IOOF Holdings Limited (ASX: IFL) is the worst performing stock on the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) this morning as it faces accusations from the Fairfax press around alleged wrongdoing.
These allegations are unproven but investors are selling first and asking questions later as reports by Fairfax Media Limited (ASX:FXJ) will put pressure on the federal government to conduct a royal commission into the sector.
That would be bad news for IOOF, which saw its share price plunge 19% to $8.63 this morning, as this could open the door to class-action lawsuits and big compensation payments as we have seen in the banking sector. There is also the possibility of tighter government regulation.
Shareholders at other financial services companies like AMP Limited (ASX: AMP) and Perpetual Limited (ASX: PPT) are relatively calm so far following the reports that IOOF has investigated staff over allegations around insider trading, front running and misrepresenting the performance of its funds.
Insider trading refers to trading of shares when a person has sensitive information about the company that is not known to the public, and front running involves acting on advance information from analysts before clients do.
IOOF disputed the report from Fairfax saying that the issues happened a long time ago and were dealt with "appropriately". Management also said clients did not suffer a loss.
But the brutal sell-off is understandable given how strongly the stock has outperformed the market. IOOF had outrun the top 200 stock index by around 17% since the start of the calendar year before today's news.
Talking about stock fundamentals and valuation is somewhat redundant as no one can really predict the fallout from these allegations.
In my opinion the best case is IOOF will pay a few tens of millions in compensation and fines, in which case the stock is arguably looking cheap, and the worst is if IOOF and its peers are forced to divest some of their divisions to protect the integrity of the industry.
One of the key problems that could be driving unethical behaviour is the "vertical integration" of the sector where financial firms provide a full range of services to clients. This may include trustee services, investment platforms, and funds management.
Having so many different functions under one company umbrella creates more opportunities for conflicts of interests but this integration is seen as necessary in driving the share prices of these firms higher as fat profits in financial services are based on economies of scale.
This is what is driving the spate of mergers and acquisitions in the sector over the past year or two and is the reason why $400 million market cap Equity Trustees Ltd (ASX: EQT) made an unsuccessful bid for $24.5 million market minnow Diversa Limited (ASX: DVA) in April.
Strong operating leverage for the industry means every little bit counts. This is because every extra dollar in sales made once a financial services firm reaches a certain size would generate a disproportionately larger profit.
Coming back to the IOOF sell off, I would wait for the dust to settle before giving the stock another look as there are currently too many unknowns hanging over the stock.
I don't think the government will force a breakup in the industry and any dip in stocks like AMP and Perpetual should be seen as a buying opportunity.
However, I think it's too early to make the same call for IOOF as it won't be able to enjoy a sustainable bounce back until there's greater clarity over the allegations and the potential outcomes.
This may not happen for a while yet.
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