It's Not the Time to Go for Brokers

In these volatile times, call your broker. But don't be tempted to buy your broker.

Pure-play brokerage stocks -- like Goldman Sachs (GS), Morgan Stanley (MWD), Lehman Brothers (LEH), Bear Stearns (BSC) and Merrill Lynch (MER) -- have plunged since the Sept. 11 attacks and appear cheap -- at least superficially. But while one or two of these names, perhaps Morgan Stanley, could rally a smidgen from there, the others are either going to fall from this point or stagnate at current levels. Most vulnerable to a further slide is Goldman, which still looks egregiously overvalued.

After the terrorist strikes, brokerages have had to deal with business disruption, a dearth of new issues and M&A opportunities, tanking stock indices and a grim economic outlook. Sure, a lot of this has been factored into stock prices. And some of the brokers are getting to be as cheap as they were in 1998, after the Long-Term Capital Management emergency. Goldman trades at 13 times expected 2002 earnings. For Merrill, this ratio is 12, for Morgan Stanley 10, for Bear Stearns it's only nine and it's a mere eight times for Lehman.

Price-to-book-value makes these names look even more alluring. Bear trades at only 0.8 of its book value, and Lehman 1.4 times. Merrill's price-to-book ratio is 1.5, while Goldman's is 1.8 and Morgan Stanley's is 2.2.

But don't be wowed by these numbers. I would contend that these levels are slightly above where some of these brokers should trade, even in good times.

It was absolute madness for brokers to trade over 2.5 times book or sport P/Es in the high teens or low twenties. The big drop in earnings we've seen this year proves that these firms are essentially hedge funds, and were absurdly leveraged to the New Economy.

Now there are two dangers. Most immediately, with an extreme market debacle upon us, it's possible that some of these firms are seriously wounded in ways that have yet to be divulged. Longer term, business will never be like it was in 1999 and 2000. Remember how the mighty Goldman pushed Webvan?

As a result, it's also extremely hard for the brokers to achieve the sort of earnings analysts are expecting for 2002, so the P/Es stated above are highly questionable. Meanwhile, if you remove intangible assets from a book value calculation, some of the brokers don't look cheap at all. For example, Goldman is trading at around 2.2 times book if you use tangible book value. That's way too high for a company that will struggle to make a double-digit return on equity over the next two quarters.

Goldman is looking particularly vulnerable because M&A is going to be very dry for perhaps as much as two years, in my view. Sure, that drought's also going to hurt Morgan Stanley, but don't forget that Morgan also has asset management and credit cards, which provide a measure of stability in down periods.

So what about Lehman? What to make of its very low valuations? To be sure, people have found over the past five years that it can be dangerous to bet against Lehman. It's managed to prove its doomsayers wrong again and again. But if it weren't for the late '90s hyper-bubble, it might've found it a lot tougher to stay independent after the stresses of 1998. And look at the sort of business it did to make money in the ensuing bubble. For instance, it was a big player in the collateralized debt obligation (CDO) market, something it boasted about in its 2000 annual report (page 18, for the curious). Remember, it was CDOs that got American Express (AXP) into big trouble. Not many of those are going to get done.

Bottom line? You could go broke buying the brokers -- even here.

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