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Can Financial Services Weather The Silicon Valley Storm?

By Benjamin Sinclair HBA, CFA, Equity Analyst
Thursday, August 11, 2016

Silicon Valley Storm "Silicon Valley is coming." These ominous words came from JPMorgan Chase CEO Jamie Dimon in his 2014 annual letter to shareholders. He has reason to be worried. More than ever, financial technology (“FinTech”) companies are threatening banks, insurers, wealth managers, and other financial institutions. Consulting giant McKinsey said that up to 60% of consumer finance profits will be at risk by 2025.

Threats are coming from a number of angles. Marketplace lenders are matching creditors directly with borrowers, in an attempt to disrupt the loan-making role currently played by banks. Other startups are dedicated to upending the payments industry, threatening established payment networks and credit card issuers. Robo-advisors, which use algorithms to construct investment portfolios, are competing fiercely against wealth managers. There are numerous other examples.

No financial institution is truly immune, and this sector has been notoriously slow to innovate.

Why Hold Financial Companies at All?

FinTech threats should not be taken lightly, but let’s not get too carried away by McKinsey’s prediction. McKinsey’s goal is to sell consulting services, and it has every incentive to provide a gloomy outlook for companies that don’t take action.

Consider too that many financial services have high switching costs. For example, new technologies such as online bill payment have made it more inconvenient to switch bank accounts. Other financial services, such as wealth management, are based on strongly rooted personal relationships. Meanwhile established payment systems, like Visa and MasterCard, create a classic network effect, in which both merchants and consumers benefit from each other’s presence.

Most importantly, financial institutions – especially the larger ones – have reacted very forcefully to these changes. For example, JPMorgan has established over 100 partnerships with FinTech companies. Banks such as Wells Fargo have streamlined their processes for loan applications. Bank of America pledged at the beginning of this year to triple spending on mobile. Put simply, the incumbents are not going down without a fight.

Let’s not forget that financial services technology has evolved many times before, and the incumbents have yet to be displaced. An interesting example comes from the late 1990s, when online banks were supposedly going to eat the big banks’ lunch. Those online banks have now mostly disappeared.

The Big Picture

In the Financial Services sector, size matters. Larger companies have some considerable advantages over their smaller peers, including lower costs, stronger brands, and greater influence. They are also better positioned to deal with the FinTech threat, whether through partnerships, strategic acquisitions, or by making sizable technology investments of their own.

To illustrate, big banks have superior customer ratings for their online and mobile capabilities, relative to small- and mid-sized banks. This is a primary reason why big banks now score higher overall for customer satisfaction, according to a JD Power survey. Interestingly, the popularity gap was especially wide among younger respondents.

Accordingly, we prefer to hold large, well-established companies in the Financial Services sector. It’s a perfect example of our approach, one that emphasizes investing in companies with industry-leading positions and sustainable competitive advantages. The rise of FinTech helps demonstrate just how important this discipline can be.

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