Investment banks on the spruiking circuit

Just imagine this. Investment banks urging investors to invest in investment banks.

A cynic could be forgiven for thinking this could be one of the greatest exercises in self-indulgence ever witnessed in the world of high finance, as rival investment banks rank each other as buys. Then again, they may just be on to something.

Five years ago, they brought the capitalist system to the brink of destruction. Accused of ripping off their clients and skating perilously close to the regulatory line – after years of lobbying to dismantle the regulatory system – they then went cap in hand to taxpayers and anyone else who would bail them out.

Just when it seemed their reputations had hit rock bottom, a bunch of them were caught rigging the London Interbank Offered Rate market, or LIBOR, the main exchange for global interest rates.

For all their sins though, no-one has ever disputed their ability to generate profits, particularly when markets are in the ascendancy. And with the US economy finally showing signs of emerging from its worst recession in almost a century, those very same institutions could be on the cusp of an earnings breakthrough.

While significant risks remain over key US policy decisions – particularly the debt ceiling negotiations – the tide appears to be turning for the American economy and corporations. US property prices finally appear to have bottomed and many analysts expect a strong rise in dividends during the next two years, which so far have run behind the rise in corporate earnings and stock prices since 2009.

While Wall Street has been bumping up against record levels, equities trading volumes have been low and there’s been precious little in the way of mergers and acquisitions, forcing investment banks to curtail costs and run leaner operations.

But as the switch – or rotation, as the popular parlance – out of fixed interest and into equities gathers steam, so too will the appetite for American corporations to expand via mergers and acquisitions. So any uptick in investment banking activity will run through to the bottom line, courtesy of the past three years of cost cutting.

This could represent an historic opportunity for Australian investors. While the domestic currency has crippled vast swathes of the Australian economy, it has bestowed international buying power at a level not seen for more than four decades.

A strategy of buying big brand, quality international stocks with exposure to a recovering global economy and financial markets not only offers the potential for capital gain. It has the added benefit of providing a major currency boost when the Australian dollar eventually recedes.

Our very own home-grown operation, Macquarie – having spent the past five years trying to unravel its infrastructure model and return to a more traditional business – first identified the opportunity last October, citing JP Morgan and AIG as the picks. Macquarie yesterday flagged a 10% rise in earnings for the 12 months to March 30, its first profit increase in three years. The bank’s forecast implies a full year profit of just over $800 million.

Bank of America, which bought Merrill Lynch during the crisis, and which received a $5 billion equity injection from none other than Warren Buffett in 2011, also is in the midst of an earnings recovery.

Rival bank Citigroup recently estimated Bank of America’s earnings per share would rise from 25c this year to $1 next year, with $1.60 mooted in 2015.

After its recent quarterly earnings statement, investors marked the stock down on concerns about the bank hitting its cost reduction targets.  It currently is trading on a price earnings multiple of 12.5, according to Bloomberg, and Citi sees capital growth in the share price.

Goldman Sachs – Wall Street’s most famous, or perhaps infamous, investment bank – recently stunned the market with a much better-than-expected quarter, earning a buy recommendation from Bank of America. It was a result struck against better-than-expected revenue with a firm eye on cost control.

Once dubbed the “bloodsucking vampire squid” for its ability to squeeze a profit or an angle out of any situation, Goldman Sachs is trading on a price earnings multiple of just 9.6. That’s relatively cheap when compared to Australia’s big four banks. But investment banking is inherently a riskier proposition than retail.

In the same research note a fortnight ago, Bank of America also cited JP Morgan Chase as a buy, Again, its earnings were much stronger than expected and again it was struck against a rise in revenue while its compliance targets with the new Basel III regulations were well advanced.

Bloomberg estimates a PE ratio for JP Morgan at just 7.8 on this year’s earnings.

Last week, after Citigroup released its results, Bank of America bestowed a buy rating on it with a headline that read: “Recovery stories take time and this one is on track.”

“We continue to believe that owning Citigroup is key for broad market outperformance in 2013,” its analysts claimed. With earnings per share growth estimated in the high teens for 2013 and next year, they claimed this was “hard to find in bank land”. Citi is trading on a price earnings multiple of 10.7.

Morgan Stanley similarly beat earnings expectations in the recent quarter. And like its competitors, it too is promising more cost reductions.  Bank of America rates it as a neutral, primarily because of its price rather than prospects. Bloomberg has it trading on a PE ratio of 13.5, substantially higher than many of its competitors.

JP Morgan also earned accolades from Bank of America analysts with a headline that read: “Hard to ignore earnings per share power at this valuation.”

“We reiterate our buy recommendation on JP Morgan. From an investor interest perspective, the stock appears to be a bit forgotten as JP Morgan does not offer an exciting turnaround story nor does it trade below book value. However, we think $6 of earnings per share for a $47 stock is just as exciting.”

Bloomberg has it trading on a price earnings multiple of 7.8.

For its own part, JP Morgan is bullish on the industry and in a global overview cited its preferred players as UBS, Credit Suisse, Barclays, Morgan Stanley and Deutsche Bank.

It would be churlish and indeed a little foolish to dismiss all this as a round of self-congratulatory backslapping.  While investors like Warren Buffet have cleaned up on the turnaround from crisis levels, particularly his investment in Goldman Sachs, there now appears to enough momentum building in the global economy to warrant a close look at investment banking prospects.

For Australian investors, there is the added incentive of the currency play; to hook into a global growth strategy with an international portfolio while the currency is at its peak.