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No slowing down for investment banks
Brokerage stocks have soared in 2005 but there's still plenty of steam left: analysts.
November 14, 2005: 4:22 PM EST
By Shaheen Pasha, CNN/Money staff writer

NEW YORK (CNN/Money) - If the stellar run in investment banking stocks in 2005 is beginning to make you nervous, relax. The ride isn't over yet.

It's been a volatile year for investment banks, which got hammered by dismal second-quarter trading activity but managed to rebound sharply and surprise Wall Street with unusually strong results in the third quarter -- courtesy of busy summer traders who opted to stay on the trading floor rather than head to the beach.

That's translated into some hefty stock gains. Lehman Brother's (Research) stock price is up about 50 percent over the last year while Goldman Sachs (Research) shares have jumped about 25 percent and Merrill Lynch (Research) has gained 16 percent.

But can brokerages manage to hold on to or add to those gains in the face of climbing interest rates, which typically squeeze profit margins for financial firms as the cost of money climbs?

In a word: yes, according to a number of Wall Street analysts.

Dick Bove, financial analyst at Punk Ziegel & Co., said the major investment banks are still trading at a significant discount to the market with brokerage stocks currently trading 11.5-times earnings while the overall Standard & Poor's index is trading 17-times earnings.

He expects stocks to climb between 15 percent to 17 percent over current valuations in the next 12 months.

Trading still hot

He said trading will continue to be strong driver of growth and while volatility is an inherent part of the business, it's unlikely that a major slowdown in 2006 will curb momentum.

"50 percent of profits come from trading and the recognition is growing that trading should grow 15 percent to 17 percent a year," Bove said. "There's a growing recognition among investors that trading isn't like gambling in Las Vegas but is a core business of the world economy."

He said investors are more willing to bet that companies will bounce back from a large trading-related loss in a quarter. And if 2005 is any indicator, that's a pretty good bet.

In the second quarter, investment banks across the board bemoaned the impact of weak fixed-income trading.

Goldman Sachs, for instance, reported that its second quarter net revenue in it's proprietary trading and principle investments business -- its largest unit -- fell 20 percent to $1.52 billion. But it more than made up for those losses in the third quarter, posting revenue from that business of $2.63 billion -- an 88 percent year-over-year jump and an 80 percent increase over the second quarter.

Still, some analysts remain cautious about continued growth in trading, given the rising rate environment.

Brad Hintz, equity analyst at Sanford C. Bernstein & Co., said investment banks should continue to have a solid run in 2006 since commodities trading and stock trading are likely to remain strong.

But he said institutional investors may become more cautious about fixed income trading given rising rates. "Fixed income is the sumo wrestler of the trading world," he said. "No other trading business comes close" to generating the same type of profits.

He said, historically, rising rates put pressure on bond trading.

He said companies with exposure to European fixed income markets may still do well in this business but he said companies, such as Bear Stearns (Research), which has 39 percent of its revenue from fixed income and debt underwriting, may experience a slowdown in growth next year.

Retail investing, M&A get nods

But Hintz was bullish on the prospects for retail investing in 2006, which could translate into higher stock gains for a company such as Merrill Lynch, which accounts for 38 percent of its revenue from retail sales.

"The retail investor has been hiding in the weeds since the decline in 2001 but they are steadily coming back with trading volume up 59 percent year-over-year in retail," he said.

He added that retail tends to pick up at the late end of the fixed income cycle and he expects the mergers and acquisition cycle to be entering its latter stage as well.

Still analysts are fairly upbeat about the potential in M&A acquisition activity, despite higher interest rates which can put a damper on the business by making financing more expensive.

Punk Ziegel's Bove said that M&A continues to look strong, especially as companies grow and need capital in the Far East. With 13 percent of revenue from its M&A business, Goldman Sachs appears to be the best bet as analysts expect M&A to trend higher in 2006.

But just how far can investment banking stocks go?

Historically, brokerage stocks tend to start to climb in the 25th month after the beginning of a bull market and run strong until the 37-month mark, said Hugh Johnson, chairman and chief investment officer of Johnson Illington Advisors.

"As you move into the mature stages of the bull market, investment banking fees begin to climb with more activity in M&A and IPOs," he said. "That's the bread and butter of these companies and what we're seeing right now is the normal stage for them to do well."

He said the stock market overall tends to pull back about three years into a bull market as investors worry about a prolonged pullback.

Given that Wall Street generally pins the start of the current bull market to March 2003, Johnson said investors may start to become cautious about investment banking stocks by the second quarter of 2006.

Punk Ziegel's Bove doesn't own shares of the companies mentioned and Sanford Bernstein's Hintz' owns shares of Morgan Stanley.

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If investment banks are a buy, what about insurance? Find out here.  Top of page

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