By Amey Stone After gaining strength for weeks, the controversy over conflicts of interest between analysts and investment banking departments at brokerage houses appears to be losing momentum. Merrill Lynch (MER) is expected to settle the investigation brought by New York Attorney General Eliot Spitzer. Plus, the Securities & Exchange Commission passed a new slate of not-too-onerous rules on May 8 designed to eliminate analysts' ties to investment banking.
Those two factors, combined with some upbeat comments from analysts and a positive earnings report from Cisco Systems (CSCO), sparked a rally for leading brokerage stocks during the week of May 6, when they jumped about 7%. That was last week, however. Although the stocks rose on May 13 in line with the broader market, brokerages still have a long way to go to make up for losses suffered during the scandal. Merrill Lynch alone has shed 20%, or $10 billion, of its market capitalization since news of the Spitzer investigation hit. Brokerage stocks may pop on good news, creating trading opportunities, but for now, long-term investors might want to stay clear.
The controversy over research is far from over. Even though Merrill is likely to settle, Spitzer is still investigating other firms. Probes are also under way by other state AG offices, the SEC, and the Justice Dept. "This is a large snowball rolling downhill," says Bernstein analyst Brad Hintz. "I don't know who it's going to hit, but I know it's going to hit somebody."
CIVIL WAR? Merrill Lynch believes it can restore investor confidence. At its annual meeting on Apr. 26, Chief Executive David Komansky apologized for the lapses in research and promised: "We are addressing this problem squarely." The firm got some support on May 10 when Standard & Poor's issued a release saying it expected a settlement in the "near future," that fines would not be "substantial relative to Merrill's resources," and that "any reduction in retail brokerage revenues will be minor."
That's all well and good. But what investors fear most of all is that a flood of civil cases will be brought against brokerage houses. "It worries me that this could be lawyer heaven," says Barry Hyman, chief investment strategist with investment firm Ehrenkrantz King Nussbaum. Even though securities litigation doesn't have the same potential for exorbitant punitive damages as personal-injury cases, individual investors could try to recover untold numbers of dollars from brokerages. For example, InfoSpace (INSP), just one Internet highflier, went from a market cap of $40 billion to its current $250 million. Clearly, every dollar lost by investors wouldn't be reimbursed, but Hyman says he worries about "the dollars -- and the unknowns."
Even if cases are eventually dismissed, they take six months or so to resolve. Longer-term, there's an unquantifiable risk to the firms' reputations, as UBS Warburg analyst Diane Glossman pointed out in a May 9 research report in which she cut earnings estimates and price targets for all the brokerages she covers.
OTHER PROBLEMS. Glossman's main reason for the downbeat assessment however, wasn't the legal entanglements. It was the industry's weak fundamentals. Trading volume is light, investment-banking business is slow, and asset-management returns are poor. "We are not optimistic about revenues snapping back meaningfully before the fourth quarter and into 2003," she wrote to clients, reiterating hold ratings on Goldman Sachs (GS), Lehman Brothers (LEH), Merrill Lynch, and Morgan Stanley (MWD). Merrill Lynch analyst Judah Kraushaar trimmed his own estimates on the big brokerage houses on May 13 in a report titled "Brokers Still Bumping Along Bottom."
Many analysts think brokerage stock valuations are quite low. The question is: Will they start rising again anytime soon? Prudential Financial analyst David Trone suggested in a May 7 report that investors buy Merrill Lynch. At that point, he estimated that it had lost $12 billion in market cap. But his worst-case estimate is that it could cost $2 billion to deal with the consequences of the scandal. If not for the ongoing concern about litigation, Hyman says he would regard the stocks -- especially Merrill Lynch -- as cheap. "But the fundamentals that would lead to a turnaround at many firms are not there," he adds.
Other analysts, Hintz included, say Lehman Brothers is a relatively safe choice. That's because its main strength is in the comparatively healthy fixed-income business. It's also at less risk of being investigated since it didn't have high-profile analysts promoting tech stocks during the Internet bubble.
"STILL POTENTIAL DOWNSIDE." Hintz warns, however, that the entire group is trading in sync with the news -- which means they could fall further if the news turns worse. Hyman says brokerage stocks can trade down to their book values in times of severe turmoil. Many are now well above that at 1.7 or 1.8 times book value. "That means there's still potential downside," he says, adding: "I'm staying away from the sector for now."
Short-term trading opportunities will emerge in the brokerage sector, just as they did on May 8. And many analysts, such as Reilly Tierney of Fox-Pitt, Kelton, think valuations are low relative to current risks. But long-term investors will likely remain wary of the group. Even if the snowball of legal issues has slowed its downhill momentum, it'll be a long time until all the industry's problems melt away. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column