As we see it, a famous quotation attributed to Mark Twain offers cautionary advice to security analysts and investors in the financial-services sector: "It ain’t the things you don’t know that get you into trouble. It’s what you know for sure that just ain’t so."

For a long time some security analysts and investors have thought they knew one thing for sure: rising interest rates are bad for the financial-services sector. But what they knew, to use Mr. Twain’s vernacular, just ain’t so in many cases. We believe that rate hikes -- especially when they rise from a relatively low starting point -- can lead to enhanced fundamentals for select financial-services companies, especially for well-managed, well-capitalized banks, investment managers, brokers, and investment banks. And as rates rise, the stocks of those companies can outperform.

The potential impact of rising rates on the sector is relevant now, because the U.S. economy is gradually recovering and, in response, interest rates may begin climbing sometime in 2010. We think that the prospect of rising rates won’t prove disastrous for the fundamentals and return potential of the financial-services sector. Quite the contrary.

For one thing, we’re struck by a Morgan Stanley study, which found that since 1980, when the 10-year Treasury yield was below 5% and started rising, it was generally highly favorable for financial-services stocks in aggregate; the stocks outperformed the broad market by an average of 2.8 percentage points. The shares of investment managers and brokers did even better, outperforming by more than seven percentage points.

The only times since 1980 when rising rates actually did prove bad for financial stocks were when the 10-year Treasury yield was initially above 5% and started to escalate. Then, financial stocks underperformed by an average of 2.9 percentage points. Even so, the stocks of investment managers and brokers still performed well, beating the market by 1.5 percentage points or more.

So, with the 10-year Treasury yield at 3.77% as of February 19 and the economy improving, we think security analysts and investors should know that today’s interest-rate environment is potentially bullish for financial stocks.

And for another thing, we think security analysts and investors should know that today’s interest-rate environment may be potentially beneficial to the fundamentals of the financial-services sector over the next two years. About the fundamentals, the true believers in the rising-rates-are-bad-for-financial-services faith seem to overlook this: when rates increase, it typically signifies an improving economy. So we believe that when rates are rising and the economy is rebounding, three prospective benefits accrue to banks, investment managers, brokers, and investment banks in particular.

Here are a few points of elaboration on that benefit:

*  When banks hold variable-rate commercial and industrial loans in an economic recovery, the credit risk on those loans tends to diminish because the finances of the borrowers are getting better. That tends to strengthen the balance sheets and net-interest margins of the lending banks. The reason: the rates on those commercial and industrial loans go up immediately when the prime rate, the rate charged to the best banking customers, goes up. In effect, the lender’s assets quickly appreciate more than its liabilities. In anticipation of higher rates on commercial and industrial loans, Morgan Stanley projects that the net-interest margins of mid-sized banks will increase by 0.39 percentage point, to 3.88%, by 2012.

*  The yield curve today is relatively steep, with a differential of 2.92 percentage points between two-year and 10-year Treasury rates, as of February 19. We think the yield curve may remain relatively steep if rates rise. That would have two beneficial effects: 1) banks’ net-interest margins would widen, and 2) mortgage loans, which have a longer life than many other loans, would produce more interest income for banks over time.

*  Although rising rates have a negative effect on the security prices of banks’ bond portfolios at first, they ultimately pay off when banks reinvest in new bonds, which provide more interest income and a fresh prospect of positive total returns going forward. Our research shows that at all but the longest maturities, the advantages of rising interest rates outweigh the disadvantages in banks’ bond portfolios. In short, the prime advantage of higher reinvestment rates ultimately exceeds the prime disadvantage of the initial capital loss.

One of the banks that we think can exploit the positive effects of rising rates is Comerica (market capitalization: about $5 billion, headquarters: Dallas). Comerica holds assets of $59 billion and the 12th largest portfolio of commercial and industrial loans in the U.S., according to American Banker. (About half of the bank’s loans are commercial.) As noted in a September 2009 Sector Focus commentary, we think mid-sized regional banks like Comerica have what it takes to succeed in a tenuous marketplace: strong balance sheets and capital ratios and ample loan-loss reserves. For instance, Comerica has continued to fortify its capital position, as reflected in its tangible common equity/tangible assets ratio, which rose from 7.6% in the second quarter of 2009 to 8.0% at the end of the year.

When rates rise in an economic rebound, this sequence of events typically plays out: corporate profits grow and the stock market responds positively, which attracts greater money flows into stocks, which in turn increases the volume of business, fee income, and commissions of investment managers and brokers.

Also, we think that if short-term interest rates rise from today’s abnormally low levels, investment managers would probably no longer need to pay fee waivers in support of their money-market funds (which yielded a record low 0.02% in February, according to The Wall Street Journal). Charles Schwab, for example, estimates that its fee waivers should end if the yields on its money-market funds rise by 1%. Eliminating the fee waivers would transform an expense into additional net income for Schwab and other providers of money funds.

