Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel look at investment banking and the two largest U.S. investment banks, Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS).
The discussion starts with an overview of the company's business model and growth plans and also dives into how to analyze investment bank stocks, how tax reform could boost profits, and which looks like the better buy now.
A full transcript follows the video.
This video was recorded on Dec. 11, 2017.
Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Dec. 11, and we're talking about the investment banks. That's Goldman Sachs and Morgan Stanley. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Matt, great to have you back!
Matt Frankel: Hey! Always good to be here!
Douglass: Fantastic. So, folks, last week, we really, for the first time, laid out the banking framework that Anand developed a couple of years ago and used it on BofI. If you are listening to this episode and have not listened to that one, I highly recommend going back and listening to that episode first, because we really go into detail and talk through what each section of Anand's analysis is and why we pick things in it and what they mean. In this one, we're going to head-to-head these banks a lot faster, and then we're going to go into detail and both pick which one we prefer of the two. If anything is opaque in this episode, I highly recommend you going back to that one.
The other thing that I'll throw out there is, I've talked a lot about how Anand's framework is really useful for me and for informing how I think about banking, and Matt, you've talked about that too. I think one of the key things to highlight with any system is, no system can cover 100% of circumstances. Anand's system is really designed for, to some extent, a traditional bank. Morgan Stanley and Goldman Sachs are very much not traditional banks. This is also a chance for us to highlight, I wouldn't call it a weakness, but some areas where Anand's framework can't provide for every possible outcome, so that's when you have to adapt it and change it over. So that's the idea behind this week's episode, and will hop right in.
The first question I think anyone is going to ask is, what is an investment bank, and why is it different from a more traditional bank? Matt?
Frankel: Traditional banks, if you heard our episode last week, we went into a nice discussion of this, as Michael said. Traditional banks generally make most of their money from lending out money. They take in deposits at a lower cost, lend money out at a higher cost, and profit from the spread between the two. Investment banks, I would actually call them a little bit more fee oriented. They tend to be a little light on loans. Investment banking includes things like M&A, advisory equity underwriting. Investment banks are the ones that bring IPOs to Market. Wealth management, especially for high net worth clients. Goldman and Morgan Stanley are both in the trillions of wealth management assets. Trading, and investment banks make investments themselves, that's a big part of their business models. But it's a lot of more fee-based types of financial activities than traditional banks.
Douglass: Yes. So, when thinking about the first part of the banking framework that we've been talking about, which is what does the bank do, as you noted, one of the first things that immediately jumps out, loans are not a high percentage of assets. For Goldman Sachs, it's about 7%. For Morgan Stanley, it's about 12%. And so, just with that, you can tell, this is a very different breed of bank from what we were talking about last week. Another point that I'll throw out there is, on the deposit side, so, this is a liability, deposits make up a relatively small percentage of the liabilities as well, about 16% for Goldman and 20% for Morgan Stanley. One of the things that that means, you can immediately know, that if a bank doesn't have a lot of its liabilities in deposits, it's going to have to get that money some other way, usually either by issuing debt or by issuing stock.
Frankel: Yeah. You can see the difference in the numbers of between deposits and other liabilities on their balance sheets. Goldman, for example, has only about 16% of its liabilities coming in the form of deposit; it's 20% for Morgan Stanley. And both have substantially more in unsecured long-term debt. Goldman, 25% comes from long-term debt, and actually about the same for Morgan Stanley. So these are more debt-reliant businesses than deposit-relying businesses, which is one reason why they're not quite as efficient as commercial banks, which we'll get to in a little bit. When you issue debt, it generally comes at a higher rate than you have to pay for deposits just from mom-and-pop consumers.
Douglass: One of the other things that'll really highlight this to you is when you're looking at the income statement and you look at revenue. For a traditional bank, net interest income, which comes from loans, is usually going to be a higher percentage. For Goldman Sachs, it's only about 10% of total net revenues. And Morgan Stanley actually lost a little bit on net interest income last quarter. Instead, what you see is, for Goldman, over 20% in investment banking, market making, and about 20% in M&A. On Morgan Stanley's side, there's a lot in investment banking and trading. This is where they make their money. It's the bread and butter, and it's very different from traditional banks.
