For Sale: Brokers, Asking: 10x Earnings

Goldman Sachs (GS), Morgan Stanley (MWD), Merrill Lynch (MER), Lehman Brothers (LEH), and Bear Stearns (BSC). They all trade at 10 times earnings. At first glance this may seem too cheap, and they very well might be, but let’s take a look at why you can buy a share of Goldman Sachs at 10x when it used to trade at a premium to the market and sport a P/E of 18 or more.

In case you haven’t noticed, we’ve been in a bear market since March of 2000, more than five years. The major investment banks have had to alter their business models. Some of the old ways of making money don’t really exist anymore; taking Internet companies public, or generating $100 per trade retail commissions. The public has soured on stocks. Those that haven’t can trade their own accounts for $7 per trade. The IPO market isn’t lively at all. Today, M&A is really the only way the investment banks are making money from their traditional businesses.

So what are these companies doing to cash in? After all, the profits at the Goldmans and Lehmans of the world have been pretty robust. John Mack, former CEO of both Morgan Stanley and CS First Boston, summed it up pretty well in a recent interview:

“The profitability at investment banking firms has moved to the trading desk. A lot of people say that certain firms are nothing, really, but hedge funds.”

Mack is exactly right. Proprietary trading has fueled much of the growth in earnings for the investment banks. A booming fixed income market has helped Bear and Lehman greatly, and Goldman and Merrill are seeing a nice pickup in M&A activity in 2005, but trading is where the extra juice has come from.

This can explain why the group once sold for 15 times and Goldman once fetched 20 times, but now the multiples are all around 10. They are basically hedge funds, making risky bets. If they are right, cha-ching. If not, bad news. Just look at how many firms got hurt when Kirk Kerkorian’s company made a bid for General Motors. Traders were short the common stock and long the bonds as a hedge. The common went up after Tracinda’s $31 offer and the bonds went down after GM debt was downgraded to junk status.

Sure the people trading for these firms are extremely smart, and they’ll do pretty well for the most part. However, investors aren’t going to be willing to pay premium valuations for companies that are relying on trading profits for a large chunk of their earnings. As far as business models go, its one of the riskier ones out there. The more risk you carry, the less someone is going to pay for a chunk of the business.

Value in Morningstar?

I’m sure most of you have heard of Morningstar Inc. (MORN), the fairly influencial investment advisory company most known for their mutual fund star ratings. These ratings, which rank mutual funds on a 1-5 scale with 5 stars being best, garner much attention and are constantly advertised in various fund company marketing materials. However, recent events once again should remind investors to be very wary of these types of endorsements.

According to SEC filings, Alberto Vilar and Gary Tanaka were removed as managers of the Amerindo Technology D Fund (ATCHX) last week after both men were arrested on federal charges of defrauding investors and stealing $5 million from their clients. As a result, Morningstar advised Amerindo Technology shareholders to sell earlier this week. “Charges of fraud against Amerindo Technology’s managers are just the most obvious reason to avoid it,” said analyst Dan Lefkovitz in a written report. “We’re worried that impending redemptions will only exacerbate the fund’s problems by forcing it to sell out of positions.”

Okay, it seems reasonable that Morningstar recommend such action given recent events, no doubt about that. My question is, why hadn’t they recommended investors in Amerindo sell before now? Morningstar had the fund rated “3 stars” before news of the arrests hit the wires. This rating equates to a “neutral” or “average” investment option. How can such a respected research firm think this fund was average?

Let’s look at some specifics. As of March 31st the fund held only 12 positions. That’s right, twelve. I’m going to go out on a limb and say that is the most concentrated mutual fund portfolio in the country, a huge red flag.

How about performance? After all, if these guys knew how to pick stocks, maybe 12 positions is acceptable, or at least warrant an “average” recommendation. Amerindo’s 5-year average annual return? Negative 20 percent. Now you don’t have to be a math or finance major to know that 5 years of 20 percent losses is going to leave you in quite a bit of a jam financially. In fact, you’ll lose two-thirds of your assets over that span with those types of returns.

