Be Not Afraid! Foreign Investment In US Large Financial Firms

Citigroup has taken a capital infusion from the Mideast. Morgan Stanley reported a capital fillip from China. Now Merrill is joining the crowd, reporting a large capital investment from overseas. UBS, the Swiss bank, has joined with these American financial institutions seeks repairs to the multi-billion dollar holes in their balance sheets.


I'm sure I've missed someone in this crowd. Mideastern, Southeast Asian, and Chinese sovereign funds are scooping up equity positions in these firms at apparently bargain basement prices.


Are we selling the sinew and bone of the world's predominant financial system to foreigners due to credit instrument losses and poor risk management among the US financial sector's largest and most prestigious firms?


Actually, I doubt it. Be not afraid! There is, I think, a silver lining or two to this story.


First, it's a global economy. Having foreign investors owning parts of our financial service firms directly puts their interests in line with our own.


Second, buying into, for example, Morgan Stanley, isn't the same as buying into Ford, Oracle or Intel. Service sector firms are different in that their key assets leave the building each night and go home.


These foreign funds aren't buying production lines, raw material reserves, or real estate, per se. They are buying shares of existing, and, frankly, damaged brand franchises, and the temporary employment relationship with traders and underwriters.


Third, to continue on a portion of my second point, it's not clear that these foreign firms are making wise investments.

For example, nearby are Yahoo-sourced charts of Goldman Sachs, Morgan Stanley, Merrill, Bear Stearns, UBS and Citigroup vs. the S&P500 Index over the past two years, and Goldman, Lehman, Morgan Stanley and Bear Stearns vs. the S&P for the past two years.

By using a collection of, first, recently troubled commercial and investment banks, then just investment banks, it's clear that most of these firms are simply damaged goods. Only Goldman has outperformed the index over the past 24 months, with Lehman next best, but still trailing a simple buy of the index.

The same firms over the past five years exhibit similar performances. The collection of badly-performing firms still mostly underperform the index. This time, though, UBS looks better. Goldman is still well above the rest of the pack and the index.

The second chart displays Lehman as being better than the index, implying that its problems have been in the recent two years.

My point is that out of some seven large US financial service firms, only one, Goldman Sachs, has consistently outperformed the S&P over the past five years.

But that's not the firm that has been on sale. Instead, the foreign sovereign funds have been buying into, essentially, the losers. Of course, they believe they are buying on the dip.

Maybe they are. Maybe they're not.

Maybe the past five- and two-year performance displays reveal that most publicly-held US investment banks can't outperform the S&P. Most commercial banks haven't, either, as I've noted here- and not just the worst of them, i.e., Citigroup.

As Wednesday's Wall Street Journal/breakingviews article noted, Goldman now has a commanding lead in average compensation on Wall Street. Its recent performance has allowed it to retain current valued staff, and probably recruit the best from its ailing competitors.

In the final analysis, financial service franchises are only as good as their recent performances. Some of the best investments aren't public. Or only recently so, and, now, not so well-performing, like Blackstone Group.

But as most of Wall Street went public over the past few decades, there has been a corresponding regrouping of talent back in privately-held hedge funds and investment banks. And they don't seem to be seeking bailouts or emergency capital infusions.

The very best US financial firms aren't even available for investment. Perhaps the foreign investors are buying into yesteryear's stories, and will be holding a very expensive bag a few years from now.

Wouldn't these funds have been more prudent by just buying S&P Index funds, if they sought exposure to, and equity stakes in the US economy? As the charts in this post demonstrate, only one large US financial services firm, Goldman Sachs, has been a consistently solid investment. Even buying Goldman at market prices would have been a better bet than buying stakes in any of the other firms.

Now, you might argue that these foreign investors are getting off-market, special sale prices. But they're getting those prices on ailing firms with poor risk management and, in many cases, completely new management teams. Who's to say the future will be any better for these firms, after a one-year pop in their price?

If the sovereign funds are just making a timing play on distressed US financial firms, then there's no long term worry, is there? But some of the announced convertible deals suggest longer time frames.

Personally, I think these foreign investors are making a common mistake- buying damaged firms at the bottom, and hoping they will turn around. Were they to have a basket of such bets, that might be a good, risk-adjusted bet.

Somehow, though, I suspect that they are taking outsized, non-diversified bets that won't do as well, on a risk-adjusted basis, as alternatives such as US index funds or buying shares in Goldman or Lehman. Or, over the next few years, perhaps even Blackstone.