NYSE Investors Beware

Before you get caught up in the hype and go out and buy shares in NYSE Group (NYX), I urge you to do some basic valuation work. Shares of NYX, the newly formed public combination of Archipelago and the New York Stock Exchange, opened at $67 per share yesterday and proceeded to close at $80. Today the stock is up another $6 at the open. Current market value at $86 per share: $13.6 billion, based on 158 million shares outstanding.

The reason for the rise has more to do with limited supply than anything else. Retail investor interest has been strong so far, and there simply aren't many shares available to buy. Much of the stock is being held by NYSE seat owners and member firms, who can't sell it right now. A supply-demand imbalance is causing a short term spike, but a closer look at the company's valuation makes it clear that anyone paying $86 is playing with fire.

Keep in mind that Archipelago (AX) stock traded at $17 before the merger with the NYSE was announced last year. The combination has resulted in a 400% increase in the value of that equity (AX shares became NYX shares beginning yesterday). I don't doubt the deal will be accretive, but isn't 400% a bit extreme?

AX was expected to earn $1.11 per share in 2006 before the deal closed. Even if that number winds up being $1.50 after the merger (a VERY optimistic projection), the current forward P/E of NYSE Group is 57 times. Buyer beware.

Investment Banks Shed Profitable Asset Management Divisions

Last year's asset swap between Citigroup (C) and Legg Mason (LM) looked like a great move on the part of Legg. After all, retail brokers are hardly the future. Individual investors can only tolerate absurdly high commissions for so long, I would hope. Trading their retail brokers for Citi's huge asset management division, including Smith Barney's mutual funds, should be a huge lift for LM shareholders, and the stock's movement since the deal was announced bears that out.Now we learn that Merrill Lynch (MER) has decided to send Merrill Lynch Investment Management (MLIM) to BlackRock (BLK) in exchange for a 49% stake in the newly formed asset management giant. As was the case with Legg Mason, Blackrock stock has gone through the roof on news of a deal.

Evidently this Merrill deal was a much better alternative than the "let's change our fund company's name to Princeton Research and Management and see if that helps get us more business." Once Morgan Stanley's deal to acquire BlackRock fell through, Merrill swooped in and decided it was a much better idea to hand over MLIM to a somebody who could better run it. Doing so also rids Merrill of having the appearance of conflicts of interest with its investment bankers, research analysts, and mutual fund managers all under the same roof.

So in a matter of months both Legg Mason and Blackrock have strengthened themselves as pure play asset managers, a business that has great margins. With the growing popularity of hedge funds and international investment options, their fortunes will be much less tied to the direction of the S&P 500 than they were five or ten years ago.

The stocks have soared, and on current profit estimates they do look pricey. However, it is apparent that margin expansion will occur, both due to cost-cutting and an overall higher average profit margin across the business. Accordingly, current analyst expectations for profits (about $6 for LM in 2006 and $5 for BLK) will prove quite conservative.

And they better since LM is trading over $130 and BLK recently hit $150 per share. It is entirely possible that 2006 is a transition year for the integration of these very large deals, but come 2007 and 2008, they should be coining money. Add in the fact that asset managers have always traded at a premium to the overall market and financial services sector, and the stocks could outperform for the rest of the decade even after the recent run-ups we've seen. Of the two, Legg Mason looks cheaper than Blockrock, however. 

Is Merrill Lynch Serious?

Merrill Lynch (MER) is changing the name of its mutual fund group to Princeton Portfolio Research and Management later this year. Now this might seem strange on the surface, just because as far as name recognition and brand awareness go, I would think investors would choose to invest with Merrill over Princeton. Maybe that's just me.

The part of this story that really got a laugh out of me was Merrill Lynch's reasoning for making the change. In essence they think a new brand will make it easier for them to gain market share in the retail mutual fund business. Their concern is that brokers and financial advisors with other major firms have avoided offering Merrill Lynch funds because they see it as giving business to their competition.

That seems like a very valid concern. I can't see many Morgan Stanley and Goldman Sachs brokers trying to sell Merrill funds to their clients. But isn't it hilarious that they think changing the name will help this problem? Do they think retail brokers are just going to start blindly recommending this new fund family without looking into them at all?

So they'll do a little research to find out exactly who these "Princeton" folks are, and they'll learn, if they haven't heard already, that it's the old Merrill Lynch fund family. And we're back to square one.

Side notes:

Amazon (AMZN) is getting hit by $4 today after earnings. As much as I like Legg Mason's Bill Miller, I really don't know what he likes about this stock. All I see is a perennial 40+ forward P/E, decent but not overly impressive sales growth, and very low margins (not much better than Borders and Barnes and Noble as was once predicted).

OccuLogix (RHEO) is down more than $9 in the pre-market, to $3 per share. The only reason I even know about this company is because I recall Cramer pumping it on his Mad Money show. Evidently their product showed no difference versus placebo. How he can suggest to average investors that they buy something this speculative on national television is beyond me. Maybe a 75% haircut in a single day will help viewers understand what he is doing. I still have not exactly figured out his motivation (and/or conflicts of interest) in pumping the small caps he does, but I suspect the answer is not comforting.