To make matters worse, the fund was down another 22% through April 30th. Oh, and did I mentioned the 2.25% annual expense ratio? So we have a fund with 12 stocks, an expense ratio which is 50 percent above the industry average, and some of the worst 5-year returns of any fund in the country. Morningstar gives this fund 3 stars. I’d hate to see what a one or two star fund looks like.

In addition to much of the equity research out there today, it appears we can add Morningstar to the list of investment advisors who should probably carry less weight in our minds than they do. Interestingly, the company recently went public and the stock is up from an $18.50 offer price to a current quote of $27.65 per share. Hmmm, perhaps an interesting short candidate?

Bullish on Financials

It’s been a tough year to like financial stocks. When the Fed is engaged in an interest rate hiking cycle, the financials tread water at best. I’d be willing to bet that I have sacrificed several percentage points of performance so far this year from holding a decent chunk of them.

That’s the short-term view though, and the longer term view is the one I can’t help but focus on. There are some great financial services companies out there and the valuations are way too low, below the market’s 16 P/E in most cases. Over the next few weeks and months, they might continue to flounder, but if you look out 2 or 3 years these stocks are going to make people a lot of money, and they often pay huge dividends to boot.

Excuse me for keeping many specific names closely held (after all – this is a free site, as opposed to my paying clients) but I have written about Capital One (COF) on this blog before. That story remains very bullish and the stock trades at less than 10 times forward earnings.

Another one I have yet to mention is E*Trade (ET). Most people think of them purely as a discount brokerage, but they have branched out and now offer banking and lending services as well. In fact, only about a quarter of their revenue is generated from stock commissions. The shares sell for $12 each and trade at only 11 times 2006 earnings.

Morgan Stanley’s Purcell To Stay, For Now

The TradeSports contract on whether Phil Purcell would be fired or resign as CEO of Morgan Stanley by June 30th was always overpriced, representing a great opportunity for traders who wanted to short it. It has been widely speculated that Purcell would be ousted in the latest battle to get Morgan back on the path to respectability.

The only problem was that the company required 75% of its Board to vote Purcell out, which equated to 10 of its 13 members. The presence of Purcell and two of his buddies (who found themselves there exclusively because of him) made it extremely unlikely he would be removed by mid-year. That would require each and every one of the remaining Board members to vote to boot him.

CNBC’s Maria Bartiromo reported late Friday, after a report was first published in the Wall Street Journal, that a Board meeting would take place over the weekend in Chicago, sparking speculation that Purcell’s reign was over. The TradeSport contract doubled in value to 50 cents in no time, yet another shorting opportunity.

Word came Sunday that rather than fire Purcell, the Board would change its bylaws to require only a simple majority, or 7 out of 13, to replace him as CEO. The contract tumbled 70% to 15 cents. It appears Purcell will get a chance to spin off the Discover credit card unit and try and bring the company back. If he continues to prove unsuccessful as a Chief Executive, you can bet it won’t be very difficult to get 7 “yes” votes to force him out.

As for the stock, it’s cheap at $52 and might fall back to the $49-$50 area on news that Purcell is staying put. Value investors should use any weakness to add shares. Very few scenarios will cause the situation to get much worse. Either Purcell starts doing his job, the company gets sold, or someone new comes in to lead Morgan in a new direction. Any and all of those options will increase shareholder value from here.

Capital One Can’t Hold Gains After Upgrade

Shares of Capital One (COF) opened up more than $1.00 this morning, were up more than $2.00 at one point, and now are unchanged after an upgrade to “buy” from Goldman Sachs today. Oftentimes an upgrade will keep a stock up throughout the day, even when the overall market tanks. Not today, though.

One reason might have to do with this Goldman analyst’s track record on COF stock. The analyst, Michael Hodes, last had a “buy” on Capital One more than 2 years ago. The stock began 2002 in the 50’s and fell to $30 per share by October of that year. Hodes pulled his “buy” rating at $30 and has held to that neutral opinion ever since.

Now trading at $75, Hodes upgraded the shares to “outperform” this morning. Goldman clients must be ecstatic. If analyst ratings were supposed to tell investors how the stock has done in the past, then Hodes’ new rating would make sense, as the stock has indeed outperformed, rising 150% in the last 30 months. Too bad that’s not what he’s supposed to do.

