Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), the two largest U.S. investment banks, reported extremely strong second-quarter results. Revenue grew by double digits at both institutions and tax reform catapulted profitability higher.

In this episode of Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matt Frankel give investors a rundown of the numbers and take a closer look at how investment banks make their money.

A full transcript follows the video.

This video was recorded on July 23, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, July 23rd, and we're talking investment bank earnings and then taking a deeper dive on investment banking itself. I'm your host, Michael Douglass, and I'm joined by Matt Frankel, as always.

Listeners, a quick note before we get started into the fun stuff, we're transitioning Industry Focus. Shannon Jones filled in for me on two episodes earlier this month while I was out on vacation. She did that in part so she could test drive Industry Focus: Financials. Starting next week, I'm very excited to announce that she will be serving as the regular host for Industry Focus: Financials, and I will be heading over to the Thursday show to replace Sarah Priestley. The lineup next week and from then on, at least for a while, will be: Shannon Jones for Monday's show; Vincent Shen for Tuesday's show; Kristine Harjes for Wednesday's show; Michael Douglass, that's me, for Thursday's show; and Dylan Lewis for Friday's show.

Longtime listeners will note that this will be the third show on Industry Focus that I will have been the host for, in addition to both Financials and Healthcare at different times. My personal goal is to get to all five one day. Fortunately, I'm more than halfway there. Dylan, Vince, I'm coming for you! Just kidding. [laughs]

With that, let's hop right into earnings. This is our second earnings episode. Last week, we talked about the Big Four. Now, we're hopping into the investment banks.

Goldman Sachs. What a bumper earnings report. Profits up 40% year over year, revenue growth of 19%. 19% year over year! That's not something you would expect for any company the size of a Goldman Sachs.

Matt Frankel: No. Actually, 19% revenue growth was the best out of the Big Four and the two we're covering today, by a significant margin, too. That's really impressive. That means, unlike most of the big banks, the bulk of the profit growth wasn't just from tax reform. I mean, that definitely helped, it pushed Goldman's return on equity up to over 14%, which was the bank's highest in over nine years. I think that's the highest since the middle of the financial crisis, when Goldman was producing a ton of trading revenue.

Goldman's results were pretty great all around. Investment banking revenue was up 18%. Really strong underwriting results. They said, "significantly higher backlog compared to the first quarter," so you can expect the revenue growth to carry into the third quarter and beyond. They achieved the top market share for M&A activity, equity underwriting, IPO underwriting. Investment management revenue looked great. It was up 20% year over year. Their assets under supervision actually grew by $15 billion, despite a slight market value decline, which means money is flowing in despite so-so market performance, which is always a great sign for an investment bank. 

My favorite reason to like Goldman is their Investing and Lending segment, which includes their Marcus consumer banking platform. Revenue soared by 23% year over year, a 67% increase in revenue related directly to the interest income they're receiving from Marcus. That's a big deal.

The only thing that wasn't great was, trading revenue was just OK. Trading revenue is a big deal for investment banks, as we'll get into in the second half of the show. But while other banks with big investment banking presences like JPMorgan Chase and Morgan Stanley blew expectations away on trading revenue, Goldman just did what was expected. That was one weak point.

But, all in all, Goldman Sachs had a really strong quarter.

Douglass: Yeah, they did. Let's actually jump into Marcus a little bit more. A couple of things I want to highlight here. First off, Goldman's CFO on the call reported that they've originated over $4 billion in consumer loans at Marcus at this point, and they're holding $3.1 billion of those loans on their balance sheet, as of June 30. They're lending, it's scaling pretty rapidly, and these are loans that they're pretty comfortable holding on their balance sheet. Additionally, their retail deposits, I'm quoting here, grew to over $23 billion. That's an enormous amount of deposit activity for a bank that historically hasn't been that involved in deposits. That's a real sign that this digital banking initiative is working well for Goldman.

Of course, the flip side of that is, now a lot of other folks are looking to get involved. Citigroup has started making noise about it, JPM as well. There's a lot of interest, and other folks building increasingly strong digital presences to try to combat Marcus' success. 

