If Leucadia’s Buying Jefferies, Should You Buy Some Goldman Sachs?
Since early last year, the book value of Jefferies & Co. (JEF) has grown more rapidly than that of Goldman Sachs (GS), the investment bank that Jefferies aspires to emulate. Monday, Leucadia National (LUK), a holding company that itself likes to emulate a bigger and better-known brand, Warren Buffett’s Berkshire Hathaway (BRK.B), decided to pay about 1.2 times that book value, by some estimates, giving Jefferies a larger capital base from which it can continue its battle to join Goldman Sachs as one of Wall Street’s power players. Despite the turmoil that followed the financial crisis, the country’s biggest financial firms have been able to hold onto their dominant position, frustrating the likes of Jefferies, which had hoped to shake up the status quo and the investment banking league tables.
But does the Leucadia merger mean that Jefferies really is worth more than Goldman Sachs, pound for pound, as the current valuations suggest?
Moody’s last month downgraded Jefferies’ debt to only a notch above investment grade, warning that the investment bank’s rapid expansion may have taken a toll on its risk management culture and practices. Market participants vividly remember how worries about Jefferies’ exposure to European debt in the wake of MF Global’s collapse and warnings from another rating agency wiped more than half the value off Jefferies shares. The investment bank has bounced back from that, however, and made it clear that rather than being the source of market risk (indeed, it lost money trading on only a single day during its third quarter, significantly less than the number of days Goldman Sachs reported a trading loss), it is more interested in being part of the solution. It stepped in to help orchestrate the rescue of Knight Capital after the market-making firm teetered on the edge of collapse in the wake of an electronic trading catastrophe that cost it $440 million in losses.
Goldman Sachs has had to pull back from taking risk; the bank’s average daily value-at-risk, or VaR, by one measure was nearly 20% below year-earlier levels in the third quarter, or an average of $81 million on any given trading day. But the less risk it takes, the lower its potential earnings. That means Goldman will have to pay careful heed to its costs, especially in the midst of an environment in which trading levels remain below normal and advisory fees harder to come by.
That said, there are a few arguments in favor of owning Goldman’s shares at this point in time.
First of all, there’s the value case. Goldman’s return on equity – a key metric for banks and investment banks – has taken a turn northward, even as its P/E ratio for the trailing 12 months has fallen. That’s a good combination.
Secondly, if you’re going to place a bet on any investment banking team to be able to re-imagine itself for the new post Dodd-Frank era by devising new sources of stable revenue while remaining nimble enough to participate in any recovery in trading activity, it’s more likely to be the savvy team at Goldman Sachs than it is to be Jefferies Group. The former has a cohesive culture and established management; the latter already is the product of a series of acquisitions of operating businesses and trading and banking teams to which the Leucadia merger will add one more layer. And while Goldman remains vulnerable to regulatory risk – what happens if rule makers determine that its market-making activities amount to proprietary trading? – no one is likely to insist that Goldman Sachs be broken up into its constituent pieces.
Opting to jump into Goldman Sachs shares could well be a good call for a risk-tolerant investor willing to bet on the long-term prospects for the investment banking industry, but those risks aren’t insignificant. True, Goldman’s share price has fallen from its recent highs in the post-election market pullback (although the Jefferies news prompted a small rally on Monday). But its PEG ratio, which sets its valuation, or PE ratio, against the rate of earnings growth, is sharply higher, a warning signal for the valuation conscious investor. The fact that the valuation argument weighs heavily in favor of Goldman on a relative basis isn’t enough to make it unequivocally exciting in absolute terms – at least at current prices. Investors could well end up overpaying for current growth or betting on future growth that could prove elusive.
Suzanne McGee is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.