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Meet the 3 best financial stocks for your portfolio

In the capitalist world there’s no escaping the fact that if you control sufficient amounts of capital making money is easier than drinking a glass of water.

The more capital money managers amass under management the higher their revenues, as fees are generally a fixed percentage of funds under management.

Staff costs are usually their biggest expense and the best money managers are scalable in that they are able to grow revenues far faster than staff costs.

Generally they will boast far lower cost to income ratios than their peers, which indicates good management, higher returns on equity and a high-performing pool of staff well incentivised to succeed for themselves and shareholders.

Below I explain why the following three businesses exhibit these credentials and are my pick of the financials for long-term growth and income.

Challenger Ltd (ASX: CGF) recently reduced its cost to income ratio to 33.8% which is a record low and impressive number given its size and fact it has two operating divisions in funds management and the provision of annuities.

The group appears to have an excellent control on costs and has a strong tailwind as Australia’s ageing population demands annuity products that Challenger is the market leader in providing. Annuity sales for the first quarter of 2016 were up 12% over the prior corresponding period and the group ticks the boxes as a long-term growth prospect. The stock is up 24% in 2015 and I expect will enjoy a strong 2016.

Magellan Financial Group Ltd (ASX: MFG) is my particular favourite with an astonishingly low cost to income ratio of just 20.6% for the last financial year. This is a reflection of the fact it’s a founder led startup still able to handpick staff despite growing at a gangbusters rate to now manage more than $38 billion in funds under management.

Compare Magellan’s cost to income ratio with that of Perpetual Limited (ASX: PPT) at 63% – even after Perpetual just undertook one of the most radical cost-cutting programs in the history of Australian financial services, also suffering FUM outflows again, Perpetual looks a sell.

However, Magellan continues to grow FUM and re-invest surplus capital to compound growth at impressive returns. Selling for $21.97 this stock ticks all the boxes and equity markets permitting I expect it will continue to outperform in 2016.

Macquarie Group Ltd (ASX: MQG) is accelerating its focus away from market sensitive activities to retail banking, wealth management and corporate lending as the core of its business. Recent evidence of this shift include two recent multi-billion dollar acquisitions to increase its exposure in aircraft leasing and car dealer financing.

The shift away from performance-based trading activities that are sensitive to financial market conditions also means it has the opportunity to reduce its high cost to income ratio. This is unlikely to be popular with staff, but looks probable over the long term and should provide subtle support to earnings per share growth over the years.

Macquarie also generates the majority of its income overseas and given earnings are now less leveraged to big market shocks, I expect it will continue to outperform in 2016 and beyond.

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Motley Fool contributor Tom Richardson owns shares of Macquarie Group Limited and Magellan Financial Group. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned.

You can find Tom on Twitter @tommyr345

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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