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Stock Screen: Securities Brokerages with Low Price-to-Book Ratios - January 23, 2012
Ever since the recent mortgage related financial crisis, securities brokerages have been in a constant spotlight. People are now more interested than ever in how banks earn their profits, and perhaps more importantly, how banks are interconnected with the global economy as a whole.
How should investors decide which companies in the industry to invest in? In the past, most analysts focused on earnings potential. As long as a bank kept posting massive earnings, investors were content. The financial crisis changed everything. Today an important metric to consider is the leverage ratio or total assets divided by shareonwers' equity. When banks use large amounts of leverage, they earn massive returns on the good bets they made. However, when they are wrong, the effects can be devastating.
The riskiest banking model is that of the pure play model, one that is largely focused on investment banking, brokerage services, and asset management. Banks can choose this model as opposed to universal banking, which combines the pure play model with commercial banking (Example: JPMorgan Chase, JPM - Free JPMorgan Chase Stock Report and Bank of America, BAC - Free Bank of America Stock Report). Historically, the pure play model has been less regulated.
How should investors measure risk? This is an extremely complicated and broad question, one that the whole field of risk management seeks to answer. But for retail investors, the easiest metrics to focus on are leverage ratios and value at risk or the risk of loss on a specific portfolio of financial assets. In addition, more knowledgeable investors should delve into the implicit risk of each operational division of a bank. As regulations start focusing on pure plays, the risk that an entire division may be closed is very much possible.
Why should investors focus on this industry? Many banks are trading near or below book value even with the recent industry upturn. If these banks are able to hold their own until the next economic boom, their investors will see a more than healthy price appreciation.
Jefferies Group is a global investment bank and securities brokerage firm. The company offers clients a wide array of capital markets and advisory services, including mergers and acquisitions, restructuring, and investment research. Unlike the two other banks listed in this screen, Jefferies is considered by many to be a middle market investment bank. For investors, this means that Jefferies may be less regulated.
The fall of MF Global, a derivatives broker that declared bankruptcy late last year, has caused some to take a closer look at Jefferies, due to their similarities in terms of size and exposure to Europe. Recently, Jefferies has announced that it has reduced its long and short positions in the sovereign debt of Portugal, Italy, Ireland, Greece, and Spain by $1.1 billion a 49.5% reduction. Net exposure to Europe as of November 7, 2011 was only $59 million, or 1.7% of shareholders equity. This is definitely a good sign. Upon the announcement, Jefferies’ share price jumped up 20%. This allowed its price to book value to rise significantly to the current 1.68.
In terms of overall leverage, Jefferies has been around 13-to-1 since 2007. For a bank, this isn’t considered overly risky.
Most important, investors need to look at Jefferies’ banking model. Larger banks will most likely have to reduce their balance sheets and financing capabilities due to regulation. It is still unclear whether mid-market operators such as Jefferies will have to meet that criteria, as we cannot determine if the bank poses “systemic risk.” However, if the bank is not included, look for Jefferies to capitalize on the opportunity to lever up. Investors should ask themselves if the change in the business environment warrants a respective change in leverage. Levering due to increased business flow is a good thing. Levering in a bad environment in order to boost earnings can be problematic.
Goldman Sachs Group Inc.
Goldman Sachs is a giant multinational investment bank and securities company. Its services include investment banking, securities and investment management, and prime brokerage. Clients include corporations, high net-worth individuals, governments, and financial institutions. Among the banking industry, Goldman is known as a “bulge bracket” firm, due to its size.
As of November 17, 2011, Goldman Sachs is one of the most heavily exposed banks to Europe, with over $38.5 billion at stake according to Fitch ratings. The bank has made efforts to hedge by purchasing credit default swaps. However, this may mean very little. If the euro zone conducts voluntary debt forgiveness, stipulation in the swaps would not be triggered.
In terms of leverage, Goldman went from about 35-to-1 in 2007 to the current 13-to-1, the same level as Jefferies. This may be overly conservative, as Goldman may be bracing for the potential regulatory storm, in addition to continued market volatility.
Is Goldman’s business model still the golden standard? For the last thirty years or so, the company has emphasized a team-oriented environment. Strong leadership has ensured that employees were not concerned with internal power struggles that crippled competing banks. But things have changed.
Goldman used to make over 90% of its earnings from proprietary trading. But new regulations have banned banks from such operations. In the future, Goldman may focus more on investment banking, a relatively low-risk division. Currently, Goldman is the world leader in brining private companies to their IPO, in terms of value.
Morgan Stanley is a global financial services firm headquartered in New York. Operating in over 40 countries, its clients include corporations, governments, financial institutions, and individuals.
Morgan in many ways is very similar to Goldman. Its exposure to Europe is only slightly less, at just over $28 billion as of November 17, 2011. The same stipulations on default swaps will also affect Morgan Stanley’s hedging abilities.
More so, Morgan has effectively the same amount of overall leverage as Goldman at approximately 13-to-1. However, Morgan’s current price-to-book value is .86 versus Goldman’s 1.12. This probably reflects steep declines in its investment banking operations of late and uncertainty regarding the impact of its decision to cap cash bonuses at $125,000.
Elsewhere, a major difference between the two iconic firms is their culture. In recent years, Morgan has shown a greater ability to retain talent, and even lured away a few of Goldman’s top underwriters.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.