Over the past five years, Bear Stearns (NYSE: BSC ) has outpaced its rivals in terms of both earnings growth and stock market returns. How does the investment bank measure up now?
Bear Stearns is not associated with the largest, most prominent investment banking deals. The decision to focus instead on other activities stems from the fact that Bear, with just $22 billion in market capitalization, is dwarfed in size by the other bulge-bracket firms. For example, the market capitalization for Lehman Brothers (NYSE: LEH ) is more than $39 billion, Goldman Sachs (NYSE: GS ) is approximately $89 billion, and financial-services conglomerates like Citigroup (NYSE: C ) and JP Morgan Chase (NYSE: JPM ) weigh in at more than $245 billion and $162 billion, respectively. The relevance of such rankings goes beyond vanity and bragging rights. To the degree that market capitalization reflects the strength of a firm's balance sheet, Bear lacks the lending power of other banks to provide financing for the largest M&A deals. Bear's small scale also limits the firm's proprietary trading, an important source of income for most investment banks.
Bear's size disadvantage is not always a handicap. The firm's competitive profile was well-suited to the market conditions that followed the stock market bubble of the 1990s, when stock markets slumped and M&A activity was slow. During the same period, low interest rates sparked a rally in the bond market, which played to Bear's traditional strengths in fixed-income sales and trading. More than 43% of the firm's revenue comes from fixed-income underwriting and trading.
That alignment of stars helped Bear achieve phenomenal earnings growth over the last several years. Bear's net income increased from nearly $619 million in 2001 to more than $1.46 billion in 2005, an increase of 135%. Sizzling earnings growth has extended into the current year. Bear has already earned $1.49 billion in just the first nine months of this fiscal year, a 41% increase over the previous year.
Investors may be concerned that market conditions will no longer favor Bear's relative strengths. In particular, Bear's franchise in mortgage-backed securities appears less valuable in a slouching housing market. While Bear has reported a gain in market share this year, industry-wide volumes in mortgage-backed securities have been lower.
Bear is also seeing increased competition in prime brokerage, an area in which the firm has historically been an industry leader. This highly profitable business of providing trading support, securities lending, and other services to hedge fund clients is under pressure as clients seek to engage multiple prime brokers and squeeze from them lower interest rates on margin loans. Bear's Global Clearing unit, which includes prime brokerage, reported that customer margin debt balances were up 9% in the third quarter, but revenue increased only 4%. That negative leverage indicates that interest rate spreads are declining.
Sizing up the Bear
Bear has generated total returns averaging more than 23% over the past five years, a much higher rate than its investment-banking peers achieved. Nevertheless, at a recent share price of $151, Bear's stock trades at modest multiples compared to industry benchmarks. Bear's P/E multiple of 11 times earnings puts it in the middle of the range for its peer group. The company's P/B multiple of just over two times book value is at the bottom of the range for its peer group.
The apparent discount on Bear's stock may reflect concerns about the firm's prospects in its industry. Robust equity markets and a pickup in M&A activity are helping to boost the fortunes of Bear's rivals. In addition, Bear is more highly leveraged than its peers. The ratio of debt to equity for Bear is 15, while the ratios for Goldman Sachs and Merrill Lynch (NYSE: MER ) are just 7 and 11, respectively. In spite of this lower level of equity funding, Bear's return on equity of 18% is the lowest in its peer group. Returns on equity might be pressured further in the next few years by the capital Bear plans to spend in order to beef up its weak presence in international markets.
There has been periodic speculation about whether Bear would be an attractive takeover candidate for a larger bank, and Bear has continually demonstrated its ability to succeed as an independent firm. Bear remains equipped as an independent firm to handle the competitive challenges it faces for the foreseeable future. But as the strategic landscape evolves in ways that do not always favor Bear's strengths, the firm is unlikely to continue to outperform its peers.