By John Reese, Validea.com
ABN AMRO, Dow Jones, Chrysler, Alltel -- it seems like every day another major company is bought out or mentioned as part of a potential merger or acquisition. This year's leveraged buyout loans are doubling last year's pace, Barron's Michael Santoli notes, adding that at least one $5 billion acquisition was announced on 26 of the first 95 trading days this year. Hopefully you're among the shareholders who have been reaping the benefits of the binge. (On those 26 days, Santoli notes, the S&P 500 averaged twice the gains it has averaged on the whole this year).
One group surely sitting pretty because of all of the M&A activity is investment banks, which garner huge fees for helping broker the deals and advising the companies involved. Many such companies had already been posting big gains in recent years, including 2006, when a record $3.8 trillion worth of deal activity was reported worldwide, according to CNN. Now, in the first four-plus months of 2007, close to $2 trillion worth of deals have already been made, CNN reports, so just think about the amount of cash that has been flowing into investment bankers' coffers.
With that in mind, I got curious about which banks have not only capitalized on the recent rush of buyouts, but have also had solid histories of strong performance. Using my "Guru Strategies" -- computer models that are each based on the philosophy of a different Wall Street great -- I found a handful of firms with investment banking services that have excelled for several years, and appear poised to continue their growth in the long term. Here's a look at the best of the bunch.
Morgan Stanley (NYSE:MS): The New York-based financial services giant, which has offices in 31 countries and a market cap of $89.6 billion, gets approval from the strategies that I base on the writings of James O'Shaughnessy and Martin Zweig. When looking for growth buys, O'Shaughnessy seeks out companies that have strong history of earnings, so the method I base on his writings targets firms whose earnings per share (before extraordinary items) have increased each year for the past five years. Morgan Stanley's EPS over the last half-decade have been $2.70, $3.66, $4.15, $4.81 and, most recently, $7.09, passing this earnings persistence test.
Growth, of course, is only one half of the equation. The other half is finding growth stocks still selling at a good price. O'Shaughnessy does this by using the price-to-sales ratio, and my O'Shaughnessy-based model requires stocks to have P/S ratios below 1.5. With a P/S figure of 1.08, Morgan Stanley passes the test.
My Zweig-based strategy likes Morgan Stanley's 23.1 percent per year growth rate (based on the average of the three-, four-, and five-year EPS growth rates), which exceeds the method's 15 percent minimum. But Zweig doesn't just like earnings to be growing; he also likes the rate of that growth to be increasing. Morgan Stanley's EPS growth rate for the current quarter (compared to the same quarter last year) is 58.9 percent. That exceeds the 56.3 percent average growth rate for the previous three quarters (compared to the same three quarters last year), which in turn easily bests that 23.1 percent long-term EPS growth rate. In short, earnings haven't just been growing; the rate of their growth has been accelerating.
Another major tenet of Zweig's is that cost-cutting measures can only go so far; for earnings to grow over time, they must be supported by a comparable or better increase in sales. Morgan Stanley's revenue growth is 21.59 percent, close enough to the historical growth rate of 23.1 percent to get the nod from my Zweig-based model.
A.G. Edwards, Inc. (NYSE:AGE): [Ed. Note: Wachovia recently agreed to purchase A.G. Edwards for $6.8 billion.] The strategy that I base on the writings of Peter Lynch is high on this St. Louis-based firm, which has more than 740 offices in the U.S. and two in Europe. Edwards, which just makes it into the large-cap category with a market cap of $5.7 billion, has benefited greatly of late from the investment banking boom. It tallied $112 million in investment banking revenue in its most recent quarter, almost double the $63 million it took in a year earlier.
While O'Shaughnessy uses the P/S ratio to find growth stocks still selling at a good price, Lynch uses the P/E/Growth ratio, which divides a stock's price-to-earnings ratio by its growth rate. The model I base on Lynch's writings sees P/E/G ratios below 1.0 as acceptable, with those below 0.5 the best-case. With a P/E ratio of 17.37 and a growth rate of 32.89 percent (based on the average of the three-, four-, and five-year EPS figures), Edwards has a sterling 0.53 P/E/G, passing Lynch's most important criteria with flying colors.
To assess the strength of financial institutions, Lynch uses both the equity-to-assets ratio and return on assets figure. My Lynch-based model requires companies to have an equity/assets ratio of at least 5 percent and a return on assets of at least 1 percent. At 40 percent and 6.64 percent, respectively, Edwards excels in both tests.
