Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Wall Street Journal recently named six Morningstar equity analysts as the Best on the Street. I'm here today with Michael Wong, who was named one of the best investment services analysts. We'll take a look at the sector and see what his favourite picks are.
Michael, thanks for joining me.
Michael Wong: It's always great to be here.
Glaser: So, let's talk a little bit about investment services, in general. Obviously, an area that was very hard hit by the financial crisis. How these firms have been doing, and what's your outlook for them in 2011?
Wong: The investment services field is quite diverse. I actually cover pretty much like three distinct industries. These would include the investment banks, the financial exchanges, and the brokerages. And when you look at each individual industry, they all have different tailwinds and headwinds.
Glaser: OK, let's take a look at the investment banks first then.
Wong: OK, so when you look at the investment banks, let's start with the large ones that many people care about. One of the big themes that will play out over the next couple of years is regulatory reform. So the big regulations that are up in the air are Basel III requirements for capital and the Dodd-Frank bill.
So, when you look at these, they've restricted lots of the large investment banks in terms of their trading operations, and banks will require much more capital in order to support their operations. Because of that, we actually like the investment banks that have less exposure to trading. So, we would actually prefer Morgan Stanley (DKP) over Goldman Sachs (GS) at a similar discount to our fair value estimate because they just have so much more asset management and wealth management versus, let's say, fixed-income trading at Goldman Sachs.
Going down the scale to the midrange, small- and mid-cap investment banks, there's also a trend that played out over the financial crisis, and it was a movement of talent from the large-cap banks to the smaller-cap investment banks. So, many of the small- to mid-cap investment banks have much more earnings power coming out of the financial crisis than they did going in. In that space, we would think of Jefferies (JEF), Green Hill, Evercore (EVR), and inter-dealer broker BGC Partners (BGCP).
We actually wrote a Stock Strategist article, maybe a year ago, looking at the head-count changes, and if you were to do brokerage revenues or some other revenue metric divided by head count, you would look for the companies that have the largest increased head count as having the best earnings power going forward.
One other theme that we've also touched upon lately is this emergence and renaissance of mergers and acquisitions. So, there are some, kind of, boutique investments banks that really specialise in financial advisory, and those would be Evercore Partners, Lazard (LAZ), and Green Hill.
Glaser: Now, let's take a look at the retail brokerages. What do you think is going to happen in that area?
Wong: Retail brokerages, they were beaten down quite a bit during the financial crisis. Trading volumes fell up excluding certain periods where there was rampant volatility. People seem to have shunned the retail brokerages, even though they have a very strong business model.
So going forward, it actually appears that investor risk appetite among the retail segment has come back. You saw a lot of inflows into domestic equity mutual funds in the US just starting in the fourth quarter and continuing into the first quarter of this year. It just kind of shows that investors are going from fixed income back into equities. You also saw a large increase in margin loans at the large brokerages, so that's positive.
Going forward, we don't see trading driving the revenues of the retail brokerages as much because they've already rebounded back to pre-crisis levels. What we do see is the rise in interest rates positively affecting the retail brokerages. This will come in as the reversal of money market fund fee waivers and also as expansion of the net interest margin on the interest-earning assets. We actually made quite good calls on optionsXpress (OXPS) and TradeStation (TRAD) over the previous year. They were both recently acquired, one by Charles Schwab (SCHW) and another one by Monex. In the space, currently, we believe that Charles Schwab is probably the best value.
Glaser: Now you mentioned M&A. One area that's had a lot of M&A talk recently are the exchanges, which is another area you cover. Can you talk to us about your outlook on the stock exchanges?
Wong: The financial exchange landscape is quite dynamic. If I were to just quickly slice them up into their separate parts, the US cash equities business has more or less stabilised. If you look at a year and a half ago, they were more or less in a pricing war, just raising through the bottom in pricing trying to get market share. They've gone to a much more balanced strategy of a pretty nice amount of market share with higher profitability. So, we've actually seen quite a bit of stabilisation in the US cash equities market.
In the US options market, there is still quite a bit of jockeying around for position. So we could see more shifts in market share there.
In Europe, after the passage of the Markets in Financial Instruments Directive, we believe that there is quite a bit of chance that there will be even more fragmentation in the European cash equities market. So if you look at the established players such as London Stock Exchange or Deutsche Borse, we could see them losing market share going forward.
If you look into the futures business, this is the sweetest spot of the exchange industry. You have many tailwinds toward futures trading. You have emerging economies and great demand for commodities. So you have people who are speculating in the agricultural sector who need to hedge agricultural commodities. You have the prospects of increased inflation; everyone is speculating on gold and silver. You also have just a general growth in the economy and the possibility of people changing their views on inflation. But there are also people wondering whether the government may try to control inflation via interest rates. So you have a lot of people speculating on interest rates. So there is just lots of tailwinds to keep strong volumes at the futures exchanges.
In that space, specifically, we see Deutsche Borse, CME Group (CME), and IntercontinentalExchange (ICE) as been moderately undervalued. We'd still generally prefer a larger margin of safety before we would invest in them.
One of the most interesting kind of plays, even though it's fairly valued at the moment, is NYSE Euronext (NYX). If I ever were to trade down to the implied exchange ratio with Deutsche Borse, we would consider buying it as it would be a decently secured chance that they will get taking out that Deutsche Borse rate which would be a net even, but there's always the chance of a bidding war coming up or them actually getting the higher NASDAQ OMX (NDAQ) and IntercontinentalExchange bid. So, you'll get a fairly valued stock with the positive optionality of a higher takeout bid.
Glaser: Looking across your entire coverage universe, where do you see valuation levels? Are stocks generally fairy valued, overvalued, or do they look cheap to you?
Wong: The financial sector compared with most of the other industries we cover is a little undervalued. We see some of the most value in some of the smaller-cap names and maybe the riskier names. One of the more risky names that we believe is undervalued is Knight Capital Group (KCG). It's an institutional brokerage. We believe it could benefit from the inflows into the equity mutual funds and just the generally high level of retail investor trading. But we would still even require a higher margin of safety to what it's currently trading at to invest in it.
Glaser: And if you were to disregard valuation for a moment, what company would you be the most excited about owning in the case of a pullback or in the case or a situation where you will be able to pick it up cheaply?
Wong: This would have to be Lazard. Lazard is more or less almost the largest boutique investment bank. They don't really like to called an investment-banking boutique. They have global operations. Approximately half of their revenue is derived from financial advisory, and within that it's one of the prominent restructuring advisory companies in the world and M&A advisory companies. That means, during the recession, its restructuring and advisory revenues went up because many companies needed to restructure their operations, and its revenues didn't fall that much.
Coming out of the recession, its financial advisory M&A revenues will likely have a very nice boost and a very nice run. And the other 50% of the revenues approximately comes from asset management. Asset management is a field that we have always liked. The firm has great returns on capital. As long as the equity markets keep on going up, then Lazard will keep on posting exceptional earnings from its asset management and from its M&A advisory businesses.
Glaser: Michael, thanks so much for your thoughts today.
Wong: Sure. Anytime, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
