Tuesday, July 31, 2012

An Old-Fashioned Mexican Standoff



How much is Smith Barney worth, and why should advisors and their clients care?
If Smith Barney-parent Citigroup and acquirer Morgan Stanley can’t reconcile a roughly $15 billion disagreement about price, advisors and their clients are likely to experience the fallout in the form of smaller recruiting checks and/or a less satisfying client experience.



A Strategic Business, Convoluted Valuation Process
It’s ironic that the retail brokerage made famous by commercials from the curmudgeonly John Houseman, “Smith Barney – they make money the old-fashioned way,” is caught up in an old-fashioned valuation dispute that may have significant adverse consequences.
The price that Morgan Stanley will pay for 14% of Smith Barney will be established by what can only be described as a byzantine process. 
The first step was for Citigroup to declare a selling price for Smith Barney. The Citi number came in at $24 billion for 14% of the brokerage.  Morgan Stanley then had an opportunity to counter. It came in with a price of $9 billion for 14% of the firm. 
I’m sure the investment bankers who devised this tortured process predicted a Mexican Standoff when they came up with this “resolution” plan.  The sheriff who will resolve it will be a third-party that determines a fair value for Smith Barney.


What is Smith Barney Worth?
There are two ways to value a retail brokerage.  One is based on a percentage of total client assets. The other is a multiple of normalized earnings. 
David Trone, a highly regarded research analyst at JMP Securities in San Francisco, arrived at a $24 billion valuation using both methodologies on Feb. 22, 2012.  The math is straightforward: 1.5% of $1.65 trillion of client assets, or 15 times normalized earnings of $1.6 billion, equals $24 billion. 
Looks like Citi’s valuation is closer to the true market value than Morgan Stanley’s.
The price resolution is particularly important for Morgan Stanley, which is facing intense pressure from shareholders. The firm has stated publically that wealth management is a key part of CEO James Gorman’s strategy to revitalize earnings. 

Why Advisors Should Care?
If Citi is correct and the value is close to $24 billion, Morgan Stanley will have to make significant expense reductions.  If Morgan Stanley’s $9 billion figure is correct, the expense reductions will be out of the brokers’ pocketbook.
Either way, there will be ramifications for everyone. The two most immediate impacts are that advisor recruiting checks are likely to shrink, and the client experience is likely to suffer.
To increase profits, it’s likely that Morgan Stanley will implement plans to increase margins.  Historically, firms have manufactured complicated investment “solutions” to increase margins. But as the financial crisis showed, those “solutions” don’t necessarily result in higher investment performance for clients.
Additionally, Morgan Stanley is likely to pare back technology investments, since there could be less capital available after the deal.


Technology Quagmire?
In fact, that technology conversion for Smith Barney clients has already been difficult.
A senior manager at the firm recently told a Morgan Stanley branch office that the firm is well aware that its integration of  the Smith Barney platform into Morgan Stanley was not perfect, but had to be done.
One Smith Barney advisor recently summed up the experience thus far: “It feels like I’ve switched firms, but without the recruiting check.”
What happens next in Wall Street’s latest valuation drama remains to be seen for both clients and advisors.
That is, of course, unless Smith Barney advisors or their clients decide to break away and realize the certain technology upgrade and other benefits of working with an independent firm.

Thursday, July 12, 2012

Higgs boson and the LIBOR Scandal


The two big news events of the past week – the discovery of the Higgs boson and the mushrooming LIBOR scandal – can be difficult to comprehend. But both can teach us something timeless about effective problem-solving and establishing trust.


Higgs boson, often described as the “God” particle, was revealed after researchers spent decades searching for this elusive secret to the universe. When the Higgs boson announcement was made last week, two teams independently verified the results.

This amazing discovery was the product of the scientific method. The intellectual rigor of this investigation by the world’s brightest minds confirmed what was true for billions of years. Thankfully the laws of the universe were the final arbiter of truth not the SEC, FINRA or the FSA.


Fudging The Rules For Gain
Now compare that problem-solving approach to the recent modus operandi in the financial services industry around setting the LIBOR rate.

In the LIBOR scandal, insiders gamed a system believed to be based on fixed rules and the integrity of the financial services industry – supposedly the stewards of a vital public trust.

The LIBOR culprits, like those on Wall Street before them, failed us in two ways.

First, the perpetrators placed their selfish interests above everyone else’s, while purporting to follow the rules.  They secretly cheated, and in the process, they dealt another serious blow to the credibility of the global financial system. This further destruction of trust is regrettable.

Second, this scandal highlights that the financial services industry has learned little from past scandals.  These so-called financial wizards still believe they possess the magic to deliver market-beating returns.

In short, they remain convinced that they are masters of the financial universe – more capable investors and traders than anyone else. In fact, that turns out to be a lie too.


It’s interesting to note that one of the most successful investors of our time, Jim Simons of Renaissance Technology, has achieved superior performance by adhering to an investing methodology that would have made the Higgs boson scientists proud.

The Fundamental Laws of Wealth Management
At a time like this, it useful to recall the fundamental laws of wealth management – the laws we have always known to be true and effective in advising clients.

They are: 1) A Primary focus on financial planning; 2) Tax minimization 3.) Keeping fees reasonable or even low 4.) Diversification.

These principles have always served advisers and clients well in good times and bad.  On the other hand, advisors risk losing the trust of clients when they promise outlier performance using exotic products and strategies, which often tend to disappoint.


So if the scientific method and the laws of the universe are good enough for scientists, shouldn’t the fundamental laws of investing be good enough for participants in financial services?

The bottom line is that the financial services industry has squandered the trust of investors. The only way to reclaim it is to follow the things we know to be true.