Skip to main content

Investors seeking exposure to the brokerage sector often gravitate toward giants such as

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. Report

and

Lehman Brothers

( LEH). However, we believe there are some highly attractive investment banks in the small- and mid-cap space that may offer greater upside potential for risk-tolerant investors.

These smaller firms tend to have fewer business lines than the giants; this increases their risk profile but also increases the profit potential. For example, poor results in trading from a major bank may offset strong results in mergers and acquisitions (M&A). With that in mind, we believe investors would do well to look at two companies: One remains on our radar screen for a possible addition into the

Breakout Stocks

model portfolio, and the other is a stock that is attractively valued at the current quote.

Greenhill

(GHL) - Get Greenhill & Co., Inc. Report

is an investment bank that advises corporations on M&A and restructuring transactions. Greenhill also operates a merchant banking fund with more than $1 billion in assets that focuses on private equity asset management.

The company is headed by Robert Greenhill, who previously founded Morgan Stanley's M&A group and who has been attracting top bankers from rival firms. Recent hires include Dhiren Shah, former head of Morgan Stanley's technology banking group, and Robert C. Smith, former co-head of financial institutions mergers and acquisitions at Citigroup.

Greenhill, which was recently trading at $63.55 a share, is off to a quick start this year. The shares are already up 13%, largely as a result of the company's outstanding quarterly results. On Jan. 26, Greenhill reported fourth-quarter earnings of 69 cents a share, well ahead of analyst expectations for 45 cents a share. Greenhill benefited from strength in advisory revenue, as well as big gains in its merchant banking unit.

On Feb. 9, Greenhill shares got another boost after

Noble Energy

TheStreet Recommends

(NBL) - Get Noble Energy, Inc. Report

purchased U.S. Exploration, an energy company in Greenhill's Merchant Banking Fund, for $411 million. Investment bank Wachovia Securities estimates the gain to Greenhill at $53 million, leading Wachovia to raise its 2006 earnings estimate to $2.43 a share from $1.95 a share.

With all the good news, why are we not adding Greenhill to the model portfolio here? First, the stock is very expensive at 32 times expected 2006 earnings of $1.98 a share. Its closest peer, Breakout Stocks holding

Lazard

(LAZ) - Get Lazard Ltd Class A Report

, trades at just 17 times expected 2006 earnings.

While in isolation a high valuation is no reason to reject a stock, that issue -- combined with the unpredictable nature of revenue -- could make any disappointments very painful. Greenhill has a stellar investment-banking franchise, recently working on deals for companies including 7-Eleven and

Maytag

( MYG). Merchant banking revenue is extremely volatile, meaning it could be very large one quarter and very small the next.

However, given Greenhill's strong banking business, we will consider adding the stock should it report disappointing quarterly earnings in the future as a result of poor merchant-banking results. We view the $50 to $55 range as a more attractive entry point.

One brokerage firm we believe is attractively valued is

Jefferies Group

(JEF) - Get Jefferies Financial Group Inc. Report

, recently trading at $54.48. Jefferies provides investment-banking services to midsized companies and institutional investors, including M&A advisory, equity trading and capital-raising services.

Jefferies recently announced very strong fourth-quarter results, earning 68 cents a share, well ahead of analyst expectations for 60 cents a share. The success in the quarter was driven primarily by investment-banking revenue, which rose 58% year over year to $167.5 million. Management also described the deal backlog as "extremely solid."

Jefferies has an interesting niche, focusing on deals for companies valued between $50 million to $2.5 billion, and

Investment Dealers' Digest

magazine recently named Jefferies the middle-market investment bank of the year. While an award such as this may seem like a superficial issue, our talks with contacts on Wall Street indicate that Jefferies is building a strong reputation as a top-quality firm.

We believe it is wise for Jefferies to focus on providing banking services to smaller companies and to avoid the crowded megadeal space. Here, competition is heating up as a result of increased inroads from independent firms such as Greenhill and Evercore Partners, which carry fewer conflicts of interest than the big brokerage houses. In addition, large commercial banks such as

Bank of America

(BAC) - Get Bank of America Corp Report

have invested heavily in their investment-banking operations, further increasing competition.

Jefferies has also made smart acquisitions in recent years, including those of investment banks Randall & Dewey and Quarterdeck, which specialized in energy and defense, respectively. We believe these two sectors are likely to experience a great deal of consolidation over the next few years and generate a great deal of investment-banking business as a result. Given Jefferies' strength in the middle markets, it is likely that they will be strong beneficiaries.

Shares of Jefferies trade at a premium to the large brokers such as Goldman Sachs, which trade at 11 to 13 times forward earnings, but the company's earnings growth should remain strong, and the firm has emerged as the premier player in the middle-market space. If we did not already have a brokerage firm in the Breakout Stocks model portfolio, we would consider adding it at the current quote.

The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research associates at TheStreet.com. In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please

click here.