The stocks of smaller, mid-cap brokers, most notably LPL Financial Holdings Inc., and electronic trading firms have the greatest potential valuation upside in 2018. Various policy tailwinds and economic drivers appear poised to give a shot to their earnings, according to Steven Chubak, an analyst with Nomura Instinet who covers brokers and asset managers.
"Though policy progress and tax reform should boost earnings across our universe, we see greater alpha potential at firms which have an element of 'self-help,'" such as positive news on expenses, he wrote last week in a 2018 outlook report titled "After the (Tax) Party, It's the After Party."
Mr. Chubak breaks down the brokerage sector into four categories: smaller mid-caps, eBrokers, universal banks and M&A independents.
His top picks this year in each are, respectively, LPL Financial, E*Trade Financial Corp., Bank of America Corp. and Lazard Ltd.
While they "should all be beneficiaries of policy changes (interest rates, taxes, M&A), we also see some additional sources of upside that should benefit stock selection," he wrote. "For [Bank of America and LPL Financial], continued expense progress should support accelerated earnings growth."
LPL Financial in October 2015 said it was keeping an eye on its expense growth and intended to slow expense growth the following year.
The group of financial stocks Mr. Chubak covers has beaten the S&P 500 since early November, when the House first released its tax plan, he noted. While that outperformance has led many investors to believe the benefits of tax reform are already priced into shares, Mr. Chubak writes the group still has room to run, with some shares still cheap. In particular, shares of eBrokers and smaller mid-caps could see earnings per share rise in 2018 by more than 20%, according to Mr. Chubak.
"Our analysis suggests most of the firms in our coverage are still trading at meaningful discounts versus their long-term average, relative price-to-earnings multiples, with the small mid-caps and eBrokers screening cheapest on this basis," he wrote.
Mr. Chubak praised three smaller mid-cap brokers, or Smids: LPL Financial, Raymond James Financial Inc. and Stifel Financial Corp., which he upgraded to a rating of "buy" due to an improved M&A and capital raising environment, he wrote.
LPL "remains one of our top picks for 2018 as we see significant upside potential to booth earnings and shares," he wrote. "In particular, [it] screens as the biggest beneficiary in our coverage from both tax reform and higher rates, which we would argue remains underappreciated by many investors."
Meanwhile, Raymond James fourth quarter trends "have been well telegraphed in published monthly metrics, with softer investment banking trends more than offset by better loan growth and stronger commissions in the private client segment," he noted.