23 July, 2007

GS or MS: Battle Of The Banks

In the truest sense of the old-school type Battle of the Bands, where local Garage hopefuls filled stages to compete for the attention of, and possible employment from a single club or record label owner, I present a Battle of the Investment Banks.

With Bear Sterns (BSC) being the latest to fall like a 100 year old Redwood doing battle with the sub-prime market. Reports have surfaced over the last week that a couple big hedge funds inside the firm that were heavily invested in this industry are now virtually worthless. Does the investment banking investor have any hope out there?

Well, there are choices aplenty in this space such as Goldman Sachs (GS), Morgan Stanley (MS), Lehman Brothers (LEH) or Merrill Lynch (MER), along with several smaller firms all fighting for business and your investment dollar. Not to mention that the big brick-and-mortar banks are expanding heavily into the investment sector.

Taking the stage here and now surely wont be a local teenager with a new birthday present electric guitar, as we're looking at and comparing the cream of the crop in the investment banking world. Goldman Sachs and Morgan Stanley are the two biggest firms by market cap and for good reason, both companies are very good at what they do, and that's attract big clients, charge huge fees, and make money off every kind of investment imaginable. Have you ever heard of Weather Derivatives? It's where people in the marketplace can place bets on how many days it'll be higher or lower than the average temperature in a given month. You've never invested in something like this? Didn't think so, but guess what, these firms do!

So which one is better now and years from now? First to the stage Goldman Sachs. (Come on, you're telling me that wouldn't make a great band name)
The stock has fallen from a peak of $234 to $205 as it's been sideswiped, like everything else in the sector by this risky-mortgage mess. More often than not it is credited as being the best investment bank in the world and it sits with a trailing P/E of 9.5! A single digit P/E for a company that's earning and growing like Goldman Sachs. This rock star sports a healthy estimated Price to growth ratio of 0.7.

Goldman is so good at what it does but seemingly analysts are confounded at exactly what it does and how it goes about doing it. Yes Goldman has booked tremendous gains over the last year in some early Chinese investments but it's investing in these kinds of things all the time and people are surprised by the success. The nature of some of Goldman's trading operations make it seem like that part of the business is being run like one large hedge that can crash and burn on a bad bet or two but I think professionals that cover this company are missing the point. These are the smartest market people on the planet and they have backup plans that have backup plans. There's risk taking and then there's too much of a good thing, that's bound to crumble, just ask those Bear Sterns funds.

Goldman appears to be masterful at managing its internal risks but they have yet to fully be rewarded for it. The run up of the stock from the 150s to the 220s last year and early into this year should've only been the beginning however a wall was hit and the shares are tumbling back to the 200s. Opportunity? I think so!

Let's look at the other company. Morgan Stanley. If you thought Goldman's fundamentals were impressive how about Morgan sporting a P/E of 7.7 and a Price to growth of 0.6. Now Morgan Stanley notoriously went through step after step of cost-cutting and re-tinkering over the last 12 months in order to boost it's shareholder value and it seemed to have spark a turnaround in the business as well. But it also was hit hard falling from a high of 76 to it's current levels around $67/share. As far as businesses go, Morgan Stanley would seem more transparent to the average investor as they have clearly drawn lines for its business units and even are a player in the credit card world with their Discover brand. However, that has been an area of contention for the company as many feel selling that business unit would ultimately lead to more value long term and as such the company announced June 30th as the day it would in fact spin off the Discover business resulting in a $14/share payout to shareholders.

Is there an opportunity here also? Yes, however here is why I believe Goldman Sachs is the better play now and for the longer term.
Both companies brought in revenues of around $39Billion over the last year, however Goldman earned a Billion more ($10B v $9B). Goldman clearly is able to more efficiently turn a profit at a slightly higher margin rate. Here's the kicker though, Morgan Stanley employs 55,000 people, while only 30,000 work for Goldman Sachs.

Not only is Goldman earning more from the same amount of revenue, they are doing it almost half the personnel! So is it likely that in the years going forward Morgan Stanley is going to go through a massive layoff spree to bring it's personnel down so it can compete with Goldman in terms of profitability? No. What does seem more likely though, is that as both firms grow Goldman should have more room to expand and hence earn more money running it's top notch trading operations and hence have more opportunities to lure business away from other firms.

Both firms look prime for a rebound later in the year however I think you'll find Goldman's songs at the top of charts more consistently than Morgan's.

Disclosure: Author is long GS and holds no position in MS


Anonymous said...

I have been adding to my GS position during the decline, and I started a position in MS when it dropped below 68. It is not disputed that GS is the best (bulge bracket) IB in the world; but I think MS could generate comparable returns during the next couple of years. For the reasons listed in your blog, I would own them both (rather than try to choose).

Anonymous said...

A significant portion of the recent decline in MS stock from its 52 week high is a result of the spin-off of its Discover Financial Services subsidiary. You make it seem in your blog that the decline is totally due to "market forces", which clearly isn't the case.

Chris Krasowski said...

I tried to briefly talk about the Discover spinoff, however the article's intent was to compare the 2 companies on a fundamental basis in their industry of Investment Banking. Although, taking into account the $14 payout from Discover, MS still fell from 76 to 67 or about 12% where GS fell from 230 to 202, which is almost around 11%. Very similar declines due relatively speaking for both companies are due to "market forces".

In hindsight I maybe should've been more clear on what portions of the declines of both stocks I was trying to convey as being potential buying opportunities going forward.

Anonymous said...

nevermind. yahoo finance for some reason decided to omit any mention of discover spin.

Anonymous said...


Thanks for your insight. I look forward to more articles on hot topics.


Anonymous said...

Hey Chris,

Good article but two points I would like to mention: 1) The # of employees at MS you mentioned is no longer correct as the DFS spinoff took a big chunk of employees with them so as far as earning per employee goes, it will have to be recomputed once MS reports next quarter for the first time post-spinoff and 2) MS is coming from a lower earning base due to years of mismanagement by former CEO Phil Purcell and under the new CEO John Mack should have better earning growth going forward as it tries to catch up by taking more risk. This has shown to be the case the last 2 quarters.

Chris Krasowski said...

To clear up a couple of things about this Discover spinoff.
First, I previously worked for Morgan Stanley and so in essence have had an opportunity to see first hand, "dug deeper" than just statistics. The discover brand had been a point of contention and shareholder frustration but some time. The decision to spin it off is a good one, so Morgan can refocus and compete fully in the industry. The resulting Market Cap hit does not change the fact that MS and GS are the two best known and biggest investment houses on the street. The point of the article is to show the merits of possible value in this sector by using the two "heavy-hitters" and showing their relative valuations in terms of growth.

Secondly, I agree that the employee numbers are changing and will change due to the spin off, but as will total revenue. John has done a great job thus far leading the turnaround of MS since he's taken over the at the helm. Initially he turned Morgan into "cost-cutting" mode which helped streamline things, and taking on slightly more investment risk has helped fuel earnings of late, but I still feel profitability is more consistent at Goldman Sachs.

Although as the first comment pointed out, both are relatively cheap and have good fundamentals going forward, so it wouldn't be a bad idea to own both firms.

Anonymous said...

Hi Chris,

Not really to comment on your article any more but I see that you used to work for MS. I currently work for MS. Just curious... did you quit to start your own investing career or something? If so how did you go down this road? I also work in IT and just recently completed a MS in FE so been contemplating a career switch.

You can contact me at cougar91@hotmail.com.