Price/Book Not So Helpful in Assessing Broker-Dealers

Much ink has been spilled in the last few weeks by pundits suggesting the Broker-Dealers provide unusual value. Maybe. But maybe not. Few times in the last year were many skeptics willing to go out on a limb to suggest these stocks were expensive at 2 to 2.5 x book value or more. Yet the shorting opportunity presented itself with lightning speed, and any value investor worth his salt knew the ROEs were not only unsustainable, but also hard to imagine achievable without unusual and substantial risks.

What can be imputed from the current valuation? Under normal circumstances, one would say that for a stock like Bear Stearns (BSC) at BV, the market is assuming that the company can barely earn its cost of capital for the next few years; for the years beyond that, it's easier to guess that the answer is a solid NO.

But the current circumstances are far from normal. CDS spreads at the recent peak suggested the broker/dealer paper was being priced near junk, yet there was Bill Gross buying GS paper in the heat of the moment. The reality is, no one knows what the true cost of capital is, since it is (and will be for the foreseeable future) a moving target. No one knows how much of the liabilities are priced off of LIBOR, or Fed Funds, or Treasuries or anything else for that matter.

Off balance sheet entities? SIV's are the old SPV's, accounting creations that allow you to use even more leverage without telling anyone.

Earnings power you say? Even broker/dealer scholar Brad Hintz (Bernstein analyst covering broker/dealers and former CFO of Lehman), who ought to know more about the business than any analyst out there, only very infrequently gets his earnings estimates within 20% of reported numbers.

Why bother trying? By all accounts, the stocks offer dead cat bounces, sold heavily on rallies 10% off the lows. At worst they are discounting a cyclical global decline in financial stocks that will lead to a multi-year de-leveraging, comparable to the GSEs, Japan Inc, mega cap US banks like C, JPM, and their hedge fund brothers.