Volatile but valuable

The swoon in investment bank shares from the pinch in credit markets has left them looking cheap, but for some gutsy contrarians they have an even stronger appeal simply because everyone hates them.

Huge drops in shares of investment banking stalwarts Goldman Sachs Group, Merrill Lynch & Co., Lehman Brothers Holdings and of course, Bear Stearns Cos. have struck fear in investors, raising worries about the stability of the financial system.

But the rollercoaster price movements signal some of the best buying opportunities in the market as valuations slide to levels some now consider cheap.

We've been buying over the last 30 days, said Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis.

For Bear Stearns and Goldman Sachs in particular, a stream of headlines describing their hedge fund horrors in an already panicky marketplace has left the stocks down 32 percent and 10 percent respectively this year.

The extraordinarily negative sentiment surrounding this sector is more a reason we are buying than its valuation -- they've just been outright dumped, Paulsen added.

Dumped is right. During the market correction between July 19 and August 3, financials were down 10.9 percent, marking them the second worst sector for that period in the Standard & Poor's 500 after materials stocks.

Financial stocks have taken a drubbing over the last six months, but selling pressure for the group has intensified over the last several weeks, as subprime mortgage defaults have ratcheted up, losses have mounted at several high-profiled hedge funds and credit conditions have tightened.

At issue is whether earnings of investment banks could come under pressure as they've been unable to sell bonds and loans that were designed to fund risky leveraged buyouts, or LBOs. If that debt is stuck on banks' balance sheets for a considerable period, brokerages could have less money available for other deals and trading.

The risks, however, are known to investors and many argue the financial sector has largely factored in those possibilities.

GOLDMAN TRADING AT LOWEST P/E

I would argue that at these prices, if their earnings are at risk to some degree ... at these prices I can live with that, said Bob Doll, vice chairman and chief investment officer of global equities at money manager BlackRock Inc.

Goldman shares, for example, are currently trading at its lowest price-to-earnings ratio in its history. Its forward P/E is currently trading around 8.1.

Doll's portfolios had been underweight financials during the period of underperformance for the sector, but with the huge declines in financial shares the firm is not as underweight to the degree we were, Doll said.

The price adjustment is reflecting certainly more credit concerns than before we went into this, said Doll, who helps oversee more than $1 trillion in assets.

Doll declined to say where he's been putting money to work but said he has a bias toward the higher-quality, globally diversified investment banking giants.

It is companies like Goldman Sachs, Lehman Brothers and on the bank side, Citigroup and JPMorgan, Doll added.

Jim Huguet, president and co-CEO of Great Companies, Inc., which recently sold Goldman shares based on its valuation, said: We would be looking at it again. It's becoming more attractive.

At $180-plus a share and estimated earnings growth of 13 percent a year, estimated returns is about 18.5 percent per year over the next 5 years, he said.

Indeed, Goldman and other brokers have about $75 billion in exposure related to the $330 billion worth of leveraged loans and bonds related to LBO transactions, calculated Prashant Bhatia, analyst at Citigroup.

But the mark-to-market impact related to brokers funding those LBOs will be in the range of 2 percent and 5 percent in 2007, which he said would be manageable.

Bhatia said while risks remain he's telling clients that Merrill and Morgan are better positioned to weather a potential credit storm and find their share prices attractive.

Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey, notes that the trailing P/E multiples of Merrill, Morgan and Lehman are under 10 times.

He's got his sights on Lehman because the company is better diversified and trading at an 7.9 multiple.

Slapping a multiple of 12 would bring shares to fair value of $94 a share, he said. Even then, Sowanick said when looking at Lehman shares relative to the historical P/E of stock markets, That's still cheap!