The Basics of Investing in Investment Banks

Worldwide Invest Better Day 9/25/2012
Worldwide Invest Better Day 9/25/2012

Could now be the right time to invest in investment banks?

Today, the big-name investment banks that stumbled during the crisis seem to be getting their feet back under them. Smaller investment banks that weren't paid much mind by investors before are even more overlooked today. And with the financial crisis fallout still keeping many investors away from the sector, now could be a good time to consider this group.

Before you hit that "buy" button though, it's important that you understand what you're getting yourself into. With The Motley Fool's Worldwide Invest Better Day right around the corner, we're providing lots of great content aimed at helping investors up their game. And today, I'm going to take you through a few basic points to better understand the world of investment banking.

Bank or investment bank?
Ever since the Gramm-Leach-Bliley Act of 1999, commercial banks have been allowed to get into business lines outside of traditional banking. That means major banks like Bank of America (NYS: BAC) , Citigroup (NYS: C) , and JPMorgan (NYS: JPM) have substantial investment banking arms. This makes separating the "just banks" from the "investment banks" a bit more challenging.

Based on types of business activities though, we can easily identify stand-alone investment banks and do a pretty good job separating the investment banking operations at, say, Bank of America, from its traditional banking business. At a high level, the two primary businesses to look for in an investment bank are corporate advisory services and trading.

Advising corporations could be called the true-blue investment banking business, and it's the business we're referring to when we call someone an "investment banker." In this line of business, the bankers work with both public and private corporations to help them raise money -- through equity sales such as IPOs or various flavors of debt -- or deal with a merger or acquisition.

Trading operations have become an increasingly important part of the investment banking business in recent years, making outsized contributions to even advisory stalwarts like Goldman Sachs (NYS: GS) . Trading at investment banks covers an extremely wide range of products from plain vanilla stocks to commodity contracts and esoteric, individually structured derivatives. Part of the trading business focuses on banking clients -- that is, helping clients either buy or sell whatever financial instrument they're interested in. The other part of the trading business -- which can overlap with the client-facilitation trading -- involves the bank tapping its savviest traders to take the bank's own money and trade it to turn a profit.

It's also worth noting that many investment banks have asset management businesses. This can include standard mutual funds as well as private equity and hedge funds. Though it's part of the picture for many investment banks, it's not technically investment banking, and it shares the same business dynamics as asset-management-focused businesses like BlackRock and Legg Mason.

The players
The world of investment banking is most often broken up by size. On the top end there are the "bulge bracket" banks, and by sliding down the ladder, we get to the "boutique" investment banks.

Think of any large bank, and it's very likely that you're thinking of a bank that offers investment banking services of some type or another. Wells Fargo (NYS: WFC) , though primarily a traditional bank, offers investment banking services. As do HSBC, Royal Bank of Canada, and Japan's Mizuho Financial. However, on a worldwide basis, the business is dominated by a handful of major banks that includes JPMorgan, Bank of America, Goldman, Morgan Stanley, and Citigroup.

Though the big banks at the top claim the lion's share of the global investment banking fees, that doesn't mean you should overlook the smaller players. Of the investment banking businesses, the trading operations are fairly capital intensive because in order for an investment bank to help clients make big trades, it needs a lot of capital on hand. The advisory business, on the other hand, is a much more capital-light business that can be very competitive on the strength of the bankers' relationships alone. Case in point, former U.S. Deputy Treasury Secretary and Blackstone executive Roger Altman founded Evercore (NYS: EVR) in 1996 and was scoring major clients like Dow Jones and IBM almost immediately.

Among the boutique banks to keep an eye on are Evercore, Lazard, Greenhill, Jefferies, and Stifel Financial.

To buy or not to buy?
A concern about the investment banking business is that it's largely a people-driven, not product-driven, business. Coca-Cola, for instance, is built around a product, and as long as people around the world continue to love Coke, the business will do well. If, however, an investment banker with great relationships decides to leave a bank, those relationships could leave right along with him. It's a similar story if a hotshot trader realizes he can make more money by setting up his own hedge fund.

That said, just like any other business, an investment bank can build a brand. That brand can be helpful in attracting customers, and it can likewise help in attracting the best and brightest bankers and traders. Goldman Sachs manages to consistently get its hands on top graduates of the best schools around the world. Why? The brand has a lot to do with it.

If you do decide to jump in on an investment bank, be aware that the business itself tends to be cyclical in nature -- it booms when the economy booms, and busts when the economy sinks. While it can feel particularly dicey to be prospecting in investment banks when the economy is in the toilet, that's typically the best time to find a bargain on the best of the banks in the business.

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