Wall Street research departments are busily selling a late-year recovery story. Merrill Lynch chief economist Bruce Steinberg, for example, forecasts five percent annualized growth in second half of 2002, underpinned by "earnings momentum" and a moderate tech-spending revival.
For clients ready to believe that story, it might be time to park some cash in the big investment banks/brokerages, some analysts say. Although first-quarter results will be abysmal, few sectors will benefit as directly from a return to brisk growth and strong earnings as the year progresses. "Once expectations for an economic recovery mount, we believe that additional upside remains for many names in the sector," says Salomon Smith Barney financial-services analyst Guy Moszkowski.
The main reason: the pickup in merger and acquisition activity that typically accompanies a recovery. Moszkowski says M&A growth largely mimics U.S. GDP growth. "M&A announcements have tended to crest in line with, or slightly lagging, peak economic conditions," he says, adding that the converse also holds true: M&A tends to bottom roughly in line with GDP. By that logic, if the economy gains traction after growing slightly in the fourth quarter of 2001, then M&A should flourish going forward.
That would create a windfall for the investment-banking giants. "When it’s being generated in meaningful volumes, M&A, is exceptionally profitable," Moszkowski says. "After all, large fees can be generated by a relatively small number of people, so that even if they are quite richly compensated, the margins remain quite high."
Further, because M&A is essentially an advisory business, requiring virtually none of an investment bank’s capital, the high margins translate directly into unusually high returns on equity for these firms, Moszkowski says. "ROE is probably the most important metric for this group," he adds.
While the entire group—Merrill Lynch, Goldman Sachs, Morgan Stanley Dean Witter, Lehman Brothers, and Bear Stearns—stands to gain from an M&A surge, Moszkowski says Goldman has the most to gain. "With 13 percent of 2001 net revenue sourced from M&A, against a 6.5 percent average for its peers, Goldman is poised to benefit disproportionately."
The $1 million question, however, is when an M&A pickup will occur. Many analysts expect some sort of upturn during second-half 2002. "There are several industries that are due for a round of consolidation," says Craig Woker, financial-services analyst for Morningstar.
He sites the telecommunications sector as a prime example. "When the leaders of those industries get their own houses in order and their stock prices firm up, they’ll start thinking about picking up some of their weaker competitors," he says. Essentially, he adds, a significant boost in large, lucrative deals will require a sustained stock market recovery, since many companies use their shares as buyout currency.
Moszkowski adds a caveat to the M&A story, however: "M&A activity as a percentage of GDP in prior recessions in the U.S. was lower than it is now, meaning that there may still be downside." He also says that he doesn’t expect M&A to return to the extraordinary levels of 1999 and 2000 anytime soon.
On the other hand, significant slack could be picked up in the euro-zone, he says. "Structural change due to the euro, along with tax reform in Germany, have raised the sustainable level of M&A in Europe for the long-term," Moszkowski says. Woker adds, "European capital markets are essentially where the U.S. was in the late 1990s." He says Morgan Stanley is the U.S. firm best positioned to benefit from increased European M&A activity, because it has the strongest presence there.
The entire group will also benefit from a rising stock market. "As valuations rise, investment banking fees rise too, because fees are based on the value of a deal," Moszkowski says. In a virtuous circle—which, of course, turns vicious in reverse—a recovering stock market also benefits the retail and institutional brokerage sides of the big investment banks. Trading volumes typically climb with the market, generating commission revenue; and income from fee-based accounts rises, too, as client portfolios grow in value.
Thus, a bet on the big investment banks essentially amounts to a bet on the capital markets. For clients ready to believe that the market has a good chance for a healthy rebound in 2002—and remember, the market hasn’t fallen three years in a row since the 1930s—the sector is worthy of consideration.
"The group has enjoyed a significant run since September 20, and it’s generally ahead of September 10 levels," Moszkowski says. "But based on historical valuations, there’s still meaningful upside as the cycle plays out. Performance will depend on the equity market and the extent to which it continues to discount economic recovery."
Sanford C. Bernstein analyst Brad Hintz concurs. "While many questions remain about the vigor of this recovery, an end to the recession appears to be near at hand. What does this mean to the securities industry? If we look at history as a guide, a recovering economy promotes capital markets activity such as IPO and M&A activity—the highest margin businesses in the securities industry. This presents a case for the cyclical rebound in the securities firms—starting first with the institutional firms such as Goldman Sachs and then carrying over to the retail firms." His top picks in the sector are Goldman and Lehman.
Alyssa Rieder, who lead-manages the Franklin Blue Chip fund, adds a cautionary note. "There’s still upside left in these stocks in terms of the whole cycle, but does that mean they can’t fall 20 or 30 percent in the near-term if the stock market doesn’t take off? No." She calls them "high-beta" stocks, adding that buying them now makes sense only if your clients "are ready to hold them for at least a year." As if on cue, the group sold off with the rest of the market in mid-February, when fallout from the Enron scandal spooked investors.
Rieder’s favorite in the group is Merrill, because, "Its retail brokerage arm is a much larger, stronger part of its business than the rest of the group." Therefore, "its beta is a little lower than the rest of the group," she says.
Woker of Morningstar likes Lehman best. "Management has really managed to carve out a niche for itself in the mid-sized deal area," he says. Woker adds that the firm’s strength in the fixed-income market acts a buffer when the equity market slides.