Brokerages On The Cheap

Wow, what a mess, eh? While the credit squeeze and the rush to safety has equity investors scared, one wonders: Is it time to go shopping? Consider the brokerages.

Wow, what a mess, eh? While the credit squeeze and the rush to safety has equity investors scared, one wonders: Is it time to go shopping?

Consider the brokerages. That group, as represented by the AMEX b/d index, has gotten positively hammered, down roughly 22 percent from highs earlier this year—way worse than the general market. While M&A and investment banking activity may be under pressure, the long-term business prospects for the group seem to be intact. CIBC World Markets analyst Meredith Whitney calls the brokerage stocks “cheap,” and says they have “the best upside potential in financials.” In a recent research report, Merrill analyst Guy Moszkowski calls the group’s valuations low and “very attractive” given the earnings power of the group.

And Bear Stearns, which helped get the recent rout going with its hedge fund breakdown, is rumored (in press reports) to be shopping a minority ownership in itself to a Chinese investor. (By the way, it appears that the sharks are circling: A recent ad in the Wall Street Journal placed by lawyers appears to be trolling for plaintiffs—disgruntled hedge fund investors who lost money at Bear.) In other words, it could be a great time to buy brokerage stocks—or even a brokerage firm.

A Buying Time

Of course investors can be forgiven for being spooked by brokerages’ exposure to collateralized debt obligations. (An independent brokerage even went out of business because of its highly leveraged speculation in CDOs; see Registered Rep.’s August cover story for details). And investors are just plain concerned about securities’ firms business lines in general, such as a weakening M&A market. On the contrary, Moszkowski says the brokerage group is “generally much better hedged and risk managed than is generally supposed, which should limit earnings impacts.” Citigroup analyst Prashant Bhatia says brokers’ exposure to LBO financings (a $330 billion pipeline, he says) will have a 2-to-5 percent annualized impact on broker earnings. “But it’s worth noting that deal spreads are pointing to a higher probability of cancellation,” he says. “Cancellation would reduce broker exposures.”

And while M&A has slowed for the third straight week—$33.7 billion in transactions last week versus $37.3 billion the previous week—announced deals for the third quarter are 95 percent higher than last year’s levels, according to an August 20 research report from Wachovia Securities analyst Doug Sipkin.

Last Friday the Federal Reserve tried to relieve jittery investors by opening the “discount window” (cutting rates to 5.75 percent from 6.25 percent), hoping to increase the flow of cash to the financial system. But the markets have shown little confidence in the Fed’s moves as of Tuesday. Results of the SEC’s investigation into the books of the major banks and brokers to see if they’re being truthful with financial reporting will certainly influence the direction of the markets.

Other than that, business isn’t nearly as bad as perceived, according to LPL’s chief investment officer Lincoln Anderson. He says the worries about the credit markets are way overblown. “I don’t see it, and I don’t agree with it,” Anderson says of the dire predictions. In terms of the economy, the housing portion of GDP will take a hit this year but burgeoning exports and capital spending will offset it, he says. And the worry that companies won’t be able to borrow with the tighter lending standards of banks? Not a worry, really, since they’re flush with cash of their own.

“The non-financial companies have assets in excess of liabilities to the tune of $1.1 trillion,” says Anderson. “That’s never happened before.”

And if the riskier types of paper are showing signs of weakness, the rest of the bond market doesn’t seem to be worried, says Anderson. “The Lehman Aggregate Bond Index is stable as a rock.”

Look at the big bond mutual funds: There is absolutely no nose-diving going on, says Anderson. And second quarter corporate earnings? For the nine-tenths of the S&P that have reported, earnings growth is coming in at 8 or 9 percent, far better than analyst expectations of 3 or 4 percent at the beginning of the quarter. Anderson likes the overall economic picture.

In the meantime, analysts like Moszkowski and Whitney, among others, believe the brokerages are companies with far better balance sheets than their current share prices reflect. Whitney says that while brokerages are trading well below 10 times earnings (“cheap in our opinion”), she uses the old price/book valuation to rate them instead, “because clearly investors don’t believe the forward earnings estimates of the group.” In terms of price-to-book, she writes that all of the brokers are trading at the low end of their multiple range as well: Bear Stearns trades at 1.3 times book, equal to its nine-year low; Lehman Brothers fetches 1.7times book versus its nine-year low of 1.2; Merrill Lynch is 1.7 times book (its nine year low is 1.2); and Morgan Stanley trades at 1.7 times book just higher than its nine year low of 1.5. Only Goldman Sachs, at 2.3 times book, trades far higher than its nine year low of 1.6.

The sector has had a nice run—it’s up 156 percent over the last five years compared to a 59 percent jump for the S&P 500. And now the sector is on a sale. Here’s a stock price performance run-down from January 1st, 2007 to August 21st for a select group of the brokers:

Bear Stearns -27.5%
Lehman Brothers -26.0%
Morgan Stanley -6.0%
Merrill Lynch -17.6%
Citigroup -10.0%
Goldman Sachs -12.1%

(Source: Yahoo Finance)

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