With that in mind, let's talk about part two of the banking framework, which is, how expensive is the bank? Of course, the two things you want to look at here are price to tangible book value and price to earnings.
Frankel: Right. These are both similar in both respects. Price to tangible book value, Goldman comes in right around 1.4. Morgan Stanley is a little more expensive at about 1.6. Price to earnings, these both actually sounds really cheap compared to the rest of the S&P. Goldman is about 13 times earnings; Morgan Stanley is about 14.5. Morgan Stanley is a little bit more on the expensive side just by those two metrics. But again, any two metrics don't really tell you the full story, so let's go deeper.
Douglass: Absolutely. So, part three, what is the bank's earnings power? Return on equity, I tend to like to look at both the last quarter and the trailing 12 months, just because, one quarter to another, there could be some weird volatility. Trailing 12 months usually gets you some sense of the longer-term differences, if any.
Frankel: Right. In this case, generally, for any kind of bank, you want to look for a return of equity of about 10%. That's generally what they need to really cover their cost of capital and make money for shareholders. In Goldman's case, they're almost at 10%. They were 9.8% both the last quarter and the trailing 12 months. Morgan Stanley was 8.9% for last quarter and 9.1% for the trailing 12 months. So, the way I would interpret that, not too big of a difference, they're both almost in line with industry benchmarks but not quite.
Douglass: Right. Of course, net interest margin isn't going to be all that helpful in this case, since so little of their money comes from loans. So let's hop on right over to efficiency ratios, which again, as a quick refresher, are essentially a sign of how good the bank is at controlling its own costs.
Frankel: Right. Efficiency ratios, it's actually a really easy metric to calculate. All you have to do is take the bank's non-interest expense and divide it by its total revenue for whatever period of time you're looking at. Lower is better, because you're essentially seeing how much a bank is spending for every dollar in revenue they're making. In Goldman's case, for the last quarter, it was about 64% efficiency ratio, meaning that for every dollar in revenue they generated, they spent about $0.64, not including interest, which as Michael said, isn't a very big factor here. Morgan Stanley is actually a little less efficient. They're about 73% for the last quarter, so they spent $0.73 for every dollar in revenue they generated. Which could explain the discrepancy in return on equity that we just talked about.
Douglass: Right. The fourth piece is, how much risk is the company, or in this case, are the companies, taking on to achieve those earnings. Really, non-performing loans is usually useful, not terribly useful here, since such a small percentage of both banks come from loans. Again, this is just highlighting how you have to adapt a framework to whichever bank you're looking at. But assets over equity is about 11 in both cases. So, what that means is, they're both, all things considered, about correctly leveraged.
Frankel: Right. With investment banks also, as far as risk goes, it's important to mention that they have a few different lines of business, some of which kind of complement each other. Investment banking consists of M&A advisory, equity, and debt underwriting. Then you have things like trading and wealth management, which really offset each other depending on what the economy is doing. Right now, trading revenue is absolutely terrible. It's actually on the fixed-income side of things. And the reason for that is, the economy in the market are doing so well and volatility has been so low that trading volume has just fallen off the cliff.
The flip side of that is, things like wealth management are performing extremely well because the way they make money on this is fee-based, and if the market keeps going up and up, assets under management for both these firms keeps going up and up and up, and they're going to be making more fee income. So that's what I mean by one tends to offset the other.
On the other side, if wealth management revenue went down because the market was performing terribly, the trading volume could spike; if volatility spikes, then trading volume would get a lot higher and then start generating more money that way. So these banks are kind of, in a way, set up to make money no matter what the market is doing, which is definitely a point to note if you're looking at investment banks.
Douglass: Particularly in terms of thinking about the risk, because people always talk about wanting recession-proof businesses. Of course, I'm not aware of any recession-proof businesses, because they all are affected by recession in some way, shape, or form. But the fact of the matter is, these offsets really do help reduce that risk.
