Investment Banks Look Good in '08

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Includes: BSC, C, GS, IAI, JPM, LEH, MER, MS
by: Markos Kaminis

"Potter is buying!" exclaimed Jimmy Stewart in “It's a Wonderful Life.” Goldman Sachs (NYSE: GS) isn't selling either; Goldman is buying - buying up Cheyne Finance, the marquee, troubled SIV portfolio. Leading a group of investors, clearly Goldman is once again on the right side of a deal, gobbling up bargains just like Potter.

I believe this was some of the most important positive news of late, and offers further hope for the troubled credit markets and financial system. It also provides a louder buy signal, in our opinion, for investment banks on the cheap. It looks to me like the non-binding agreement hinges on the investors' ability to negotiate reinvestment opportunities for the creditors of the company. Goldman is looking bright, as usual, as it does not even seem to own yet what it would turnover for profit, if I understand correctly.

Jim Cramer spoke wisely when, last month, he announced that Goldman Sachs is a buy. While my only concern is the timing, and the possibility of profit-taking in GS after its outlier performance of ‘07, I have to agree the investment banks on the whole look attractive. Jim said Goldman would benefit most from the coming new capital wave driven by sovereign investment funds, and I agree it should do well in garnering that business.

In another important announcement last month, Saudi Arabia indicated it would be creating a sovereign wealth fund that could have more than $900 billion to invest. With its neighbors in the Middle East looking increasingly to international investment, it appears a competitive nerve has been engaged in Saudi Arabia. The Saudi coffers have been operating under a mandate to invest locally, while other Saudi institutions, individuals and the royal family have not limited themselves in this manner. Besides bragging rights, there’s an important benefit to diversification outside the politically strained region that the Saudi's and others cannot ignore.

Goldman’s valuation is not rich when compared to its peers, based on analysts' estimates. Now that it’s survived Q4 without a charge, I can give the all clear for long-term picking at GS. However, I remain concerned that some profits could be taken on the stock in early '08 and placed into other beaten down shares of GS's rivals like Merrill Lynch (NYSE: MER), Morgan Stanley (NYSE: MS) and Citigroup (NYSE: C). I am still shy about touching Citi, with the dividend at risk, but Citi should also be a clear beneficiary of Saudi investment, considering Saudi royal ownership interest in the firm. Also, the table below seems to indicate that some of the dividend risk is priced in to the shares.

In any event, this looks like an interesting industry to consider for '08. Judging by valuations versus historic levels, as seen in the table below, brave investment now looks wise. As I’ve pointed out in the past, this looks like another opportunity to benefit from inflection point recognition, or for the layman, being in a stock in anticipation of changing trends. The reason greater returns can be had in a turn around story is because of the risk of error in that prediction of change. Look at it this way, it’s harder to stop a moving object and reverse its kinesis than it is to maintain momentum. It’s also harder to predict where that first object will be at any given time, as compared to the second.

* Prices used from close Jan. 9, 2008

** Average P/E generated from average of high and low P/Es over five years with one exception BSC, where only 9 data points were available instead of 10.

I looked at the average P/E ratio** over the five years ended in 2006, and took the group’s average, applying that multiple of 13.5X to the forward year earnings estimates of each firm to generate a price target. I then compensated for likely asset sales in this group, and their likely future impact upon forward earnings, by taking a 20% cut off the target price generated with the average industry multiple alone.

If I had used company specific multiples, it would have offered a lower multiple for Goldman, which I believe deserves a higher multiple than peers due to recent performance. These targets only apply if the industry is indeed undervalued due to the extraordinary circumstances of 2007. If the industry can move toward mean valuation on the back of sovereign wealth investment, then we could extrapolate appreciation potential as seen in the far right column. Not bad if it plays out... In order to avoid company specific risk, while still benefiting from what looks like industry potential, one might buy into a relative ETF.

One side note... Analysts often prefer to use price-to-book to gauge the industry because of the cyclical nature of earnings. However, with book value in question at many of these firms, we’re not sure the market would view the metric more valuable now.