From a 52-wk high of $27.12 on Jan 3, 2011, Jefferies Group's (JEF) shares have traded to an intraday low of $9.79 on November 3, 2011 before recovering to near $12 by the end of the day. The destruction of value has been immense, but should be put into to context of the broader population of investment banks. It is my thesis that the concern about Jefferies is not so much fundamental as it is related to the major decrease in market value over the past six to nine months.
Stepping back for a moment, it is useful to consider that Jefferies is almost exclusively a wholesale investment bank focused on capital markets with very little in the way of retail operations. This sets it apart from Raymond James Financial (NYSE:RJF), sometimes offered as a comparable which has derived only about 27% of its segment income from capital markets in the first nine months of its current fiscal year and another 56% coming from its private client business and the balance coming from asset managment. This does not make Jefferies a better company or its stock a better investment, in fact Raymond James may very well be in a better part of the financial services space than Jefferies, but the point is they are not comparable in terms of operations.
A much more appropriate comparison would be to another investment bank that derives the majority of its income from capital markets and although the scales of operations are different, Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) serve as the best models, especially the former since Morgan Stanley retains a large retail operation. The following table shows the price to book ratios of the three firms as the close on November 3, 2011:
If we look at the share price of Jefferies and Goldman Sachs , we see some broadly consitent trends over the past five years:
From the bottom in March 2009 to today, the two companies share price performance has been remarkably similar although difficult to quantify precisely due to the amount of volatility at that time and now -- picking one start date or another can change the answer dramatically. Although share performance has been similar choosing today as an end-point, Jefferies outperformed by quite a margin during the interim. If we select March 9, 2009, when the S&P closed at 676, the Jefferies share price went up as much as 250% and remained up at least 200% until April of 2011 compared to Goldman Sachs which increased by less, peaking at a 150% increase and remaining about a 100% increase until the April 2011 timeframe.
Was the outperformance of Jefferies stock ever warranted? The following table shows some comparitive financial metrics for Jefferies and Goldman Sachs at their respective 2010 year-ends:
Most financial institution analysts would agree that price to book is strongly related to returns on equity. I would add that returns on assets shows how risky the returns on equity are; a lower return on assets implies a company needs more assets earning a lower return to generate the same return on equity. In this case I don't see one firm having materially more risk on this metric, but one clear relationship does emerge and that is the lower level of returns on equity at Jefferies and the higher price to book ratio which is the opposite of what one would expect.
It is my view that the market was valuing Jefferies shares higher (and in fact perhaps overvaluing them) because there was a belief that::
1) the company could take market share due to troubles at other banks;
2) its niche, namely the middle market, would perform better over the coming years; and
3) ts revenue stream, which is more investment banking than sales and trading, was more sustainable and stable than other banks more reliant on the latter.
It is beyond the scope of this article to challenge all these market views in detail, but my own view is that even to the extent they are true, the impacts on growth and stability are probably over stated. I will add that in my view only the first point is marginally important and the third point especially is flatly wrong and shows a misunderstanding of the concrete reality of the competitive dynamics in the investment banking business.
While the story up to now may give some insights, we still must address the key question of why does this matter. After all, the worry about Jefferies is sovereign exposure and not valuation, right? Well, my view on this matter is that the real issue investors are confronting today is not the fundamentals of the company, but the fact that the stock has fallen by 65% from the high. Seeing the destruction of wealth in the equity value, investors are now starting to obsess over various aspects of the business -- put differently, the tail is wagging the dog.
However, I think the concern is misplaced. Jefferies is doing what capital market investment banks do -- for example they hold gross exposures to a wide range of securities in order to serve their clients. It's the reason they exist in the first place and if done with care it is both a socially useful business and one that can generate adequate returns for its shareholders.
The stock has come down to earth because Jefferies is confronted by the same economic dynamics as every investment bank and its stock price likely should never been at $27 to begin with given all the fundamentals. The current share price may be a little low, but it is broadly consistent with the underlying profitability of the firm, comparable with the company's erstwhile competitors and therefore I don't think investors should read too much into the valuation. This isn't to say investment banks don't have risk -- in fact, I believe all financial institutions have very unique non-linear risks in the development of their business over time; the point here is that the very dramatic fall in Jefferies' share price should be seen more in the context of a company's whose stock was too highly valued, rather than as a signal that the company is now distressed.
Disclosure: I am long JEF.