We'll turn to the non-numbers stuff -- again, everything we just looked at is a snapshot in time, and what you really need to understand that on a deeper level is to dig in and look at those businesses, their growth opportunities, their growth threats, and what the overall opportunity for both companies looks like.
We've looked at our snapshot in time. Let's now turns to the qualitative stuff. We have a pretty clear idea of where the banks are. Now, the question is, where are they going? I think one of the key things that we really need to emphasize here is, in both cases, both banks are looking to become more traditional in a lot of ways. They're both seeking to grow their deposits and they're both seeking to give out more loans.
Frankel: Yeah, and they're both doing it in different ways. We'll start with Goldman. Goldman has gotten into online banking to try to attract low-cost deposits, which are cheaper than debt financing. But they still offer some of the most competitive rates available online. Their online bank is called Marcus. The Marcus platform is actually getting into unsecured personal lending. It launched last October, so a little over a year ago.
Out of all the major unsecured lending platforms -- Lending Club, things like that -- Marcus was the quickest one to get to $1 billion in loan volume. Goldman has the distinct advantage that they have enough capital available that they can grow as quickly as they want to. But they're trying to do it in a different way.
I actually spoke to the head of Marcus not long ago, and he was trying to explain to me how they're trying to grow in the right way, trying to be different than the rest, adapt to consumer preferences and really take a different approach to lending. I can tell you just from speaking to some of their customers that their application process is smoother and quicker than pretty much any of the other guys. The interest rates people have gotten are more competitive than the others, because they can afford to run it at slightly more compressed margins than, say, a Lending Club. So this is really opening up a new revenue stream for Goldman.
In Morgan Stanley's case, they are really emphasizing trying to digitize wealth management to open up their platform to traditional clients, not just the ultra-high-net-worth people. Their robo-advisor -- which, by the way, we did an episode about robo-advisories not long ago. I'm sure Michael will be happy to send the link to anyone who's interested. [laughs]
Douglass: Sure. Send us an email to email@example.com.
Frankel: Morgan Stanley's robo-advisory platform just launched. So that's one way they're trying to branch out into more traditional areas of banking and investing. Morgan Stanley is actually about to launch a digital mortgage platform in the first half of 2018, with their goal of trying to get their own customers to get mortgages through them. They see that as an untapped financial need that they can meet better for their customers, integrating it where they already have their wealth management accounts and other assets. So like you said, both of these banks are trying to branch out, but they're both doing it in pretty different ways.
Douglass: Yes. And it's interesting, because -- and this highlights an overall thing that's happening across banks, where everyone is talking about digital. But what's interesting about Goldman and Morgan is, they both seem to really be living into that. The Marcus platform, the way Goldman executives describe it is, they're saying, "Listen, it's a business that everyone has seen before. Unsecured consumer lending is not a new thing. But we're trying to really build this platform with a consumer focus. We're not trying to grow it to $20 billion tomorrow by taking on a lot of terrible risk." I think they mentioned that their average FICO scores were something around 700. So that's a pretty good and relatively low-risk group of people that they're lending to. Their goal is to differentiate by having more capital than the fintech firms, so they can grow faster, and on the flip side, treating this as a digital and consumer-focused initiative, so they're not trying to combine a lot of other things together into one platform, but really just launch this and make sure that it works, which they view as an advantage over the other institutions.
Frankel: Right. In addition, Morgan Stanley, to mention another growth avenue, Morgan Stanley is really emphasizing wealth management. Their wealth management emphasis is much bigger than Goldman's, I want to say about twice the size. But they're not only trying to grow it, but like you said with the digital theme, they're trying to do it a lot more efficiently. They said the robo-advisory, for clients who want to lower their fees.
