
Financial 15.0%
Heath Care 11.9%
Industrials 11.2%
Information Technology 17.7%
Materials 3.6%
Utilities 3.4%
Telecom Services 3.1%

Over the last several years, banking balance sheets have suffered one of the harshest economic periods since the Great Depression. As the housing industry collapsed due to overbuilding, coupled with years of loose lending, banks found themselves saddled with many failed loans. The banks with the most aggressive loan departments suffered the biggest losses Bank after bank failed as the FDIC had to guarantee deposits and arrange mergers with other banks, usually with large losses to the FDIC trust fund. Many insurance companies, brokerages, and REITS also suffered losses. Dividend cuts were common.

The aftermath of the crisis has left us with several different categories of investment choices in the banking community; those few that raised the dividend, the ones that maintained the dividend, or the ones who cut payouts. All three offer the dividend growth investor unique choices. In researching for stocks to add to our model portfolio I used several screens narrowing the list down to four different financial groups: banks, insurance companies, brokerages, and REITS.

Banks that survived the screen were small community or regional banks. None of the very large banks qualified in the process. There were several small community banks that were deleted form the list due to extremely thin trading in the shares.

Stock Current Yield Payout Ratio Past 5 Year Dividend Growth Rate Years of Dividend Increase out last 5 Years. Est. 5 Yr. EPS growth rate.
Community Bank Shares (CBIN)*** 3.9% 49% 4% 4 10%
Cullen/Frost Bankers (NYSE:CFR) 3.3% 52% 7% 5 8%
Bank of Hawaii (NYSE:BOH) 4.0% 57% 4% 3 8%
Well Fargo (NYSE:WFC) 1.7% 10% -33% 3 10%

*** Thin trader. Use limit orders if purchasing.

Well Fargo is included as a potential recovery in the shares and a huge dividend cut in 2009. The firm raised the dividend once this year and recently reported earnings that were sharply higher than expected lending credence to a strong recovery in the shares.

Many insurance companies also experienced sharp earnings declines, often due to the investment portfolio's exposure to poor bond or derivative investments tied to the housing industry. I list several in the following table.

Stock Current Yield Payout Ratio Past 5 Year Dividend Growth Rate Years of Dividend Increase out last 5 Years Est. 5 Yr. EPS growth rate.
AFLAC (NYSE:AFL) 2.7% 20% 16% 4 12%
Harleyville Group (NASDAQ:HGIC) 4.5% 55% 16% 5 9%
Chubb (NYSE:CB) 2.5% 25% 9% 5 10%

The next group, a income favorite among investors, is the REIT group. Each stock considered steadily increased the dividend over the last five years.

Stock Current Yield Payout Ratio Past 5 Year Dividend Growth Rate Years of Dividend Increase out last 5 Years Est. 5 Yr. EPS growth rate.
Realty Income (NYSE:O) 5.1% 92% 4% 5 4%
Corporate Office Properties (NYSE:OFC) 5.4% 67% 8% 5 9%
Ventas (NYSE:VTR) 4.3% 75% 6% 4 8%

Our last industry group is asset management. Only two stocks were able to make it to the finish line.

Asset Management
Stock Current Yield Payout Ratio Past 5 Year Dividend Growth Rate Years of Dividend Increase out last 5 Years Est. 5 Yr. EPS growth rate.
BlackRock (NYSE:BLK) 3.0% 45% 19% 4 13%
Eaton Vance (NYSE:EV) 2.6% 44% 10% 5 9%

Over the last 20 years the financial sector has returned an average 9.6%, with a one year rolling range between -70.75% to +95.2%. The decline in this sector is the worst of all S&P 500 groups and second only to information technology with the highest return. The S&P 500's range for the 20 year time frame was -44.7% to + 50.2%, with an average return of 8.1%. Despite the crushing blow to financials over the last few years, the sector has outperformed the market, although with a great deal more volatility.

My picks for the dividend growth stocks in this sector are Cullen/Frost Bankers and Wells Fargo. I'm betting on the recovery of Wells to overcome the low dividend.

In the insurance group, I believe the best bets are AFLAC and Harleyville Group. I wrote an article on Harleyville several weeks ago, found here.

In the REIT sector, while Realty Income is a favorite among many, I favor Corporate Office Properties. It has a nice yield which is much higher than its lows of 2.2% in 2007.

In the asset management area, the clear winner is BlackRock. Earnings have advanced steadily for the last 13 years with only a dip in 2009. Dividends have increased in all years since inception except 2009.

  • Cullen/Frost Bankers is a financial and bank holding company that provides financial and banking products and services in Texas. The banks primary earnings are derived from loans, consumer banking services and trust and investment management.
  • Wells Fargo is a diversified financial company offering banking, insurance, investments, retail banking, and brokerage. The company operates in 50 stares and the District of Columbia.
  • AFLAC is a general business holding company whose principal business is supplemental health and life insurance. It operates under two segments which are AFLAC U.S. and AFLAC Japan.
  • Harleysville Group is an insurance holding company. It is engaged in property and casualty insurance selling products through 1.300 agencies.
  • Corporate Office Properties Trust is a specialty office real estate trust. The company focuses on renting to the U.S. government, information technology and data sectors. The company operates in two primary areas, wholesale data centers and commercial office real estate.
  • BlackRock is an investment management firm. It offers managements in fixed income, alternative investments, and its BlackRock Solutions investment systems.

The financial sector is a challenge for most investors who demand a long history of dividend increases. The deep economic downturn of recent years put a severe strain on most banks if not run in a very conservative manner. Insurance companies, as previously mentioned, were troubled with portfolio returns. REITS, so dependent on real estate values and rentals, suffered as well. As an investor, the financial sector could be a gold mine of future value and dividend increases if the economy recovers back to previous levels.

Disclosure: I am long AFL, HGIC, BLK.