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.