Why Schroders plc looks set to beat HSBC Holdings plc

I would argue that the lower reaches of the FTSE 100 offer better investment potential than the 30 or so largest firms in the index.

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It's tempting to go for a FTSE 100 tracker fund to try to capture upside potential in the index while at the same time achieving diversification. However, a basic FTSE 100 tracker fund allocates around 70% of our invested funds to the largest 30 firms because of allocation by weighting -- the biggest firms end up with more of our money than the smaller ones do.

In effect, a weighted FTSE 100 tracker keeps most of our investment out of the companies with the greatest potential. The solution, to me, is individual stock-picking, and I think smaller firms such as Schroders (LSE: SDR) can outpace giants like HSBC Holdings(LSE: HSBA).

Big problems

The big banks have many well-documented on-going problems. In the case of HSBC, regulatory headwinds combine with lacklustre growth in the firm's international markets to produce flat business progress. Is there a big bank around today that isn't involved in major restructuring and navel-gazing as once profitable lines of business dry up and directors rethink operational business models?

Right now, I see the big banks as risky. Profits are high, having recovered from cyclical lows following the financial crisis. Low price-to-earnings ratings and high dividend yields look like more of a warning than an attraction. When valuations are low after a period of strong profits, the banks are dangerous reckons legendary one-time Fidelity fund manager Peter Lynch.

The big banks are among the most cyclical beasts on the stock market and when profits are up, as now, I reckon the path of least resistance is down -- for profits and for the share price. In the meantime, valuation-compression seems set to keep investor total returns in check as the market tries to discount rising profits in an effort to anticipate the next collapse.

A focused business model

Rather than risk an investment in HSBC, I think family-controlled fund manager Schroders looks like a better bet in the financial sector. The firm's over-200-year heritage inspires confidence and the constant arrival of fee income has driven a good performance on total returns in recent years. It's interesting to compare how investors have fared with Schroders and HSBC.

It's true that past performance of an investment is no reliable guide to its performance in the future because investments can go down as well as up, but a good track record tells us something about a company's form, in my opinion.

At today's 2,422p share price Schroders trades on a forward P/E rating of just over 13 for 2017 and pays a dividend yielding around 3.9%. That's a comfortable valuation for a firm that has proved its growth credentials.

An economic slowdown will likely weaken Schroder's shares if it comes, but the firm's focused business model -- fund management -- should leave the company less vulnerable than an out-and-out cyclical firm with a complex and geared business model such as HSBC.

Are you looking for decent shares?

I would rather take my chances with Schroders than with HSBC Holdings, but you may wish to consider a company uncovered by one of The Motley Fool's top investors. He believes the best days for the business featured in this free report remain ahead.

Turnover has been growing at around 10% a year for this business, with profit growth not far behind. The firm has a decent record of rising dividends that looks set to continue, given its clearly identified path to growth. If the dividend keeps rising, share-price appreciation could follow.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.