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WALL STREET, CALIFORNIA: Financial Services Mega-merger

Too Late? Hurry Up and Buy? Hold On?


If you're an avid mutual fund investor who watched from the sidelines Monday as Travelers Group and Citicorp unveiled the latest financial industry mega-merger, you may be thinking one of two things:

Either it's time to rush into a financial services stock fund, betting on more huge gains. Or it's too late to buy, after more than a decade of spectacular performance by the financial sector.

Oddly enough, both impulses may be wrong.

Financial-sector funds are likely to remain strong performers because the broad forces propelling them still are in place. Sure, the sector has been red-hot for many years. But every mega-merger along the way was just further proof that banking and brokerage stocks had more room to run.

At the same time, however, anyone expecting immediate--or towering--gains in the sector could be out of luck. Forget for a moment that an economic downturn or sudden interest-rate shift would bash financial stocks. At least in the short term, lofty valuations could limit financial stocks even if the broad picture stays favorable.

"This is exactly the time not to rush in," said David Ellison, manager of the FBR Financial Services fund in Boston. "The worst thing in investing is to be anxious."


The Travelers-Citicorp deal is the most dramatic example yet of the powerful currents that will drive consolidation in the banking and brokerage industries for years to come. Companies, under pressure from shareholders to boost stock prices and facing the need to steel themselves for a new era of global competition, have come to believe they must link up.

From the more than 14,000 banks in 1985, there are fewer than 9,200 today. Within 20 years, said Tom Finucane, co-manager of the John Hancock Financial Industries fund in Boston, there'll be 4,000.

"There are more deals and more consolidation ahead of us," he said. "It's just a question of timing."

In the last 10 years, financial services mutual funds have climbed a staggering 728%, on average, according to Lipper Analytical. That far surpasses the 362% advance of general stock funds. It even tops technology funds' 558% rise.

Bank stocks rallied in the early 1990s by overcoming past loan troubles, shedding unprofitable business lines and cutting costs. Since then, a strong economy has propelled loan growth. Increases in fees, such as monthly service charges, have made earnings more dependable. And many banks have added new services, such as mutual funds.

What's more, the ongoing slide in interest rates in the 1990s has aided banks' balance sheets and persuaded investors to pay up for the stocks, on the assumption that the industry's good fundamentals will persist.

"The financial services sector is a growth sector, and, therefore, we're willing to pay for companies that have demonstrated that they can grow," said Jeff Morris, co-manager of the Invesco Strategic Financial Services fund in Denver.

Nevertheless, the bank and financial sector has gotten so pricey and that even mergers won't guarantee a boost in some of the stocks' prices in the short term.

Although Citicorp shares soared 26% on Monday and Travelers jumped 18%, "This deal is one of a kind," said Eric Withrow, analyst at SNL Securities in Charlottesville, Va. "You're not going to see too many stock-price rises like this."

A key reason is that merger mania has pushed financial stocks up to record levels relative to earnings and underlying assets.

Of 109 bank and thrift deals announced this year, the median price-to-earnings ratio paid by acquirers for the targets has been 23.9, according to SNL Securities. That's up from 16.4 in 1995. The median price-to-book-value paid has been 2.7 this year versus 1.7 in 1995.

Because valuations are so high, the premium that acquirers are shelling out for their targets--that is, the amount paid above the target's stock price in the market--has dropped this year. In some deals, in fact, buyers are scooping up competitors for less than their market values. That means investors who own the targets are actually losing money in the mergers.

Since January 1997, seven deals have come at less than their market price, according to SNL Securities. Those include H.F. Ahmanson's for Coast Savings in October and Zions Bancorp.'s planned purchase of Japan's Sumitomo Bank Ltd., announced last month.

The average merger premium paid was 21% in 1996 and 18% last year, according to SNL. So far this year, it's dropped to 10%.

"Clearly, if you look at most of these deals . . , the seller has not gotten a big premium over the current price," Ellison said. "It's not like you're up 50% in a day."

So Ellison's strategy has been to avoid chasing possible target stocks and instead to own the banks that are doing the buying. These are the strongest companies, ones that will not only hold up in a downturn but that also will be rewarded with high stock prices going forward, he said.

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