Smaller Investment Banks Offer Big Potential

By Todd Shriber | July 16, 2009 AAA

When it comes to investment banking and securities trading, Goldman Sachs (NYSE: GS) is nearly unrivaled in terms of the profits it delivers. In what has been a sour environment for mergers and acquisitions, IPOs, and related investment banking activities, Goldman's trading operation has more than picked up the slack, particularly in fixed-income trading. As a result of Goldman's robust trading profits, Wall Street analyst expect the company to earn $3.54 a share in the second quarter.

But Goldman isn't the only kid on the high finance block. There are several companies that would be considered "mid-tier" investment banks. These companies don't carry the same reputation on Wall Street like Goldman or Morgan Stanley (NYSE: MS), but they could be solid investments in their own right.

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Companies like Jefferies & Co. (NYSE: JEF), Greenhill & Co. (NYSE: GHL) and Lazard (NYSE: LAZ) weren't jaundiced by the financial crisis of 2008 the way some of their larger peers were, yet these solid companies often go unnoticed by many investors seeking exposure to financials. At around $150 a share, Goldman's price tag can be intimidating to some investors. Fortunately, the stocks we're going to highlight here haven't risen to such lofty levels ... yet.

Let's take a further look at this trio to see if there are some compelling opportunities.

Greenhill has a price/book ratio of 10.9 and forward P/E of 24.1.

Jefferies has a P/B ratio of 1.65 and a forward P/E of 18.

Lazard has a P/B of 8.35 and a forward P/E of 14.2.

Does Greenhill Equal Green For Portfolios?
Greenhill is a New York-based investment bank focused on mergers and acquisitions and merchant banking. The shares are up over 30% in the past six months, far outpacing the S&P 500, but also substantially lagging Goldman Sachs' 95% return. Despite the meltdown in the financial markets over the past year, Greenhill has been expanding, acquiring top talent from fallen Wall Street firms, hiring 11 bankers from Bear Stearns and another 11 from Lehman Brothers.

The company is highly profitable with a 35% pretax profit margin, and its 2008 per-employee revenue of $1 million was actually better than Goldman Sachs during the same period. As well, Greenhill's profits may be getting a boost, as the company recently advised Validus Holdings (NYSE: VR) on its $1.65 billion acquisition of rival IPC Holdings. Greenhill also acted as an adviser to PartnerRe (NYSE: PRE) during its $2 billion buy of Paris Re. Both deals were announced in July.

Greenhill shares are up 58% in the past 52 weeks, no small feat, but the company does have $49.4 million and operating cash flow of just $32.7 million. Trading at close to $80 and 50 times trailing earnings, Greenhill isn't cheap, but it could be poised for great profits when M&A activity resumes in earnest. In the meantime, $1.80 per share annual dividend isn't too shabby.

Jefferies' Wild Ride
Share of Jefferies have been all over the place during the past 52 weeks, trading between $7.97 and $29. The stock has stabilized around $20 and is up more than 50% in the past six months. Now may be the time to consider a position in the stock because Jefferies joined the list of banks known as primary dealers for the Federal Reserve's market operations. More importantly these banks serve as underwriters for the Treasury Department's debt auctions, an area that is booming.

Like Greenhill, Jefferies has been poaching talent from troubled rivals, including the hiring of three dozen former UBS bankers in June. Perhaps even more noteworthy is the fact that Jefferies never took a single penny of taxpayer dollars to shore up its capital position. Even Goldman Sachs can't say that.

Jefferies is close to being fairly valued right now and $22 seems to be a consistent resistance point for the stock, but with a strong balance sheet that features $102 a share in cash, the stock could be worth a look, especially if $22 is broken on a strong volume.

Time To Love Lazard?
Lazard is one of the financials that definitely flies under most investors' radars. The stock is up 5% over the past six months, but that lags Greenhill and Jefferies by a wide margin. The company joined its rivals mentioned here in stealing 14% of global M&A advisory fees from larger rivals this year, and that should translate into good news for Lazard shareholders.

One red flag is Lazard's $1.26 billion in debt, which cannot be fully exterminated by the company's $547.3 million in operating cash. The company never engaged in some of the more risky practices that landed other investment banks in hot water, so over the long haul, Lazard isn't likely to be deeply impacted by the debt load. Lazard is probably a long-term play on the boutique investment banking sector at this point.

Bottom Line: You Don't Need Goldman To Make Money In Financials
There's no denying the allure (and performance) of Goldman Sachs stock, but with that price tag, it's not for everyone. While we're not so bold as to say Jefferies will reach similar heights, its savvy management and exposure to government debt issues combined with the fact it doesn't have a tab with Uncle Sam makes it the best of the trio highlighted here. (To learn more, check out The Rise Of The Modern Investment Bank.)

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