Banks have begun reporting their earnings results for the fourth quarter of 2022, and as many investors expected, investment banking revenue was hit hard, especially when compared to the bumper year in 2021.
This puts investment banks on the spot. As Wall Street struggles with lower debt and equity trading and fewer advisory fees, banks are also beginning to set aside loan loss reserves again in anticipation of an economic slowdown.
So far, the sector’s difficulties do not seem to have really touched share prices in any meaningful way. However, with more tough times ahead, I decided to compare two investment banking stocks that came on my radar due to the Oracle of Omaha, Warren Buffett (Trades, Portfolio).
According to 13F filings, Buffett’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) sold out of its position in Goldman Sachs (GS, Financial) in 2020. After slashing the position by 84% in the first quarter of that year, the guru exited the rest of the holding in the second quarter.
Then, in the third quarter of 2022, Buffett’s firm initiated a new position in Jefferies Financial Group (JEF, Financial). The position is relatively small for a Berkshire holding, valued at approximately $13 million based on the stock’s third-quarter prices, so it is likely that it was initiated by Buffett’s portfolio managers, Todd Combs and Ted Weschler. Still, it is interesting that Berkshire decided to go with Jefferies rather than picking up shares of the larger and more popular Goldman Sachs again. This begs the question: Which of these investment banking stocks is the better investment from a value perspective?
Investors should be aware that 13F reports do not provide a complete picture of a guru’s holdings. They include only a snapshot of long equity positions in U.S.-listed stocks and American depository receipts as of the quarter’s end. They do not include short positions, non-ADR international holdings or other types of securities. However, even this limited filing can provide valuable information.
Buffett’s tumultuous history with Goldman Sachs
Banks have long been a core part of Berkshire’s portfolio. In fact, financial services is the industry that the company had the second-most equity investments in as of the third quarter’s end, behind only technology due to the massive 41% of the equity portfolio that is dedicated to Apple Inc. (AAPL, Financial). More than half of Berkshire’s financial services holdings are bank stocks, though credit services holdings have taken up more space recently.
Buffett’s fondness for banks stems partially from their easy-to-understand business model and partially from their role as an ever-growing part of infrastructure in the U.S. The guru has a strong “bet on America” philosophy, and a big part of betting on America is betting on the growth of its financial system and trusting that it will not collapse.
To that end, Buffett invested an incredible $5 billion in Goldman Sachs at the height of the financial crisis. Buffett had a professional working relationship with Goldman Sachs for more than 50 years before that, which is why the bank’s representatives said they felt comfortable approaching him for its liquidity needs.
Just two days after Goldman Sachs became a bank holding company on Sept. 23, 2008, the company sold $5 billion in preferred shares to Berkshire with a 10% dividend yield and the stipulation that Goldman Sachs’ top executives not sell their own shares before Buffett sold his. Berkshire Hathaway also gained warrants for $5 billion worth of stock at $115 per share as part of the deal.
Around the time he sold out of the stock, Buffett did an interview with CNBC’s Becky Quick on Feb. 24, 2020. In the interview, he had the following to say about Berkshire’s bank holdings:
“Banking is a good business if you don’t do dumb things on the asset side, I mean, basically, the banks we own earn between… 12% and 16% or so on net tangible assets. That’s a good business, that’s a fantastic business against the long-term bond at 2%.”
This interview raises the possibility that “dumb things on the asset side” may have been a contributing factor to Buffett’s sale of Goldman Sachs, though this is all just speculation.
Despite liking the banking industry overall, Buffett has expressed disdain for investment bankers in the past. For example, in his 2015 letter to shareholders, Buffett called investment bankers “expensive money-shufflers” who “clamor to be fed.”
What makes Goldman and Jefferies different?
Given Buffett’s history with Goldman Sachs, I think it is safe to conclude that particular investment decision was an entirely different ball game from just buying shares on the open market without arranging any special deals, which is what Berkshire did with Jefferies.