Flat Curve Could Hamper Commerce in Short Term

Shares of New Jersey based Commerce Bancorp (CBH) have been strong lately, along with other bank stocks, as investors hope the Fed will stop hiking interest rates when the Fed Funds rate hits 4.5% early next year. However, after a run from $27-$28 to $33-$34, shares of CBH could see weakness in the short term.

Although the company's long term growth prospects remain among the brightest in the industry, the flatness of the yield curve will make it difficult for CBH to beat, or even meet, Wall Street's profit expectations in both the fourth quarter and early 2006.

Any guidance reduction in Commerce's soon-to-be-released mi- quarter update will likely cause a 5 to 10 percent sell-off in the stock. At that point, long term investors can be more aggressive with their positions.

Buffett's Possible Successor

Probably the number one concern among Berkshire Hathaway (BRKA) followers is the successorship of Warren Buffett. Buffett is in his mid seventies and clearly will not be around forever. What will happen when the cockpit is turned over to someone else? Will someone else be as investment savvy as Buffett? Surely not. Will Berkshire stock drop as Buffett himself is most likely valued highly by current shareholders?

Many people think Lou Simpson will take over for Buffett when the time comes. Simpson is the CEO of capital operations for Geico. Basically, he manages the float for Geico's insurance business, which amounts to several billion dollars. Interestingly, while Buffett gets the credit for portfolio additions to Berkshire's investment portfolio, often the smaller buys are the work of Simpson, not Buffett.

Taking a look at Berkshire's holdings as of June 30th, we can get a good idea of which investments are the work of Buffett, and which have Simpson's fingerprints on them. Buffett's largest holdings are the ones he has held for years. Gillette, Coca-Cola, Wells Fargo, American Express, Washington Post, to name a few. After subtracting Berkshire's top 10 holdings (mostly those older buys) as well as its position in Proctor and Gamble (due to the pending merger) and PetroChina (which was one of BRK's largest holdings until it was trimmed dramatically in the first half of 2005), Berkshire's $35 billion public company portfolio is narrowed down to less than $3 billion invested in 20 companies.

Since Buffett has stated in the past that Simpson manages about $2.5 billion, it is safe to assume this small portion represents what investors should expect to see on their position sheets should Simpson be named Buffett's successor. As a result, more often than not relatively small new additions to BRK's portfolio are the work of Simpson, not Buffett himself.

The Buyouts Mount

After Washington Mutual's (WM) purchase of Providian and Bank of America's (BAC) recent buy of MBNA, it was widely expected that smaller credit card issuer Metris (MXT) would eventually get a similar takeover bid. In fact, readers of this blog were alerted to the potential of Metris even before those deals were announced.

Below is an excerpt from our post "Metris Continues its Turnaround" posted in December 2004:

"With some analysts still bearish on the company's future, combined with a staggering 24% of the float sold short, there are many reasons to think that Metris shares will continue their march higher in 2005. Contrary to popular belief, it's not too late to get in, even at the current $11 price tag."

Today's $15 per share cash bid by HSBC closes the book on the Metris story. Fortunately though, there are still excellent values in the financial services area, making reallocation of that capital a very opportunistic redeployment. Investors who want to stay in the credit card space should turn their attention to long-time Peridot favorite Capital One Financial (COF).

Capital One Reports Another Excellent Quarter

Late Wednesday Capital One Financial (COF) reported 2nd quarter earnings of $2.03 per share, well ahead of analysts' estimates of $1.75. Managed loans increased 13 percent to $83 billion and the company maintained its full year earnings guidance of $6.60 to $7.00 per share.

Capital One continues to be the best performing credit card company in the industry. They expect their pending acquisition of Hibernia Bank (HIB) to close on September 1st of this year, which will enable them to extend their product line into the branch model.

Despite the good news, investors still can pick up COF stock for 10.8 times 2006 earnings. Not a bad price at all for the leading company in the credit card space growing in the 10 to 15 percent range on an annual basis.

Bank of America/MBNA Deal Boosts Capital One

Credit card companies have been hot acquisition targets lately. The sale of Providian (PVN) sparked speculation that more deals would follow as independent card companies aren't very plentiful. Today's announcement that Bank of America (BAC) will buy MBNA (KRB) for $35 billion only furthers that thesis.

MBNA is getting a very nice premium, with the purchase price of $27 being about 30% above the stock's $21 closing price yesterday. B of A is paying 13.5x MBNA's 2005 EPS estimate of $2.00 per share. Such a price has resulted in a repricing of other credit card firms in the market. Longtime Peridot favorite Capital One (COF) is rallying $5 per share (7%) today. With Providian and MBNA now out of play, COF is the last remaining large credit card company without a merger partner.

