Who's Emerging Stronger From The Financial Crisis?

Investment Banking is a Human Capital Business
The investment banking business is predominately driven by relationships and brains. The more traditional investment banking lines of underwriting, financial advisory, and private wealth management (the area into which many investment banks have recently expanded) are based on relationships. High-margin underwriting and financial advisory deals flow into investment banks through the connections built up by rainmakers while on Wall Street and over their tenure in the industry. Relationships with accredited investors also enable investment banks to distribute underwritten securities. Similarly, the wealth management division's financial advisors gather and retain assets from their networking and relationship management skills.

The other common legs of investment banks, asset management and sales & trading, are more a result of brains. Healthy assets under management growth comes from benchmark-beating performance and the resulting net asset inflows. The ability to generate a track record of outperformance comes from having a team with differential and superior insight. It is also firms' research analysts' insight that forms the backbone of many trading operations. Finally, it is in the minds investment banks' employees that the genesis of financial innovations that satisfy the investing and risk-management needs of clients are created.

As investment banking is a human capital business, employee headcount can be viewed as a proxy for a firm's strength and potential earnings power.

Headcount Through the Financial Crisis

From this table, we can see that most of the larger investment banks were, on net, reducing their ranks until the first two quarters of 2009. Primarily this was because it was only in early 2009 that investment banks reversed their downtrend, and began posting positive earnings due to a tripod of reasons: an overall market rally, recovery in underwriting revenues from belief in an economic recovery, and strong fixed income trading revenues. (For a more thorough discussion of that period, please read our former Stock Strategist, "Rising Profits Are Bound to Fall for Most I-Banks.") We see that most investment banks and broker-dealers had higher headcounts at the end of 2009 than at the end of 2007, when signs of the financial crisis began to show. However, there are certain companies that have outpaced their peers in building out their capabilities during the crisis.

Bulge Bracket: The Strong Become Stronger
In terms of business model changes among the bulge bracket investment banks, we believe  Morgan Stanley (MS) made a strategic shift that positions the company favorably for years to come. In the second quarter of 2009, Morgan Stanley combined its Global Wealth Management Group with  Citi's (C) Smith Barney wealth management business to form a joint venture (JV). Morgan Stanley owns 51% of the JV and has the option to purchase the remaining 49% during the next several years. This increased the company's wealth management business contribution to net revenues from 15%-20% before 2008 to more than 35% during the last three quarters. In general, wealth management is a stable business that should produce superior returns on capital over an extended period of time. The wealth management expansion also decreases the company's reliance on trading revenues, which could be negatively affected by potential regulation.

The other behemoths of investment banking took different actions based on their particular circumstances.  JP Morgan (JPM) through its acquisition of Bear Stearns,  Barclays (BCS) through its acquisition of much of Lehman Brothers' operations, and  Bank of America (BAC) through its acquisition of Merrill Lynch built out their investment banking platforms. Relatively strong capital levels going into the crisis allowed them to be opportunistic. The expansions of JP Morgan's and Barclays' investment banking units were more extensions than they were changes of business strategy, and aren't as game-changing in context to their overall size. On the other hand, Bank of America's acquisition of Merrill was transformative and has recently demonstrated the diversification benefits of combining commercial and investment banking operations under the same umbrella. Citigroup, due to its book falling apart earlier and more severely than peers, has decreased the size of its investment banking business by only retaining a minority stake in the Morgan Stanley Smith Barney joint venture, the sale of its Japanese brokerage business Nikko Cordial Securities, and the sale of its commodities trading business Phibro. As  Goldman Sachs (GS) changed how it reports its staffing levels, it isn't clear if the company has more revenue producers now than in 2007. However, the company hasn't announced any material acquisitions or divestitures, so excluding its becoming a bank holding company, we believe its capabilities and strategy remain largely similar to what they were prior to the financial crisis.

 

Middle-Market Investment Banks: Balancing Out Business Lines
Among the more middle-market orientated investment banks,  Stifel Financial Corp (SF) and  Piper Jaffray Companies (PJC) have made great strides. Stifel has been a serial acquirer. During the last two years, the company acquired privately held broker-dealer Butler Wick and more than 50 wealth management offices of  UBS (UBS) located in the USA. Furthermore, Stifel recently announced a planned merger with  Thomas Weisel Partners Group . The merger with Thomas Weisel will even out its institutional and wealth management business, and add growth oriented industry expertise. We believe management's experience with previous acquisitions gives it a high likelihood of a successful integration.

