Investment Banking Winners & Losers in Early 2013

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There is no industry more wild, crazy, or fun to look at then those specializing in investment banking. This ultimate cyclical industry has become a tad less cyclical when many of the remaining large players became banks in order to qualify for government bailouts in the troubled times late last decade. As banks, and subject to higher regulatory scrutiny and capitalization rules, earnings have moderated their erratic swings somewhat. I am focusing today solely on companies whose revenue focus is trading market making and underwriting. Some large commercial banks, especially JPMorgan ChaseCitigroup and Bank of America have investment banking arms, but those sorts of institutions are not today's focus.

By most measures, Goldman Sachs (NYSE: GS) is the largest investment bank in the country. Over the past ten years, annual revenues have ranged from a high of about $88 billion to a low of $23 billion, and profits have ranged from over $13 billion to just over $2 billion. 2012 turned out to be a good, yet not a great year. The second half of the year was boosted with a number of large debt issues, as many are leery that long term debt rates will hold at this low rate forever.

Largely as a result of this increased activity, along with a strong stock market, Goldman Sachs reported fourth quarter 2012 earnings of $2.9 billion, or $5.60 per share, swamping analysts' expectations of $3.66 per share, and roughly tripling the $1.84 per share reported in the fourth quarter of 2011. For all of 2012, earnings came to $7.5 billion, or $14.13 per share, nearly tripling the 2011 total. The 2012 profit represented a 10.7% return on shareholders' equity, which while substantially better than 2011's 6.3%, hardly compares to the 25% or more return on equity achieved during Goldman's Sachs’ salad days six to eight years ago. That return on equity ratio is important to management, as bonuses are tied into increasing that profitability measure. Due to increased regulatory scrutiny from Goldman Sachs being a bank, those days of 20% - plus returns on equity are likely a thing of the past.

Looking into 2013, continued uncertainty in the domestic economy, along with deepening malaise in Europe do not bode well. Goldman Sachs stock price is up some 35% over the past year, and is touching 52 week highs as I write this. I agree with analysts who see earnings more or less treading water for the next couple years, and I believe the stock has gotten ahead of itself a little bit. Goldman Sachs is the premier company in the investment banking niche, but with its 1.65 PEG it hardly excites me at this price and absent a pull back to 120 or below, I would not be a buyer of Goldman Sachs.

Morgan Stanley (NYSE: MS) has a much better PEG than its larger rival, at 0.58. It also has a slightly more optimistic analyst rating, at 2.5 compared with Goldman Sachs' 2.7. But a lot of that profit growth is coming on the heels of relatively depressed 2012 annual earnings of $0.13 per share. The reason for that low PEG is that from the depressed profit levels of 2012, Morgan Stanley has nowhere to go but up.

How far up can we expect Morgan Stanley to go, earnings wise, over the next year or two? One thing is that this big investment bank has been hemorrhaging DVA adjustments in recent quarters. Those should even out as the economy shows signs of growth and interest margins spread. But as for earnings from operations, Morgan Stanley is more reliant on the North American economy than is Goldman Sachs, and I do not see a huge upsurge in domestic investment banking activity going forward. With the stock price up 30% over the past year, I don't see much upside for the stock price. I am inclined to pass on Morgan Stanley as well.

I do think we find better values in second tier investment banks. One I like a lot right now is Piper Jaffray (NYSE: PJC). This company offers investment banking services, but on a smaller scale than its larger peers. It had a rough 2011, so its 2012 earnings of $41.3 million, or $2.26 per share represented a nearly threefold increase from 2011. I am confident there is plenty more growth in store. The company will benefit from jettisoning its money losing Hong Kong division, and is positioning for growth in the eastern United States, outside of its traditional western footprint. The company is forecast to have nearly 20% profit growth over the next five years, driving its PEG down to 1.0. While the stock price is up 80% in the past year, there is plenty more growth available and I see this as a winner in the investment banking sector for the next 12 to 18 months.

Finally I wanted to take a look at Raymond James (NYSE: RJF), which spent much of 2012 digesting the purchase of Morgan Keegan from Regions Financial (RF). In its first quarter of its fiscal 2013, which ended December 31, 2013, revenues of $1.11 billion were up 41% from the first fiscal quarter of 2012, and profits came to $86 million, or $0.61 per share. The per share amount was up 15% from the year ago quarter. I expect as Raymond James gets costs from the Morgan Keegan addition under control that its margins will spread, and, barring a stock market collapse, expect earnings up roughly 30% from 2012, to about $3.00 per share. All of this would be terrific news, if the stock had not already climbed 28%, which while considerable, is less than other stocks covered in this article. That, along with a reasonable PEG of 1.04, makes Raymond James an attractive long term holding.

StockCroc1 has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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