The 13.5x multiple for KRB implies that COF shares remain undervalued. Capital One should earn $7 this year, making a implied buyout value of $95 per share, versus its $74 closing price yesterday (shares are up to $79 this morning). While the speculation today will be that COF will be next in line to get a bid, I seriously doubt they are interested in selling. Nonetheless, the stock remains both undervalued and a Peridot core holding even as they remain independent.

For Sale: Brokers, Asking: 10x Earnings

Goldman Sachs (GS), Morgan Stanley (MWD), Merrill Lynch (MER), Lehman Brothers (LEH), and Bear Stearns (BSC). They all trade at 10 times earnings. At first glance this may seem too cheap, and they very well might be, but let's take a look at why you can buy a share of Goldman Sachs at 10x when it used to trade at a premium to the market and sport a P/E of 18 or more.

In case you haven't noticed, we've been in a bear market since March of 2000, more than five years. The major investment banks have had to alter their business models. Some of the old ways of making money don't really exist anymore; taking Internet companies public, or generating $100 per trade retail commissions. The public has soured on stocks. Those that haven't can trade their own accounts for $7 per trade. The IPO market isn't lively at all. Today, M&A is really the only way the investment banks are making money from their traditional businesses.

So what are these companies doing to cash in? After all, the profits at the Goldmans and Lehmans of the world have been pretty robust. John Mack, former CEO of both Morgan Stanley and CS First Boston, summed it up pretty well in a recent interview:

"The profitability at investment banking firms has moved to the trading desk. A lot of people say that certain firms are nothing, really, but hedge funds."

Mack is exactly right. Proprietary trading has fueled much of the growth in earnings for the investment banks. A booming fixed income market has helped Bear and Lehman greatly, and Goldman and Merrill are seeing a nice pickup in M&A activity in 2005, but trading is where the extra juice has come from.

This can explain why the group once sold for 15 times and Goldman once fetched 20 times, but now the multiples are all around 10. They are basically hedge funds, making risky bets. If they are right, cha-ching. If not, bad news. Just look at how many firms got hurt when Kirk Kerkorian's company made a bid for General Motors. Traders were short the common stock and long the bonds as a hedge. The common went up after Tracinda's $31 offer and the bonds went down after GM debt was downgraded to junk status.

Sure the people trading for these firms are extremely smart, and they'll do pretty well for the most part. However, investors aren't going to be willing to pay premium valuations for companies that are relying on trading profits for a large chunk of their earnings. As far as business models go, its one of the riskier ones out there. The more risk you carry, the less someone is going to pay for a chunk of the business.

Value in Morningstar?

I'm sure most of you have heard of Morningstar Inc. (MORN), the fairly influencial investment advisory company most known for their mutual fund star ratings. These ratings, which rank mutual funds on a 1-5 scale with 5 stars being best, garner much attention and are constantly advertised in various fund company marketing materials. However, recent events once again should remind investors to be very wary of these types of endorsements.

According to SEC filings, Alberto Vilar and Gary Tanaka were removed as managers of the Amerindo Technology D Fund (ATCHX) last week after both men were arrested on federal charges of defrauding investors and stealing $5 million from their clients. As a result, Morningstar advised Amerindo Technology shareholders to sell earlier this week. "Charges of fraud against Amerindo Technology's managers are just the most obvious reason to avoid it," said analyst Dan Lefkovitz in a written report. "We're worried that impending redemptions will only exacerbate the fund's problems by forcing it to sell out of positions."

Okay, it seems reasonable that Morningstar recommend such action given recent events, no doubt about that. My question is, why hadn't they recommended investors in Amerindo sell before now? Morningstar had the fund rated "3 stars" before news of the arrests hit the wires. This rating equates to a "neutral" or "average" investment option. How can such a respected research firm think this fund was average?

Let's look at some specifics. As of March 31st the fund held only 12 positions. That's right, twelve. I'm going to go out on a limb and say that is the most concentrated mutual fund portfolio in the country, a huge red flag.

How about performance? After all, if these guys knew how to pick stocks, maybe 12 positions is acceptable, or at least warrant an "average" recommendation. Amerindo's 5-year average annual return? Negative 20 percent. Now you don't have to be a math or finance major to know that 5 years of 20 percent losses is going to leave you in quite a bit of a jam financially. In fact, you'll lose two-thirds of your assets over that span with those types of returns.

To make matters worse, the fund was down another 22% through April 30th. Oh, and did I mentioned the 2.25% annual expense ratio? So we have a fund with 12 stocks, an expense ratio which is 50 percent above the industry average, and some of the worst 5-year returns of any fund in the country. Morningstar gives this fund 3 stars. I'd hate to see what a one or two star fund looks like.

In addition to much of the equity research out there today, it appears we can add Morningstar to the list of investment advisors who should probably carry less weight in our minds than they do. Interestingly, the company recently went public and the stock is up from an $18.50 offer price to a current quote of $27.65 per share. Hmmm, perhaps an interesting short candidate?