Magazine

Watch Your Step with Wall Street Stocks


The Federal Reserve has cut short-term interest rates below 2% for the first time in 40 years. Investment banks are rolling out corporate bonds at record speed. Multibillion-dollar initial public offerings of big names such as Prudential are back in vogue. And financial-services firms have escaped Enron Corp.'s (ENE) collapse relatively unscathed--so far. Is it time to sink your spare cash into Wall Street stocks?

Tread carefully. After posting dismal earnings for the fourth quarter, analysts expect brokers' earnings to drop 7% in 2001 and then jump 19% in 2002, vs. a 15.5% rise in the earnings of Standard & Poor's 500-stock index companies, according to Thomson Financial/First Call. But that assumes the economy will rebound by mid-2002. "If we get back into a recovery, brokerage stocks probably make sense," says First Call research director Charles L. Hill. "But if you're worried there is too much optimism in the economy, then all bets are off. This is a fairly high-risk situation."

Too much confidence may still be embedded in many securities firms' valuations. Trading at 14.2 times 2002 earnings, vs. their historical average of 13.9, brokers command a slight premium, says Goldman, Sachs & Co. analyst Richard Strauss. Yet Amy Butte, analyst at Bear, Stearns & Co., cautions that brokers may have to get by on a lot less business, slash their head count by 12.5% from their levels at the start of 2001, and make do with a 15% return on equity, vs. an average of 18% during the past two decades. "Investors have to be careful that the earnings growth expectations are in line with valuations," Butte says.

Investors with iron nerves should check out those securities firms better positioned for a downturn than may be recognized. Henry McVey, analyst at Morgan Stanley Dean Witter & Co., likes Lehman Brothers Inc. (LEH) partly because it is trading at a discount to many of its peers. "Lehman has built a sturdier equity franchise than most investors perceive," says McVey.

Big believers in diversification should look at Citigroup (C). It is the only financial services firm that analysts agree has truly cracked the code of selling advice on everything from potential merger partners to insurance. Yet its stock price is trading at only 14.2 times estimated 2002 earnings, vs. its historical average of 18.3.

Another way to navigate the sector is to stick with players who dominate higher-margin businesses such as investment banking. Goldman Sachs (GS) and Morgan Stanley (MWD) have been particularly hard-hit by the drought in lucrative equity underwriting and mergers in 2001. But by the same token, when the economy picks up, they could rebound most sharply.

Really gutsy investors might want to take a chance on Merrill Lynch & Co.'s (MER) turnaround. Right now, Merrill is making a painful overhaul of its operations, reducing its head count by as much as 15%. It's not yet clear whether those cuts will enrich Merrill's franchise. Still, some analysts are placing their faith in Merrill Lynch President Stan O'Neal to reengineer the brokerage correctly. If that happens, present weak expectations could be replaced by windfall profits. With the combination of cost savings and a potential improvement in the brokerage business over the next 12 to 18 months, "you could have something quite powerful in terms of improvement in return on equity and margins," says Guy Moszkowski, financial services analyst at the Salomon Smith Barney unit of Citigroup.

Longer term, some securities firms are selling at attractive prices. But the harsh new reality of slower growth for an industry facing a potential shakeout has not yet been fully reflected in many firms' prices. Investors who plunge in now should realize it could be awhile until they see a return. By Emily Thornton


Reviving Keynes
LIMITED-TIME OFFER SUBSCRIBE NOW
 
blog comments powered by Disqus