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WALL STREET, CALIFORNIA | SECTOR SPOTLIGHT / JAMES
F. PELTZ

Going for Brokerages

Although the trading houses are susceptible to market swings, selective stock pickers can find solid value. And a rule change by the Fed could fuel brokerage takeovers by banks.

November 05, 1996|James F. Peltz

The stock market is still near record highs, so it stands to reason one might lean toward brokerage stocks. Easy money, right?

Hardly.

Sure, the brokerages have risen on the market's historic tide in 1996, with many posting double-digit earnings gains this year that have lifted their stock prices sharply higher.

Dow Jones' index of 96 industry groups shows the major brokerage stocks with a 26% average gain so far this year, ranking the group 13th overall and well above the 14% gain for Standard & Poor's 500-stock index.

But the market's rally will inevitably slow or stop. Then what?

The solution is to hedge by being picky. If the market tanks, a choice selection can include brokerages that should prosper anyway. If the market keeps rallying, most of the brokerages will probably climb some more in any case. Nothing is lost by being choosy.

That means narrowing the field to see whose prospects look most enticing: the big New York wire houses or the regionals, the full-service firms or the discounters, the retail-oriented firms or those that heavily trade for their own accounts.

And there's one other factor that's going to play a big role in those prospects. By year's end, the Federal Reserve Board is expected to allow commercial banks to expand the amount of stock and bond underwriting they can do, to 25% of their securities affiliates' revenues from the current 10%.

Once the rule is in place, some commercial banks will try to expand overnight by acquiring existing brokerage firms, experts predict. Such deals could be quick windfalls for brokerage-stock investors.

But that's not easy money, either. No one knows for sure which brokerages will be gobbled up, or at what price. Also, the Fed's proposal isn't brand-new; the central bank has been talking about the rule change for months, which means Wall Street has had plenty of time to build that takeover premium into the brokerages' current stock prices.

With all of that in mind, what are the choices? One way to narrow the field is to see which brokerages are still trading at low prices relative to their profits, even with this year's rally.

Some of Wall Street's most familiar names are selling at relatively cheap price-to-earnings multiples, according to the research firm Market Guide Inc. in Lake Success, N.Y. Salomon Inc., for instance, is selling for little more than 6 times its trailing annual earnings (after excluding special charges and other one-time gains or losses) and Bear, Stearns & Co. and PaineWebber Group Inc. are carrying P/E multiples of less than 8. (The median P/E for the group is 9.2.)

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Lest one think Wall Street overlooked something, it's no coincidence that the trio includes Salomon and Bear Stearns. They specialize in trading securities for their own accounts, as opposed to serving huge retail networks for individual customers, and thus they tend to be much more susceptible to swings in the market, and are heavily dependent on their own trading skills. So Wall Street keeps a wary eye on them.

They have their fans, however. Salomon, currently trading near $45 a share, is a favorite of Alison Deans, an analyst with broker Smith Barney Inc. (which is owned by insurance giant Travelers Group). One reason: Salomon is working to build up the non-trading parts of its business and reduce its exposure to the markets' volatility.

Speaking of the major firms, Lehman Bros. Holdings Inc. is repeatedly rumored to be a takeover target, mainly because it has a strong underwriting franchise but remains small enough to be acquired by, say, a major insurance company or foreign bank.

Be careful, though. The rumors have helped send Lehman's stock on a roller-coaster ride in 1996 and now it's back trading at about $25 a share--its average price for the year overall. It's also trading at 8.5 times its trailing annual profit, a lower multiple than the one being accorded the much stronger and financially predictable Merrill Lynch & Co.

The heaviest takeover speculation involves the regional brokerages, which are viewed as the ripest buyout candidates for commercial banks after the Fed makes its rule change.

Oppenheimer & Co. analyst Steven Eisman is recommending three stocks on that basis: Alex. Brown Inc., McDonald & Co. and Morgan Keegan Inc. Why them? All have strong investment banking operations for their size--and investment banking is what the commercial banks are after.

And what about the discounters? Thanks to its swelling mutual fund business and surging profit, discount king Charles Schwab Corp. is one of the richest brokerage stocks around. At one point this year it traded for a princely 34 times trailing earnings; the stock still carries a multiple of 20 at its recent price of about $25 a share, and it's up more than 20% this year.

That didn't stop Michael Freudenstein of J.P. Morgan Securities from recently putting Schwab on his buy list. He noted that Schwab continues to add new customers at a record pace, with 1 million likely to sign up this year.

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