Keep Your Eye on the I-Banks

The investment banking index's relative performance vs. the market has slumped, though S&P still sees positive fundamentals for the group

by Sam Stovall From Standard & Poor's Equity Research

52-Week Relative Strength—Investment Banking & Brokerage

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The S&P Investment Banking and Brokerage subindustry index was one of the stellar performers in 2006, jumping 39% compared with the S&P 1500's climb of 13.3%. Since early this year, however, the 12-month relative strength for this group has slumped. Is this relative price decline only representative of a near-term digestion of two years' worth of above-average gains, or should we be concerned about this group's ability to increase its solid earnings-per-share (EPS) growth trend?

Take a look at the accompanying relative performance chart. As a reminder, the blue line is the subindustry index's rolling 52-week price performance compared with that for the S&P 1500. Any point above 100 indicates sector outperformance vs. the S&P 1500 over the prior year, while points below 100 indicate sector underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's 17-year mean relative strength.

Tempered Enthusiasm

Analyst Matthew Albrecht covers the investment banking and brokerage subindustry for S&P, and has a positive fundamental outlook on the group. Despite quarterly volatility, he views the subindustry group as a growth industry and very leveraged to a strong economy. Albrecht sees increased profitability as higher-margin equity capital markets and merger-and-acquisition activities rise from cyclically depressed levels. S&P also expects continued volatile growth in commission revenues, customer margin lending, and merchant banking.

Albrecht's enthusiasm is tempered somewhat by an inverted yield curve—where short-term interest rates are higher than long-term ones, thought by some observers to be a signal of impending recession—and potentially widening credit spreads, which S&P expects could negatively affect fixed-income underwriting and proprietary trading revenue in 2007. Generally, S&P thinks stock market gains in recent years have contributed to improving investor confidence, which has resulted in higher capital market activity, commission revenue, and asset management fees. Albrecht believes that most stocks in this industry should trade at premium multiples based on what we see as improving investor confidence, despite slowing economic growth.

Despite difficult comparisons with 2005, various companies in the industry had record results in 2006. Revenues from investment banking remain strong, due mostly to M&A advisory fees. Commodity and credit product transactions have helped fees from the trading desks, in Albrecht's view, at the larger brokerages as traditional equity and fixed income trading volume declined somewhat. On the other hand, the online brokers saw typical seasonal volatility, but their focus shift toward asset gathering has lent some measure of predictability to results.

Cyclical Rebound

Reflecting on the size and number of investments many of these larger companies have made abroad to gain a larger piece of developing economies, S&P expects the merchant banking business to have a pronounced effect on results in the coming years. In light of improved profitability, Albrecht expects the companies to increase head count and compensation over the next few years, while maintaining operating leverage. He sees increased price competition among brokerage firms and expects online discount brokers to continue to take market share from full-service brokers.

Based on S&P's expectations for a cyclical rebound, Albrecht views the industry's longer-term outlook favorably. Through Feb. 23, the S&P Investment Banking & Brokerage index advanced 1.4%, vs. a 2.3% gain for the S&P 1500. Despite the group's strong performance, the analyst believes valuations remain attractive with the group trading at a discount to the S&P 500, but near its 10-year historical average p-e multiple.