Investment: Should you invest in... the financial sector?

THERE IS little doubt that the financial services business is likely to show considerable growth over the next decade. But the question of which companies are best placed to take advantage of this process is less clear-cut. The "other financials" sector is one of the "mixed-bag" market groupings, where the niche of an individual company is more important than the fact that it shares a financial business with its peers.

Broadly speaking, there are four types of company within the sector - stockbrokers, companies offering other forms of financial advice or service, trade finance houses (often with considerable overseas exposure) and fund management companies. It is the latter group that has been attracting the most attention recently.

"The really positive news within the last couple of weeks has been Prudential's offer for M&G Group," said Richard Peirson, manager of Framlington's specialist Financial Fund. "It was not just M&G that rose on that. Perpetual, Schroders and several other fund management companies bounced back very sharply."

Mr Peirson warns, however, that this particular rally may only be short- lived. "Some of this has been overdone," he says. "Prudential paid a premium price for a trophy brand name with M&G. Even though it has been underperforming for some time, M&G is still one of the best-known names in retail fund management."

This opens the question of whether the Pru/M&G link-up ushers in an era of corporate activity that may see more takeovers. "The M&G bid could be an indication that the Pru feels that returns from life and general insurance are not as attractive as those from fund management," said Jeremy Batstone, of NatWest Stockbrokers. "The Pru's own figures assume that the unit trust business is going to increase threefold over the next few years, which will leave some of these fund management companies in very promising positions."

Gavin Oldham, of the retail brokers The Share Centre, said: "The arrival of ISAs is going to have a big impact and the fund management companies are going to be the major beneficiaries in the retail market, as the Government has applied CAT standards only to collective investments."

Mr Batstone sees potential for further consolidation. "One effect of the deal is that other fund management companies are now wondering whether they will be involved in the consolidation process.

"Perpetual is an obvious one that stands out, as is Schroders, which is often talked about as a takeover target. It is one of the last remaining independent merchant banks with the controlling family still owning 47 per cent of the shares."

Similar factors affect other types of company within the sector, although the position is not as clear among the stockbrokers. "I'm not sure you can be over-specific about the effects of consolidation here, as it is so much a `people business'," Mr Oldham said. "Mid-range private client business is coming to the fore, so there is a lot of longevity. There is quite a lot of hot air about the inevitability of mergers."

This suggests a promising future for acquisitive brokers such as Brewin Dolphin, Rathbone Brothers and Gerrard (which owns Greig Middleton), provided they can offer the right type of private client service. Mr Oldham said: "There is enormous potential growth in this particular market, both in terms of customer demand and their ability to access services, through such areas as the Internet. If you look at some of the ratings of retail brokers in the States, you see evidence of this - there was a period recently when Schwab became worth more than Merrill Lynch."

Beyond these growth stories, the waters become darker. "It is not a particularly homogeneous sector," said Mr Peirson, "so it is not easy to give a broad view of major trends. One general point you can make is that this group has tended to underperform both the overall financials index and the main market over the past three or four months, ever since the sharp drop in market confidence last October."

In other words, whilst the big banks and insurers have already bounced back quite strongly, the smaller, more diverse companies in this sector have taken longer to respond. But respond they undoubtedly have. "The sector was the second best performer in the market during February," Mr Batstone said, "rising 14.1 per cent." This compares with a 12-month rise to the same date of just over 15 per cent.

This sluggishness is put down to the fact that the group at present contains no FTSE constituents. Mr Peirson said: "Most of the companies in this sector have been mid-cap or small-cap and have, therefore, been underperforming."

Mr Oldham said this phenomenon has been repeated across the whole stock market."Smaller cap companies have found that their market makers have largely disappeared as a result of the introduction of order book trading for the FTSE 100 companies. A lot of houses have discovered they don't need a market-making function to trade large caps, so have dispensed with it altogether and a lot of liquidity has dried up from the mid and small- cap market as a result."

Mr Batstone says this situation could get worse. "M&G is currently the largest stock in the sector and when it goes, the sector is going to become even less attractive to those institutions who don't bother with companies when they fall off the screen."