Just to throw a couple of figures out there, Morgan Stanley's wealth management business, which is not the highest-margin business, which is why they're not as efficient as Goldman, their wealth management business, they're margin has gone from 9% to 22% since 2010. They've reduced their branch count because of their more enhanced digital capabilities. And they're really trying to, not only grow it, but make it more efficient. Whereas Goldman is trying to remain the king of traditional investment banking, like M&A, where I believe they're still the No. 1 in terms of market share. Equity and debt underwriting, I believe they're also No. 1 in terms of market share.
So these banks are going in slightly different directions. Morgan Stanley estimates that their clients still have about over $2 trillion worth of assets with other asset managers, and they're trying to bring some of that in. So if they're successful, that could be a big game changer for them.
Douglass: And one of the things we should also mention here is some ways in which they are very much the same. One of them is that their assets under management have risen substantially in both cases, of course, because the stock market has been doing so well. Now, this is due to a combination of both strong market performance -- so, if you own a share of X stock that's being managed by Morgan Stanley and that stock doubles in value, then lo and behold, Morgan Stanley has doubled how much, in terms of assets, that they are managing on your behalf. But, the second piece is also net inflows. That's people putting more money into both Goldman and Morgan Stanley and saying, please manage this money too for me. Of course, one of those is much better long-term for the bank than the other.
Frankel: Right. Assets under management for Goldman is about a 2-to-1 mix of market performance and net inflows, meaning that about two-thirds of the game they've seen in their asset management business has just been because the market is doing so well. That's great. But then, when the market falls, your assets under management go down proportionately, whereas net inflows, that's just new money coming in, adding to the pot regardless of what the market's doing. You're going to be better off relatively than you would have been without that money coming in. So net inflows, in my mind, represents real growth in wealth management business.
Douglass: Yeah, absolutely. I think one of the other things that we should mention is, there's some incoming catalysts for the banking sector as a whole, potentially. One of them is that the Fed may be raising rates in a couple of days. We'll know more soon. The other is tax reform as a potential catalyst, because both of these banks have effective tax rates in the 30% range right now.
Frankel: Yeah, definitely. We don't know exactly what tax reform is going to look like right now, but it's pretty certain that if it passes, we're going to get a pretty big corporate tax cut. Twenty percent is the rate that's been floated around. Now, they're saying maybe 22%, 25% to get it done. Even so, this could translate to billions of dollars in additional profit for banks and investment banks in general, because they don't quite get the benefit of the interest rate hikes that more traditional banks do. So this could be a big catalyst going forward, especially if it actually gets down to 20% like they're proposing.
Douglass: Right. Now, whenever we're doing a versus of two different companies, it makes sense for us to talk about which one we prefer. Matt, do you want to lead off, or do you want me to?
Frankel: I'll go ahead.
Douglass: Sure, shoot. Which one is your preference?
Frankel: I like Goldman right now. I can't honestly say I'm going to log off of here and buy either one tomorrow. Actually, I'm not allowed to.
Douglass: [laughs] Right.
Frankel: But out of the two, I would definitely prefer Goldman. I really like the direction they're going with the consumer lending platform. The gentleman in charge of it, his name is Harit Talwar. I'm a big fan of his style and how he's approaching it. And not just that, Goldman looks a lot better from a valuation perspective at this point.
Douglass: Yeah, it's hard for me to turn down a stock that's cheaper and also has some very credible growth opportunities. It feels to me like Goldman is, in a lot of ways, diversifying very intelligently. And like you, I really like the Marcus platform. I think it's a potentially meaningful differentiator. And if they're able to attract all those deposits, that would be a big thing for them. I also, as I've shared in the past, only own one bank, and it's not either of these; it's BofI. Last week's episode is particularly interesting if anyone is curious about that company. But I think both Goldman and Morgan have some good opportunities. But also, I would hand the advantage to Goldman.
All right, folks, that's it for this week's Financials show. Question, comments, you can always reach us at firstname.lastname@example.org. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!
Matthew Frankel has no position in any of the stocks mentioned. Michael Douglass owns shares of BofI Holding. The Motley Fool owns shares of and recommends BofI Holding. The Motley Fool has a disclosure policy.