Monday, May 14, 2007
Bank on I-Banks (New York Magazine)
Don’t hate investment bankers for raking in millions. Invest in their absurdly profitable (yet still undervalued) outfits and share the wealth.
By James J. Cramer
Stop envying Goldman Sachs’ Lloyd Blankfein already. Don’t begrudge Bear Stearns’ Jimmy Cayne and Lehman’s Dick Fuld their millions. Let Merrill’s Stan O’Neal and Morgan Stanley’s John Mack get paid more than Croesus. You heard it here first: They deserve it. In fact, they deserve more than they earn now.
Those five men are underpaid because they are about to make you very rich if you buy their stocks. Personally, I’m partial to Goldman Sachs, the most undervalued stock of the quintet. But the truth is, you can own shares in any one of these companies and I would expect you to make 50 percent on your money within the next year, and double it within the next three. Despite their immense profitability, the stocks of these companies are some of the least expensive of all the thousands I follow, and, after crushing declines since the year began, they’re ready to begin a steep ascent.
First, let’s talk about why these stocks are cheap. Moving product to generate trading commissions, once a mainstay of these firms, has diminished markedly in the past decade. The buying and selling and underwriting of stocks and bonds, which used to generate gigantic profits, has seen its share of the bottom line almost vanish, crushed by brutal competition. Nonetheless, the perception remains on Wall Street that equities matter greatly, and that commissions on those equities are the difference between good and bad profits for the whole entities. That’s totally untrue. I envision a day when these firms won’t even charge commissions if you put your money with them. So basing an investment decision on whether trading is up or down—as many of the analysts do who opine on these stocks—is ludicrous. That faulty analysis produces the beautiful phenomenon called undervaluation.
What are the real fulcrum factors to performance? First, take the global M&A boom. Back when I peddled stocks and bonds for Goldman Sachs in the eighties, the I-banks were mostly U.S.-focused. Now M&A is a worldwide business that is dominated by the five American I-banks. These firms didn’t even know where some of these countries producing their current deals were two decades ago. Today, their brands are considered local in places as diverse as Warsaw, São Paulo, and Macao. And no investment bank outside our country has anything close to the M&A experience and expertise the big U.S. I-banks have. Usually, one or two of these firms has a hammerlock on the big M&A deals at any given time, but right now there are so many transactions and so many great deal-makers at each firm that the pie is big enough for everyone to feast on.
Next, there’s asset management. For most of the past century, the investment banks were reluctant to manage other people’s money. Why bother? They made plenty from the commissions they earned from stock and bond trades. But with the emergence of discount brokers and online trading, those commissions were badly squeezed (trades that used to cost $200 came to cost $8). Then the multiyear bull market created a new sea of wealth that begged to be managed. These firms, with their top-shelf brand names in finance, decided to get in on the action, and immediately won over many of the clients they pursued, including the newly ultrarich twenty- and thirtysomethings and hugely successful company 401(k) plans. I can recall going to my boss in 1985 and urging Goldman to go after 401(k) money before it grew too big. He laughed: The money could never amount to anything; it would always be too small for Goldman Sachs, he told me. Today, these divisions make fortunes, and the marginal cost of managing additional funds is almost nil.
The major firms, with balance sheets swelled by so much money sloshing through their organizations, also decided to harness the house’s money (and trading expertise) and trade it for their own accounts. Proprietary trading, making bets with the firm’s capital, is another major profit center that barely existed a decade ago. True, these earnings are derided in some quarters as unstable and inconsistent, like those of a hedge fund, even as the profits have been both stable and amazingly steady. But it’s investors’ current predilection for investing in publicly traded hedge funds that makes no sense. Why invest in one of these new IPOs for relatively unknown hedge funds when you could buy shares instead in one of the top I-banks? Their own internal hedge funds have better, lower risk and higher-return track records than any hedge funds I follow.
Another business that has exploded out of nowhere is the one that’s gotten all the press: private equity. Advising the Blackstones and the KKRs remains a great business. But being a KKR or a Blackstone is even better! As private-equity funds come public, as a number are trying to do, they will increase the value of all private-equity players, including the big I-banks. Again, you’ll pay a premium investing in the publicly traded equity funds when you could pick up a Goldman, say, with its own private-equity fund of $20 billion, on the cheap.
The final business that’s catapulting the I-bankers’ bottom lines is the profits from what I call the private-equity aftermath. An I-banker takes in huge fees to do a private-equity deal, but the big gains are in the financing the banks provide—stupendously large high-yield bond deals that allow the fixed-income departments of these firms to generate still more cash.
What could go wrong with the scenario I foresee? A worldwide economic slowdown could hurt the big I-banks’ business, but everywhere except the United States seems to be getting stronger, not weaker. A big change in Washington might cause more scrutiny and higher taxes, but the I-banks aren’t dumb; they’re equal-opportunity political donors. Finally, there’s Citigroup. It is a well-known punch line around Wall Street that earnings are so high at the five major banks because of one key player: Chuck Prince, the man in charge of Citigroup. If he were to be fired or decide to spend more time with his family, Citi could reassert itself both domestically and globally as a margin-slasher of Big Five profits. Don’t laugh; he’s so incompetent that he helps everybody else’s bottom line.
To me, though, those concerns can’t derail these five I-banks. Well-run, unchallenged franchises, with growing markets and new businesses, undervalued because of a recent hiccup in a tiny part of their operations, these banks may be the single best group of investments in the world. Buying shares in them won’t make you Blankfein money ($54 million last year in salary and bonuses). But this could be your best shot at profiting from Wall Street’s latest big party.