Anything can be a value investment if you get a sweet deal like the one Buffett worked out with Goldman Sachs. There is no denying that Goldman Sachs is the premier investment bank in the U.S., though. Its prestige is hard to compare with, and prestige goes a long way in a business where pay is often dependent on it. So why would Buffett and his portfolio managers choose Jefferies instead? Some key divergences that stand out are scale, strategy and valuation.
A smaller company has room for growth
With a market cap of $8.59 billion compared to Goldman Sachs’ mammoth $118.87 billion, Jefferies is by far the smaller of the two companies. While Goldman Sachs has prestige that is doing a good job of keeping it in its spot as the top investment bank, it is naturally going to have a tougher time posting long-term growth instead of just cyclical growth.
This was highlighted by Goldman Sachs’ foray into consumer banking. There are many reasons why it would be beneficial for the investment banking giant to get into consumer banking, but they all boil down to difficulty posting long-term growth at the apex of its sector.
As the smaller company, Jefferies has more room for growth, most notably in terms of its potential to disrupt the industry and take market share from larger competitors. In fact, in the earnings report for the third quarter of 2022, Jefferies CEO Richard Handler said, "Investment Banking and Equities were very resilient, and we expect we have gained market share in those areas as we continue to support our clients through this volatile time." Jefferies’ fourth-quarter 2022 earnings report noted, "Our Equities franchise continued to expand in breadth and capability, while gaining market share across the majority of equity products in 2022.”
In this case, “smaller” is a relative term, as Jefferies is still the largest pure-play global full-service investment banking company that is headquartered in the U.S. That does not limit its ability to take market share from larger competitors that offer a wider variety of services. As the modern financial structure evolves and becomes increasingly complex, we are seeing more conglomerates lose out to companies with narrower areas of focus, which is something to consider.
Jefferies maintains its focus on investment banking
Another key difference between these two investment banking companies is that Jefferies has a narrower focus on investment banking and related services, while Goldman Sachs actually makes most of its revenue from other sources.
Goldman Sachs’ biggest source of revenue is its global markets segment, in which it acts as a market maker by executing transactions for clients, taking the opposite side of a transaction if it cannot match clients with another buyer or seller. It also has an asset management segment and a consumer and wealth management segment.
Meanwhile, Jefferies divides itself into investment banking, capital markets and asset management segments, each of which had roughly equivalent revenues in the fourth quarter of 2022, though investment banking still led the way.
Jeffries credits its narrower specialization as one of the reasons it has gained market share, growing to be the sixth-largest investment banking firm in terms of both mergers and acquisitions and global equity capital markets in 2022 (excluding China), up from 12th and 13th place, respectively, five years ago.
While investment banking revenue and equity trading revenue both tend to decline in recessionary conditions, investment banking can partially mitigate declines with advisory fees. This is the situation Jefferies saw in fiscal year 2022, with advisory revenue coming in at its second-highest level ever (only surpassed by 2021).
Valuation and takeaway
When it comes to valuation, I am not surprised to see Jefferies consistently trades at a lower price-book ratio than Goldman Sachs.
This would seem to put Jefferies in the undervalued category and Goldman Sachs in the fairly valued category, which makes sense with their respective market caps, but bank stocks are heavily cyclical based on the ups and downs of the economy as well as fiscal stimulus measures and major monetary policy decisions.
Since this is the case, the dividend is an important consideration for long-term investors, as is finding a good entry point that is not at the very top of a cycle. Jefferies has a dividend yield of 3.15% and a three-year dividend growth rate of 40.4%. Meanwhile, Goldman Sachs has a dividend yield of 2.55% and a three-year dividend growth rate of 27.3%. Both companies have maintained robust share buyback programs since they recovered from the financial crisis.
Despite the attractive dividend yields, especially for Jefferies, both of these stocks have seen their share prices rise considerably in recent years. With talk of a recession around every corner, lower share prices might be available soon. Overall, though, I can certainly see why Berkshire would prefer Jefferies over Goldman Sachs. It has a higher dividend yield, a lower valuation and a growing percentage of the market share in investment banking.
