Bear Stearns is gone. Lehman Brothers (LEH) is fighting to stay afloat as an independent company. Merrill Lynch (MER) is right up there with the investment banking operations of Citigroup (C) as the domestic firms with the most bad mortgage exposure. Goldman Sachs (GS) is seen as the cream of the crop, but they surely are being dragged down with everyone else too, even though they reported pretty good numbers Tuesday morning.
Although the investment banks are down a ton, I have not been taking the contrarian side of that trade and scooping up any shares. And I do not plan to do so either. There are two main reasons I just do not feel comfortable investing in pure investment banks.
First, the highest margin products for these firms have either peaked this cycle already or have disappeared completely and will take years to recover. Structured products carried the highest levels of profitability, but many are no longer going to have a place within the industry. Others will take months or even years to regain their luster.
M&A activity has also peaked with the private equity boom. Deals are still going to get done, but 2007 was the peak of the cycle. As a result, overall margins at investment banks will decline as they de-lever and no longer sell as much of their highest margin products.
Second, the balance sheets at these investment banks really are black boxes from an investor perspective. Even though disclosures have improved in many cases over the last few quarters, we really do not know exactly how these firms make their money and what they are holding. Their financial statements break out categories such as sales and trading or principal transactions, but that really does not tell us what exactly they are selling and trading. Balance sheets remain quite opaque.
Without transparency and high margin products to keep profits growing [ROE's will decline as leverage comes down] and investors informed, it is really hard for me to justify investing in these firms that have no core banking deposits like traditional banks do. The Wall Street business model is just a lot more complicated than a traditional bank. As a result, the latter group is far more attractive to me when bargain hunting in financials.
Disclosure: No positions in the companies mentioned at the time of writing
Investment Banks: Through a Glass, Darkly
Chad Brand is the founder and President of Peridot Capital Management LLC, a Seattle-based independent registered investment advisor (RIA), specializing in highly customized investment management services for individuals and families. We work with our clients to deeply understand their goals and help craft and execute personalized plans in order for them to reach their short, intermediate, and long-term financial objectives. Our company’s goal is to provide our clients with a financial professional who acts as their personal financial concierge, providing the kind of unique client relationship that makes them feel like they are the firm’s only client. This philosophy is in stark contrast to the country’s largest investment firms, which often put sheer size and profits above their customers’ interests.REGULATORY DISCLOSURES:Peridot Capital Management LLC is a registered investment advisor in the states of Maryland, Missouri, Texas, and Washington. The firm may not transact business in states where it is not registered or exempted from registration. In most states, the firm is exempt from registration if it has fewer than six clients who are residents of that state. As a result, Peridot Capital Management LLC is free to provide services to residents of every state and applies for registration as required. Individualized responses to persons that involve either the effecting of transactions in securities, or the rendering of personalized investment advice for compensation, will not be made without registration or exemption. The content published represents the opinions of Mr. Brand and he and/or his clients may hold positions in securities discussed. Such positions will be disclosed at the time of publication, although subsequent changes to those positions will be made without notification. The information contained in posts is believed to be accurate when published, however, mistakes could be made. As a result, do not rely on the content exclusively for your investment due diligence. The commentaries published do not way constitute investment advice, as readers’ personal investment goals and risk tolerances will dictate which investments are appropriate for them. Our posts are meant to be one of many sources for readers to conduct their own research into specific investments. Consult an investment professional before acting solely on information provided. If you do not have an investment professional to work with, you may contact Peridot Capital Management LLC directly.