War, What Is It Good For?

War, or rather, the prelude to war has been, historically, bad for the stock market. Look back at the markets leading up to the outbreak of the Korean War, the Cuban Missile Crisis, Vietnam, and The Gulf War in 1990-91. Consider too the downward trajectory of the market during January and early February.

One group of stocks harder hit than most during these saber-rattling times is the brokerage sector. The temptation might be to avoid the sector, since brokerage shares are essentially high-beta, leveraged plays to the health of capital markets.

It might sound loony, but it could actually be a good idea to buy shares in the sector during times of increasing geopolitical tensions. Your clients might not be ready, but if you invest in your firm's shares via your retirement plan, brokerage stocks, a depressed group, have serious long-term potential. Why? For starters, says Brad Hintz, who covers the brokerage industry for Sanford C. Bernstein, brokerage stocks are now trading at the lower end of their historic book value range (a book value of one is the “floor” underneath their share price since book value is a close proxy to the firms' true liquidation value). Plus, when a conflict is settled, even unfavorably (as in Vietnam), brokerage stocks tend to jump — 6.5 percent on average in the first 15 days of settled conflicts since the Korean War.

Further, as brokerage stocks sink closer to their book values (the price floor), their beta — volatility — drops. But when a conflict is resolved, the beta soars. Hintz calls this “one-way” beta. “They [brokerage shares] can rise more rapidly than they fall,” Hintz says, noting that this group is “not for the faint of heart.” But, “At this point, we recommend maintaining at least a market weight investment in the group.”

There is a potentially unprecedented anvil hanging over the industry: a potential wave of arbitration by individual retail investors, claiming firms (and, in some cases, their reps) put them in unsuitable investments (see related story on page 49). And since federal regulators are trying to get the term “securities fraud” worded into the global settlement, that will certainly add some potent fuel to the retail investors' claims.

Even if there is a swift resolution to the Iraq crisis, there is no denying that the industry is in a severe slump. Investment banking is practically dead (a new issue drought not seen since 1975). And the retail investor has virtually gone on strike. Wall Street earnings have been kept alive by deep payroll cuts, as the industry has experienced the biggest decline in the number of jobs and the second-largest decline in percentage of total jobs lost since 1974, as well as and other painful cost-cutting measures.

Yet, a number of high profile analysts, Hintz included, remain optimistic that an attractive lending environment coupled with the improved liquidity of high-yield debt and senior loans could provide a spark to the current market malaise. The thinking is that while business seems pretty dead in the first half of 2003, the growing interest and liquidity in senior loans and high yield securities will provide an excellent source of financing for acquisitive companies in the months ahead. As weaker conglomerates sell off under performing divisions to such suitors, the demand for high-margin, fixed-income advisory sales and services will soar. And if that happens, the full-service firms should have enough cash to focus on building out their retail businesses, Hintz says.

Says Hintz, “We believe that the earnings power of the institutional firms will benefit as the delayed but eventual capital markets recovery takes place. Retail brokerage activity is still expected to rebound much more slowly.”

Also, consider the relatively low valuation of the sector. According to Hintz, full service brokers currently trade anywhere from 1.3 to 1.8 times book value, which is about a third of the multiple the group was able to garner at its peak over the past decade. On a price-to-earnings basis the sector is equally attractive. Whereas the average full service broker currently trades between 12 and 15 times next year's earnings, historically the group has experienced periods (as in the late 1990s) where the average P/E topped 20.

For the contrarian, the question becomes which to buy and which to avoid? Naturally, opinions vary. Hintz favors Goldman Sachs and Lehman Brothers, which derive 23 percent and 31 percent of their revenue, respectively, from fixed-income sales and advisory services from institutions. Goldman Sachs, with an industry leading 13.1 percent share of global equity underwriting, appears well positioned to take advantage of any pick up in M&A. However, at 15.1 times the current 2003 First Call estimate (of $4.36 a share) and 1.7 times book value, Goldman's shares already reflect that upside.

Lehman Brothers, which trades at 12.3 times the current fiscal 2003 First Call estimate (of $4.19 per share) and 1.5 times book value, might be a better deal. In fact, analysts, including Morgan Stanley's Henry McVey and Hintz, view its sizeable exposure to fixed income securities, its improving net leverage ratio and its more than 100-basis point improvement in net margins over last year as being its most alluring features.

Morgan Stanley, which trades at 12 times forward earnings and 1.8 times book value has its fans for two reasons: its diverse revenue base (between 25 percent and 30 percent of its revenue is derived from markets outside the U.S.) and its management team. Morgan Stanley has been among the most consistent firms, generating a return on equity of 24.7 percent over the past 15 quarters. This dwarfs many of its peers, including Goldman Sachs and Lehman Brothers, which had ROEs of 21.3 percent and 21.6 percent over the same time frame.

Bear Stearns' Daniel Goldberg is bullish on Merrill Lynch, which trades at 12.1 times forward earnings and 1.3 times book value. Goldberg reckons Merrill has the most to gain in an equity market rebound. Roughly 40 percent of Merrill's revenue is derived from equity sales and underwriting, and Merrill is one the most efficient brokers on the street, generating about $125,000 per employee, roughly 15 percent more production per employee than any other bulge bracket firm.

Henry McVey says Merrill's increased focus on high margin, fee-based advice is its most attractive quality. In fact, McVey is forecasting that margin improvements in its private client business — coupled with its 26 percent reduction in headcount — have the potential to boost Merrill's pre-tax profit margins by 200-basis points over the next year to 21.6 percent of revenue. On a percentage basis, that would be higher than it has been at any point during the last five earnings years.

Where They Stand

Shares of full-service brokerage houses at a glance