Brokerage houses are in a position than banks to take advantage of the current market and economic environments, according to Alison A. Deans, an analyst at Smith Barney Shearson Inc.
Ms. Deans has been a brokerage analyst for eight years and a money-center bank analyst for 3 1/2. Her top picks among banks are Bankers Trust New York Corp. and Chemical Banking Corp., but she is biased toward brokerages such as Merrill Lynch & Co., and Morgan Stanley & Co.
A low-rate, slow-growth environment favors brokerage business because they are asset managers and traders. In addition, she said Merrill and Morgan Stanley have a detailed knowledge of the expenses and profitability of their business lines, which only Bankers Trust among money-center banks can match
Investors have begun to embrace brokerage stocks. In the past two weeks, brokerage stocks are up 10% to 15%, said Ms. Deans. Bank shares have been sluggish. On the year, brokerage stocks are up 40%, while bank stocks are up 9%.
Q.: Why do you prefer brokerages to banks?
DEANS: It has been a great couple of years for recovery stocks, but over the next couple of years, the way to play financial services is to invest in those companies that will show meaningful growth that is genuine growth, not recovery growth. Bank stocks have been strong because of earnings recovery, while brokerage stocks show great revenue potential.
To be effective competitors in the financial service industry over the next couple of years, companies have to be low-cost producers, profitability oriented, and very competitive. We see more of that in the brokerage industry.
There's some skepticism about banks. Have these companies genuinely changed? To some degree, they haven't proven themselves yet.
Q.: What makes this a better time for brokerage?
DEANS: We think loan growth is going to be relatively sluggish. We also think that deposit rates can stay this low for a long period of time, fueling a tremendous amount of money moving out of short-term investments - bank savings accounts and money-market accounts - into longer-term investments.
Brokerage firms and asset managers are the primary beneficiaries of that. Merrill Lynch, for example, has proven to be one of the most effective asset gatherers worldwide, with over half a trillion dollars in assets.
Q.: Are brokerages more cost conscious than banks?
DEANS: Merrill created a management information system that allowed them to monitor all the expenses tied to businesses by customer and by product.
All of a sudden, a person running the dealer desk was aware of the cost of all those phone lines, all the support staff, all the office space. They could make decisions on that information. Morgan Stanley and Bear Stearns and PaineWebber have similar systems.
Merrill Lynch disappointed shareholders all during the 1980s, when they never brought the benefit of being No. 1 to the bottom line. At the height of the bull market in the brokerage industry in the 1980s, Merrill only achieved a 15% return on equity. Morgan was at 30%.
Now Merrill has a 30% return on equity, and the stock has quadrupled off its low.
Of the banks I follow, only Bankers Trust has that type of system. Bankers Trust focuses on expenses. They were cutting costs when their earnings were healthy several years ago. They are expanding headcount slower than their businesses are growing.
Citicorp sounds as if it is doing something along those lines. The same with Chemical.
If Citicorp does what Merrill Lynch did, then the shares are the investment of a lifetime. If they don't, you've made your money in that stock.
Q.: Has Chemical become a new company?
DEANS: What has impressed me about Chemical has been the top-line growth.
During a time when there should have been disruption from the merger [with Manufacturers Hanover Corp.], they have been experiencing net growth.
Chemical's loan portfolio hasn't suffered the same degree of runoff as we've seen with the other national lenders. They've increased their middle-market market share by close to two percentage points, and their retail market share is up close to a percentage point.
That suggests to me that the merger has been pretty well executed, particularly because this is a tough environment for top-line growth for the industry.
The other important aspect is that they are clearly a top player in the wholesale businesses - capital markets, global trading, loan syndication. They are a quality player. And I've found that these trading profits are far less volatile than some of the other firms'.
In addition, their profitability [return on equity] is in the mid-teens right now, and even if you fully tax it, it is in the low teens and approaching mid-teens.
I think Chemical could be a $50 stock in 12 months. [The stock was trading at $40.125, off 12.5 cents Thursday afternoon.]
Q.: But some investors are still skeptical, right?
DEANS: There's still a tremendous amount of skepticism out there that this is the same old management. Will they be able to cut costs? Will they ever become a strong player in the banking business?
Chemical still gets a money center multiple. The price to book is 135% versus 175% for a regional. The P/E on this year's earnings is nine times. The average regional's is 11-12 times earnings.
People are not seeing a dramatic decline in expenses. Chemical came through with the cost cutting they promised, but nothing more.
Q.: What do you like about Bankers Trust besides cost control?
DEANS: I think they are an underappreciated company.
If you look at the price-to-book multiple and the P/E multiple, J.P. Morgan & Co. does better. I think Morgan is a great franchise. But the difference is not as wide as the difference in the stock multiples suggests.
I think over the past several years, Bankers Trust has had less volatility in per-share earnings, higher return on equity, and the mix of revenues has been less from investment gains than Morgan. Bankers Trust gets a much higher percentage of earnings from trust fees and has much slower expense growth.
Bankers Trust does not focus much investor attention on those trust businesses, but they are one of the largest master trust banks, one of the largest banks in 401(k) plans, one of the largest domestic players in passive asset management. These are high profit-margin businesses.
My price target: low 90s. [The shares traded at $78.875 Thursday afternoon, off 37.5 cents.]