Discounting Private Equity’s Impact on Wall Street
Last month we warned our viewers about problems in the subprime sector spreading into the stock market. Only a week after putting out our warning, stocks had their biggest one-day loss in several years. Brokerage stocks were particularly hit hard by the sell off. Goldman Sachs, Bear Stearns, and Lehman Brothers are all down 10% from their highs earlier this year. This coming week will give us a great glimpse into whether blow ups in the subprime industry are impacting profits at Wall Street firms. Bears will try to bounce on any small opening into mortgage troubles hurting profits.
Incredible profits we’ve seen on at the brokerage firms thus far in the business cycle, in our view, are only a prelude to bigger growth ahead for the sector. Investors should be focusing on where we are in the private equity cycle. For most of the top brokerage firms, subprime represents only a small portion of their business. Wall Street’s brightest were well aware that it was only a matter of time before the sector collapsed. Brokerages acted more of a middleman by packaging loans from underwriters into securities sold to pension funds and hedge funds. Buyouts by private equity started to heat up last fall and appear to be growing bigger by the week. With the lag time between when a deal is announced and the time it is completed, we will see earnings at investment banks move well beyond analyst estimates this year.
The firm poised to benefit most from private equity is Goldman Sachs (conflict of interest note: author owns a position in Goldman Sachs). At 9 times earnings, Goldman Sachs is a bargain without the boom in private equity. Last year Goldman earned $20 and by our estimates could surpass $50 should merger & acquisition activity continue at the pace we expect. By our estimates, Wall Street’s leading firm could see its share price rise three-fold in a few short years. Lehman Brothers, Merrill Lynch, and Bear Stearns could also see rapid appreciate in their share prices.