5 Stealth Financial Stocks to Beware

Bubbles love banks. To properly chase house and stock prices to unsustainable highs, buyers need big dollops of cheaply lent cash. House buyers congratulate each other for using "other people's money." Stock buyers convince each other that prices are justified by profit growth. (Never mind that the profits come from filling new houses with financed trimmings, and from spending the sudden abundance of "equity" on treats.)

Banks love bubbles, too. Rising asset prices keep loan payments prompt, at least for a while. The flood of new loans and the low delinquency rates make for giant profits. Stock buyers applaud the banks -- which they own, after all -- and chase their share prices higher, becoming wealthier themselves, and qualifying for more financial services, which generate more profit, and so on.

That's more or less how in 2006, financial companies came to make up 22% of America's stock market value. They weren't just facilitating the economy from the sidelines; they were the economy. The finance sector went from being half the size of manufacturing to double its size in 16 years.

Financial stocks are among the market's most abused this year. Investment banks within the S&P 500 are down 71%. Thrifts and home lenders are down 89%. The sector as a whole has shrunk to 13% of the index's value. Small enough? Maybe not. In the early 1990s, financials made up 7% to 11% of the market's value.

On its own, though, the financial sector's relative size might not tell the whole story. Banks aren't the only companies that have acted like banks in recent years. That non-financial stock portfolio you're hiding out in -- the one composed of the likes of tractor maker Deere (DE) and power-plant builder General Electric (GE) -- might give you a bigger stake in finance than you suspect. Some manufacturers and service companies depend on in-house finance divisions for more than a third of their profits. Those divisions provided twin benefits in bubbly years: Product buyers got easy credit terms, and an annuity of finance income offset lulls in product sales. Now those same divisions present twin problems: Bad loans could lead to earnings-sapping write-downs, while the absence of a bubble might vanish much of what looked like manufacturing and service profit in recent years, but was really bank profit in disguise.

This column has avoided recommending bank stocks in recent months. One exception: Bank of America (BAC), whose stock I thought looked cheap enough in early November. It's plenty cheaper now. If you're likewise shunning banks, give care to the ones hiding in manufacturing and service stocks you're considering. Be sure to scour financial statements to find out how much of profit during the last boom year came from finance, and how large a pile of money is owed by customers, and whether delinquency rates are rising. Your findings might surprise you. Have a look if you like at the small sampling of companies below.

Note that I recommended Caterpillar (CAT) at the end of October, based on a valuation that seemed to more than make up for the finance risk. Shares are up 6%, vs. a 9% drop for the broad market, and still looks plenty cheap.