SECTOR SCOPE by James A. Anderson March 29, 1999

The New Allure of Wall Street Stocks
Financial-services firms are looking good again, but it's easy to get burned in this volatile sector

Why is it that brokerage and investment-services stocks have climbed 40% so far this year? Let us count the reasons: Trading commissions keep rolling in. Interest rates are low and probably wonít threaten the stock market anytime soon. Corporate mergers continue at a blistering pace, meaning that investment banking fees will keep piling up. And donít forget that the love affair between investors and mutual funds seems to grow by the hour.

Thatís a marked change from just six months ago. The third quarter had just started when the shine on brokerage stocks tarnished overnight. First came Russiaís debt debacle. Then worries aplenty cropped up over the hedge-fund high jinks of Long-Term Capital Management. Brokerage and investment stocks, which had gained 85% in 1997, went into a tailspin. A Standard & Poorís index of 11 companies in the sector slid 32% in August alone, compared with a 15% slide for the S&P 500. And though by the end of last year brokerage stocks had regained their footing, the sector ended 1998 with a tepid 11% gain, compared with a 27% rise for the broad market.

For the time being, the group can bank on solid fundamentals to maintain its recent momentum. Start with the hottest commodity: stocks. Trading volume on the New York Stock Exchange and Nasdaq rose 24% last year, and thanks to tech-stock mania has continued to run at a healthy clip in 1999. "This market has some resiliency," says Michael Schneider, an analyst with Standard & Poorís. "People are continuing to plow money into the market, which in turn should keep commission revenue strong."

NO HANGOVER. Investment banking looks like a good business to be in this year, too. According to Securities Data Corp., $386 billion worth of corporate mergers have been announced so far this year, compared with $249 billion for the same period in 1998. At that rate, M&A income will more than make up for any decline in initial public offering fees -- if indeed there's any hangover from 1998's late-summer IPO drought. "We thought that last yearís activity would be hard to repeat," says Richard J. Peterson, chief investment strategist Securities Data. "But so far, weíre charging well ahead of expectations, and the pace looks to be sustainable."

If thereís a lesson to be learned from last yearís ups and downs, however, itís this: things can change in a hurry for Wall Streetís shares. Volatility, in fact, is what has historically crimped price-earnings multiples for the group. Since 1982, investment banking and brokerage stocks have traded at a 35% discount to the market. At the end of February, however, the sector was averaging a p-e of 23.4 to the marketís 24.4.

That makes some market-watchers fidgety. True, Morgan Stanley Dean Witter (MWD), a company many consider to be the industryís new bellwether, blew the doors off analystsí expectations with a 50% earnings increase in first quarter vs. the year earlier. But there's a common perception that fee income can switch directions in no time. "If this market loses footing, thereís a good chance that these stocks will get whipsawed," says Carl Dorf, a portfolio manager for the Pilgrim Bank & Thrift Fund. "And if the market tanks, underwriting deals wonít get done, commissions will drop, and earnings estimates will get decimated, much as we saw in last year's third quarter."

RETAIL = STABLE. For investors looking at the brokerage and investment services group, the best way to guard against another slide is to invest in companies that cater to the armchair investor. Those include discount brokerages and asset-management companies with good mutual-fund offerings. As a source of fees, it turns out, do-it-yourselfers are more reliable through thick and thin than is Corporate America. "Show me two brokerage stocks, one more retail in nature, the other more traditional, and right now Iíd choose the first," says James Ellman, lead manager for the AIM Global Financial Services Fund. "Retail has a more stable base of fees."

If youíre looking for growth within the retail realm, look at online traders. Last year, 14% of all equity trades were executed online, a 50% jump from 1997. "Thereís been a shift in how people buy and sell mutual funds and stocks," says Jeff Morris, portfolio manager of the Invesco Financial Services fund. "The Internet has fundamentally changed how financial services are distributed, and thatís going to continue."

Whatever evidence you want of the Netís inroads into the brokerage business, Charles Schwab (SCH) provided proof in last year's fourth quarter. About 61% of the companyís trades were made online, or 93,000 daily, pushing Schwab's commissions to a record $375 million. Analyst John Koller of Value Line says a rough-and-tumble market should only boost Schwab's earnings and margins. "Schwab is the best blue-chip play among the Internet brokerages," says AIM's Ellman. "They have more Internet brokerage customers than the others combined." Thereís one problem: Schwab sells at a p-e of 81 times 1999 earnings. Still, Wall Street expects a 36% jump in its earnings this year and 23% in 2000, according to Zacks Investment Research. That's reason enough to stay alert and buy on weakness.

UNLOCKING VALUE. Railroad buffs might be surprised to see Kansas City Southern (KSU) mentioned in the same sentence as brokerages and asset-management companies. The fact is, though, that KC Southern is one of the hottest companies in the business, thanks to Janus, a subsidiary that is quickly developing a reputation as a top manager. New accounts are pouring in, and assets under management rose 15% in the first two months of 1999. While the companyís railway operations might be a drag on earnings near-term, Value Line analyst Jonathan B. Chappell predicts earnings growth of 24% and 16%, respectively, this year and next. What's more, management is intent on finally separating the two businesses, a move that would unlock the value of its asset-management operations. KC Southern stock could fetch as high as $60 this year vs. the $53.69 it closed at on Mar. 26, says Invesco's Morris.

If thereís a value play in the group, itís Alliance Capital (AC), a subsidiary of Equitable Life that manages both institutional money and a roster of mutual funds. Alliance, a master limited partnership, yields a healthy 6.4%, paying out most of what it earns to shareholders. The stock trades at a p-e of 13 times 1999 earnings. Pilgrimís Dorf says the companyís funds have done well, and he thinks Alliance could post average annual earnings growth of 12% to 15% the next few years. And thanks to its sizable dividend, the stockís downside should be limited, says Dorf.

Perhaps the best performing of the pure Wall Street mutual funds is the Fidelity Select Brokerage & Investment Fund (FSLBX), which is up 14.61% so far this year. Though it posted a total return of just 5.67% in 1998, the fund has averaged a total return of 35.20% over the past three years, and 25.55% over the last five.

James Anderson who teaches journalism for the City University of New York, writes Sector Scope every other week for Business Week Online

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