Not reflected in the fourth quarter of 2009 numbers for Piper Jaffray is its recent acquisition of asset management firm Advisory Research. This should increase asset management's contribution to net revenues from approximately 5% to more than 10%, and increase the asset management division's contribution to pre-tax income to nearly 25%. Though the acquisition should help bridge the gap between its returns on equity and its peers, it may still be several years before the company earns economic returns on capital.

Broker-Dealers: Well-Timed Acquisitions and Hiring Spree
Of the companies whose core business is brokerage,  Knight Capital Group  and  BGC Partners (BGCP) stand out. Prior to the acquisition of fixed income broker-dealer Libertas in the third quarter of 2008, Knight was nearly a pure equities shop. The acquisition was well-timed, as fixed income trading has been one of the highlights of brokerage earnings over the past year. Besides fixed income trading, Knight recently announced a pending acquisition of a reverse mortgage provider, Urban Financial, and an agreement with investment bank Houlihan Lokey that leverages Houlihan's capital markets experience and Knight's distribution platform. We see the profitability of fixed income trading being lower going forward than the heady quarters of 2009, and the company's venture into reverse mortgages and capital markets is untested. That said, we are encouraged by Knight's willingness to branch out from its equity trading roots, as the industry is highly competitive.

BGC Partners has built out and bulked up its platform. In 2008, the company acquired OTC energy broker Radix and in 2009 it acquired Brazilian interdealer broker Liquidez. These acquisitions expanded the company's product scope and geographic reach to potentially faster growing areas. Even without counting the acquisitions, the company's organic increase in broker headcount is relatively impressive. We do have to caution that the over-the-counter (OTC) derivatives (from which BGC Partners and its interdealer and wholesale broker peers such as  GFI Group  derive a material portion of revenues) are currently the subject of potential regulation. A larger brokerage force does not necessarily translate into higher earnings if the profitability of the company's brokered products is legislated away.

Boutique Investment Banks: Story Stocks Poised for Growth
The boutique financial advisory investment banks have all re-examined and made adjustments to their business models during the last two years. The storied  Lazard (LAZ) has been going through a restructuring process over the last several quarters. Following the passing of Bruce Wassersteain, the legendary deal maker, CEO, and chairman of Lazard, Kenneth Jacobs took over the reins. Since Jacobs' appointment, he's changed the company's compensation policy and has been right-sizing its workforce. Though Lazard's total headcount is down since 2007 and managing director headcount is up only slightly, trimming the fat and selective hiring could translate into the company being leaner and meaner going forward.

The smaller boutique financial advisory banks are evolving growth stories.  Greenhill (GHL) increased its managing director headcount nearly 75% since the beginning of the financial crisis. Recruitment slowed considerably in the second quarter of 2009 as the larger investment banks regained their footing. As managing directors are the primary source for financial advisory deals, Greenhill has dramatically increased its earnings potential. The company has also shown a renewed focus on financial advisory as it is stepping back from its merchant banking business, but expanded its fund placement advisory group and presence in Australasia.

 Evercore Partners (EVR) has dramatically grown its total headcount with a more modest but still impressive growth in senior managing director count. The difference in respective growth rates is partially attributed to the broadening of its business lines. Ralph Schlosstein, former president and co-founder of asset manager  BlackRock (BLK), became CEO of Evercore in 2009. Since then, Evercore has made several strategic investments in asset managers, made a push into equity underwriting, and also plans to start an equity brokerage business. We believe the smaller boutique financial advisory investment banks are some of the highest quality growth stocks in the financials industry. That said, as with many growth stocks, their market valuations may occasionally get too far ahead of their intrinsic values.

Conclusion: Many Names Are the Same but the Businesses Have Changed
Many of the investment banks and broker-dealers have outgrown their business descriptions of several years ago. They've expanded their product offerings and some are simply materially larger. Headcount at investment banks and broker-dealers can be viewed as a stock of inventory: the more you have, the more potential sales you can make. That said, increased headcount in a business that may be under pressure, such as the equities trading business or over-the-counter derivatives, may not lead to increased earnings. We recommend that investors take another look to make certain that their investment thesis for taking a position in a certain investment bank or broker-dealer still holds, as many of them and the industry are different from a few years ago.