My Zweig-based method is also high on A.G. Edwards. The firm's EPS have increased each year over the past five years, and its 32.9 percent growth rate (based on the average of the three-, four-, and five-year figures) doubles my Zweig method's 15 percent minimum.
One word of caution, however. While A.G. Edwards' earnings have grown by 32.9 percent over the long term, its revenues have increased just 7.32 percent. That means that those nice earnings increases have been driven in large part by other measures, which Zweig sees as difficult to maintain in the long run. While its fundamentals are strong and indicate that the company is well-positioned for future growth, you shouldn't expect it to keep posting 33 percent earnings returns every year.
Citigroup Inc. (NYSE:C): With a market cap of $271.3 billion, Citigroup is the fourth-largest company traded in the U.S. It offers a diverse array of financial services, including investment banking, and recently served as an advisor in Porsche's $37.8 billion buyout of Volkswagen, according to CNN.
My Lynch model likes the Manhattan-based firm's yield-adjusted P/E/Growth ratio of 0.89 (based on the average of the three-, four-, and five-year EPS figures), which comes in under the strategy's 1.0 maximum. It also likes Citigroup's 6 percent equity/assets ratio, which shows the firm is in good financial health, and its 1.16 percent return on assets, which indicates the company is profitable.
The model that I base on O'Shaughnessy's "Cornerstone Value Strategy", meanwhile, looks for large companies, because O'Shaughnessy believes they exhibit sold and stable earnings. For Citigroup, this model's $1 billion market cap minimum is no problem.
When looking for value stocks, O'Shaughnessy compares stocks to the market average in a number of ways, including cash flow per share. Citigroup's current cash flow per share ($4.73) is more than the market mean ($1.61), passing one of my O'Shaughnessy-based criteria, while its trailing 12-month sales ($102.7 billion) are more than 1.5 times the market average ($17.5 billion), passing another O'Shaughnessy-based test. One final reason the firm scores high on this model: its stellar 3.93 percent dividend yield.
One last point worth mentioning is that my guru models aren’t the only ones that think Citigroup is a good value. Investors may have also noticed the headlines earlier this month regarding Edward Lampert’s large accumulation in the stock. Lampert’s ESL Investments, a highly successful hedge, owns about $800m worth of Citigroup.
Goldman Sachs Group, Inc. (NYSE:GS): Sachs, another of the New York-based investment banking giants, has worked on the recent $100 billion ABN AMRO takeover bid launched by a Royal Bank of Scotland-led group, as well as AstraZeneca's $14.6 billion buyout of the biotech firm MedImmune, according to CNN. It's one of several I/B firms that get strong interest from a single guru strategy, but I've chosen to include it because it comes close on four other strategies I use.
The strategy that really likes Sachs is my O'Shaughnessy-based growth model, which likes its $93.6 billion market cap and the fact that the firm's EPS have risen from $4.03 to $5.87 to $8.92 to $11.21 to, most recently, $19.69. That passes this method's earnings persistence test.
But while Goldman Sachs' earnings have been growing significantly, it still sports a 1.26 P/S. That, according to my O'Shaughnessy-based model, indicates it is still selling at a good price.
UBS AG (NYSE:UBS): The Switzerland-based banking titan is another of the investment banks that gets approval from a single guru strategy, but I've chosen to include it over the others because it has been an advisor in a bevy of recent M&A activity, including some of the ABN AMRO offers, the Volkswagen deal, and the pending $25.7 billion buyout of student loan service SLM Corp, according to CNN.
Its $124 billion market cap makes UBS just what my O'Shaughnessy-based value strategy looks for: the kind of large company that can produce solid, stable earnings. In addition, the firm's cash flow per share of $5.73 not only exceeds the market mean of $1.61, it nearly triples it, passing another of my O'Shaughnessy-based value tests. And its trailing 12-month sales of $76.6 billion easily come in at more than 1.5 times the market average, passing another of this model's tests.
The M&A binge from which UBS and the other firms I've mentioned have benefited almost surely won't last forever. In fact, more than a few analysts are beginning to question whether the buyout rush is on the verge of spinning out of control, resulting in unwise -- and unprofitable -- deals. But the companies listed above haven't simply capitalized on recent M&A activity. Each has a history of several years of strong earnings and good fundamentals. Their profits might not continue the warp-speed growth of the past year or so, but they should still be good enough to make these firms worth considering for your portfolio.
At the time of publication, John Reese and his clients held positions in all of the stocks mentioned in this article.
John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best. Click here for more of Reese’s insights and analysis, and to learn about subscribing to the Validea Hot List. At the time of publication, John Reese and his clients held positions in all of the stocks mentioned in this article.