Morgan Stanley Analyst Understands COF

You won’t find me praising Wall Street analysts very often, but sometimes investors can find a diamond in the rough here and there. Morgan Stanley’s upgrade of Capital One (COF) this morning, following the lender’s announced buyout of Hibernia (HIB), warrants such praise. The analyst raised the rating on COF to buy from neutral.

An upgrade in and of itself never gets me too excited. The next thing I look at is the particular analyst’s track record with respect to that individual stock. After all, if they’ve been dead wrong on a company for years, why should one all of the sudden listen to them now? A little research finds that Morgan Stanley last put a buy recommendation on Capital One shares on May 12, 2004. This bodes well for investors, as you can see from the chart below.

After getting hit hard in early May of last year, Morgan came out and pounded the table when others were fleeing the name. The buy recommendation at $63 was the right call, and I’d be willing to bet few other analysts were making the same conclusion at that time. It looks like we can add the Morgan Stanley’s Ken Posner to the list of relevant Capital One analysts.

Capital One to Buy Hibernia

Investors who closely follow Capital One Financial (COF) shouldn’t be very surprised to hear that the company has agreed this weekend to buy New Orleans-based Hibernia Corporation (HIB), a bank with over $22 billion in assets, for $5.3 billion in cash and stock. The writing for a deal like this has been on the wall for a while. Capital One, which focuses on marketing directly to customers, is seeking to boost its reach by acquiring a regional bank, opening up new avenues for growth.

From an investing standpoint, it makes little sense to bet against Capital One based on this acquisition. The company is run brilliantly, having increased earnings per share at least 20 percent every year since its IPO in 1994. Wall Street will likely sell off COF shares tomorrow, given the company is paying a 24% premium and many will likely question the decision for a direct marketing lender to spend over $5 billion for a bank with branches in Louisiana and Texas.

In such a case, investors who have missed out on Capital One’s magnificent track record thus far should consider stepping up to the plate and buying the stock on any merger-related weakness. The stock trades at only 11 times 2005 earnings, and that valuation will only get more compelling should the stock get hit tomorrow. And who knows, an analyst downgrade or two might spark enough of a sell-off that existing shareholders, such as myself, should consider adding to their positions.

Capital One Shares Crushed After 4Q Report

After blowing earnings estimates out of the water for the first three quarters of 2004, Capital One (COF) fell short last week when it reported fourth quarter profit below the consensus estimate. Shares of COF were slammed, falling 5% after the announcement. The stock also saw analyst downgrades after the earnings miss, much to the delight of shareholders, I’m sure.

The earnings miss was mostly attributable to higher than expected marketing expenses and more money set aside as loan reserves. While Wall Street seems to see this combo of unexpected news as a warning sign, that conclusion makes little sense. While seen as a financial services firm, Capital One is just as much a consumer marketing company. The better job it does of marketing to the public, the more loans it can make, and the more money it pockets.

Unless the advertising dollars were failing to provide an adequate ROI, Capital One’s $511 million in marketing spend for Q4 (which was more than Citigroup and JPMorganChase) will allow it to continue its rapid growth, hardly a bad sign. Higher loan reserves don’t indicate more difficulty in collecting debts, as some are quick to conclude. Rather, more loans outstanding require higher reserves, even when the default rates on such loans remain the same or even decline.

In the mid seventies, COF shares trade at 11 times 2005 earnings. Not bad for a company that has grown earnings per share 20 percent annually since its IPO.

Metris Continues Its Turnaround

Credit card issuer Metris Companies (MXT) continue to be a stellar performer in 2004. Shares of the once financially troubled firm have tripled this year from $4 to $12, greatly contributing to Peridot Capital’s success year-to-date. The stock pulled back to $10 after an analyst downgraded the stock, citing full valuation.

However, the shares have moved back toward the old highs as news of early debt repayment and refinancing of existing debts hit the wires. In addition to the strong operational turnaround orchestrated thus far, any interest expense reductions the company is able to secure, based on the improving performance of its loan portfolio, will serve as yet another catalyst for incremental earnings gains going forward.

With some analysts still bearish on the company’s future, combined with a staggering 24% of the float sold short, there are many reasons to think that Metris shares will continue their march higher in 2005. Contrary to popular belief, it’s not too late to get in, even at the current $11 price tag.