4 Reasons to Consider Investing in Financial Stocks

The financial sector has been hit by pricey and embarrassing data breaches, is enduring a never-ending rollout of new regulations and is skating by on thin margins.

Is now the time to buy?

It is if you are able to tap into long-term trends and can detect stocks and mutual funds that are poised for a lift. Analysts also point out that acquiring stock in companies supplying and supporting the financial sector can be a side door to getting in on the sector. Here are four points to consider and one strategy to avoid if you think the financial sector could amount to more than pocket change.

"If you can find a financial stock in which its return on assets is more than 1 percent, then those are companies you might be interested in if they are also well-priced," says Gavin Magor, a senior financial analyst with Weiss Ratings, based in Jupiter, Florida.

Read: [10 Questions to Ask Before Investing in a Sector.]

Banks have largely "cleaned up their books" from the fallout of the recession, says Marty Mosby, director of bank and equity strategies at broker-dealer Vining Sparks IBG LP, a research firm based in Memphis, Tennessee, that specializes in financial stocks and analysis. Now, banks are waiting for household earnings to start growing so Americans can start spending again. Most of the money center banks, or the international headquarters of banks, are still working through regulatory and balance-sheet complications in the wake of the financial collapse -- a situation that has undermined performance, Mosby says.

"If you are looking at a money center bank, we suggest you look at Bank of America, which is the most asset-sensitive, or Citigroup, which is the only one trading at a discount," Mosby says.

Bankers can't wait for interest rates to rise in sync with a more rapidly expanding economy, Mosby says. He predicts that scenario will emerge in the first half of 2015. "That's the next catalyst that banks need to further their recovery," he says. "We like banks that are more asset-sensitive, with about three-quarters of their balance sheet rebalancing in the next two years through retail deposits, short-term lending and the like."

See: [Find the Best Mutual Fund for You]

Meanwhile, the banking industry is consolidating. Big banks are eating smaller ones, and midsize banks must decide if they will be predator or prey, Magor says.

"Medium-sized regionals have a chance to expand their reach," Magor says. "It's hard for small banks. Their customers expect the latest technology and the latest services. They're under a lot of pressure." That's why banks with $1.5 billion and less in assets are in the crosshairs of large ($6 billion and more in assets) regional banks, which want to bulk up, Magor says.

Banks that make significant numbers of real estate loans are poised for a steady positive run, says Justin A. Barr, president of Bank DataWorks.com LLC, an analytics firm based in Highland Park, Illinois. Real estate comprises 51 percent of all loans, which explains why the financial and real estate sectors are chained to each other.

Construction and land-development loans are up 13.4 percent this year across all banks, Barr says, even though homebuying is flat to eroding. "Look at the stock or fund's exposure to real estate loans and assess the risk," Barr says. He cites the Bank of the Ozarks, whose metrics set a high bar: With $6.3 billion in assets, and net interest margin greater than 5 percent, the bank also has an exceptionally low percentage of nonperforming loans.

Barr isn't the only one to notice Bank of the Ozarks. The stock is "very fully priced," he says, trading at 20 times its 12-month earnings. The opportunities, he says, are with regional banks with similar metrics that are still selling for less than top dollar.

Insurance companies might appeal, given that they are steady performers, Magor says. He's enthusiastic about health, life and property and casualty insurers, but not so much about mortgage insurers.

See: [Should You Invest or Pay Off Debt?]

Mortgage insurers who count on mortgage market-makers Freddie Mac and Fannie Mae are facing an obstacle course of new regulations, Magor says. Requirements for greater reserves will force stability on the companies, but they could also erode yield, Magor adds.

Suppliers and service companies, such as software vendors, data centers and security firms, are benefiting from regulation-driven change, Magor says. Firms and funds with commanding contracts with large and regional banks are likely to see steady returns for the medium term, he says.

Finally, don't buy into conglomerates that own banks with the expectation that the bank's earnings represent an actual slice of the financial sector. Although retailers such as Nordstrom and Wal-Mart own their own banks (mainly to support their in-house credit operations), the actual net gain from the banks isn't much compared with their core businesses. Many organizations that used to own banks have "pulled back" as regulatory burdens have accelerated, Mosby notes. "The effect of the captive bank would be diffused through the overall operation," Mosby says.