Consequently, we think better times are ahead for investment managers and brokers such as BlackRock (market-capitalization: about $27 billion, headquarters: New York), Eaton Vance (market capitalization: about $3 billion, headquarters: Boston), MF Global Holdings (about $770 million, New York), Charles Schwab (about $21 billion, San Francisco), and T. Rowe Price Group (about $12 billion, Baltimore). All have diversified client bases and large operational scale, modest debt, and, in our opinion, the ability to expand their already leading market shares.

Black Rock, the world’s largest investment manager, is responsible for about $3.4 trillion in assets. The company recently gained a foothold in popular indexed investments and iShares exchange-traded funds by acquiring Barclays Global Investors. Our analysis indicates that inflows to these new BlackRock investments may accelerate in 2010 and 2011. The Federal Reserve thinks enough of BlackRock to have the company serve as its investment manager; BlackRock manages the assets of the bankrupt Bear Stearns and the collapsed American International Group that the Federal Reserve acquired in receivership. Also, about 25% of BlackRock’s institutional clients think enough of BlackRock to have the company manage more than one of their portfolios.

Eaton Vance is the fifth largest retail investment manager of separate accounts, its fastest growing business, and has built a leading franchise in stock and bond mutual funds. Eaton Vance’s assets under management total $163 billion. We think the company’s tax-managed investments in particular could attract billions more, as investors seek to minimize their tax liabilities, since tax rates are anticipated to increase in the years ahead. Overall, the performance of Eaton Vance’s mutual funds has been distinctly above average: in the 2009 Barron’s rankings of mutual-fund families, Eaton Vance placed in the 13th percentile for five-year results and the 27th percentile for 10-year results.

MF Global Holdings is the world’s largest independent broker of exchange-traded futures and options and does business on more than 70 exchanges. Among professional traders, the company is admired for its efficient, confidential execution and clearance of securities trades. With assets of $56 billion, MF Global Holdings handles more than 8 million futures and options contracts per day. Partly due to their expectation that short-term rates are headed higher, Wall Street analysts project the company’s earnings per share will grow 17% annually over the next three to five years, according to Reuters.

Charles Schwab is a name synonymous with discount-brokerage services. The firm originally served individual investors but now garners more than half of its assets from financial advisers. In recent years Schwab has earned less than 20% of its revenue from clients’ trading activity, down from 53% in 1999 -- a reflection of how it has developed a more comprehensive set of products and services during that time. Schwab has assets exceeding $1.1 trillion and has consistently generated pretax margins of about 40%.  Schwab ranked first in overall customer satisfaction among individual investors in the latest J. D. Powers and Associates survey.

Like Schwab, T. Rowe Price Group is named for its founder, Thomas Rowe Price Jr. The firm is known for the superior performance and below-average fees of its conservatively managed mutual funds. "We try to avoid performance extremes," says James Kennedy, chief executive officer, who believes that approach has been instrumental in the firm accumulating $391 billion in assets. We think T. Rowe Price’s target-date funds, whose asset allocations are based on an investor’s retirement date, will account for a growing percentage of the firm’s asset base; according to SmartMoney magazine, inflows into the target-date funds will account for 16% of the firm’s assets in 2015, up from 11% today. The firm also is a leader in the 401(k) retirement-plan market.

If that correlation persists, we think Lazard, an investment bank (market capitalization: about $3 billion, headquarters: Hamilton, Bermuda), would be well-positioned to capitalize on any pickup in M&A activity. Lazard also manages money ($129 billion in assets) and has a cash-rich, low-debt balance sheet.

One fertile M&A field for Lazard to plow may be mid-sized companies, which generate annual revenue of $1 million to $500 million. More than 800,000 such companies, with a market value of $3 trillion, are owned by baby boomers, in the estimation of the McLean Group, an investment bank. We think that over the next five years many of the baby-boom entrepreneurs are likely to cash out of their businesses. And during that time, big companies will continue to be merged or acquired -- more companies than have been merged or acquired since deal volume began to contract in 2007, in our view. As we’ve observed before, as long as there are chief executives with animal spirits leading big companies, there will be acquisitions for investment banks like Lazard to help make happen.

And as long as there are security analysts and investors, there will probably be some who cling to the belief that rising rates are negative for the financial-services sector. But we think that belief has never been universally true -- and is unlikely to be universally true in the near term. With interest rates at near-historic lows and poised to rise as the economy picks up steam, we think the outlook for the fundamentals and stock prices of the sector is good -- much better than those diehards who "know" otherwise might ever suppose.

The views expressed represent the opinions of Turner Investment Partners as of the date indicated and may change. They are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. Opinions about individual securities mentioned may change, and there can be no guarantee that Turner will select and hold any particular security for its client portfolios. Earnings growth may not result in an increase in share price. Past performance is no guarantee of future results.

Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm with more than $17 billion in assets under management in stocks, as of December 31, 2009. Turner manages growth, international, core, value, quantitative, and alternative separately managed accounts and mutual funds for institutions and individuals.

As of January 31, 2010, Turner held in client accounts 358,970 shares of Comerica, 354,502 shares of BlackRock, 100 shares of Eaton Vance, 2.5 million shares of MF Global Holdings, 6.0 million shares of Charles Schwab, 3.1 million shares of T. Rowe Price Group, and 865,975 shares of Lazard.