Goldman's stance on this is essentially, "Listen, even with a relatively small market share long-term," not that they're predicting that, but it's certainly possible. Competitive, online, we all get it, it may in fact be that they aren't a massive winner long-term. But even with a relatively small market share across, it can still meaningfully move their business forward. They believe that they can maintain some differentiation with all they're doing to develop the tech back end, and because they aren't as tethered to some of the older ways of doing things that the universal banks largely are. So, that can be a long-term benefit to Marcus.

Frankel: It's also interesting to point out that Goldman is not stopping with just personal loans and savings accounts. They did a presentation about a month ago where they mentioned areas like mortgages, credit cards, auto loans, checking accounts, things that traditionally have not been in their wheelhouse that they're planning on jumping into. We recently learned that they're going to be Apple's co-branding credit card partner. I don't know of a bigger way to make an instant impact in the credit card space than to partner with a company like Apple. 

So, when Goldman is getting into this consumer banking business, they're jumping in really strong. They're not just tiptoeing in the water. They're jumping into this full-force. If they actually do add mortgages, auto loans, and other things like that -- they also mentioned insurance, for example, for consumers -- they could really produce some serious revenue if they're successful.

Douglass: Insurance is a huge opportunity. It's interesting, one of the things they're trying to do is test doing some lending to folks with somewhat lower FICO scores. Think your 630-660 range. They call this "deliberate testing." It represents less than 5% of originations. But they're trying to go a little further down on the credit ladder to see what things look like down there. 

To be clear, overall portfolio quality through Marcus is very strong. Average FICO score is over 700, so I think we can feel pretty good that this is intentional, thoughtful risk that they're taking on. 

But I will say, it does make me a little bit nervous. This consumer lending historically has been something that the banks haven't been that involved in. Particularly given that Goldman doesn't have that much experience in this particular area, I'm a little bit nervous that this might be chasing yield, and that when the credit cycle turns -- as it inevitably will one day -- that could become a real problem for them.

Frankel: I agree with that. That makes me nervous. On one hand, I don't want to question Goldman's ability to manage risk, because they've done that very, very well for a very long time. But as Michael just said, this is a new area for the bank. Traditionally, their clients, institutional investors and high-net-worth investors, are not low FICO score risk. This is definitely a new area for them that is worth watching.

Douglass: Yeah. Just to sum up their quarter and where things stand, it's very clear that they're investing very heavily in the digital bank. Certainly, their acquisition of the Clarity Money app is also part of that move to make this as robust an online offering as possible. I think it puts them in place, long-term, to compete with your Mints and the online financial hacking softwares and apps that have really seized a lot of people's interest and have done a lot to democratize banking. 

Then, of course, the quarter itself, pretty darn good. Sure, trading was a little bit disappointing, but consumer banking looks pretty darn huge. Of course, valuation, Matt, you and I have talked about this before, is pretty attractive.

Frankel: Absolutely. Goldman is trading for right around 1.2X book, which is less than all of the Big Four banks except Citigroup. And, Goldman has significantly underperformed the banking sector in 2018. So, Goldman is trading like a pretty cheap bank right now. If you think that consumer banking especially is going to be a big future catalyst, then Goldman looks like a pretty compelling value right now.

Douglass: Yeah, and that's not something I say lightly with one of the big banks. OK, that's Goldman. Now, let's turn to Morgan Stanley. 

Remember, one of the really important things when thinking about any one company's success or failure is to look at their closest comps wherever possible. If somebody makes smartphones, you want to compare to other folks making smartphones to understand whether there are secular trends or there are things that are really specific to that company. Remember that lens as we talk about Morgan Stanley. 

Like Goldman, a great quarter by most measures. Earnings are up 49%. 12% revenue growth -- not quite as strong as Goldman's, but I'll take 12% revenue growth from a big bank any day of the week.

Frankel: Yeah, definitely. You have to remember that Morgan Stanley doesn't have quite as big of a consumer banking growth engine and a fueling revenue. That's a big differentiator there. But, Morgan Stanley's earnings looked pretty great all around, just like Goldman's. Investing banking revenue was up 20%, just like Goldman. And just like Goldman, M&A activity, underwriting, IPOs were really strong areas. 

The big difference in Morgan Stanley's earnings was, they blew trading expectations out of the water. Analysts expected trading to be pretty flat year over year, but Morgan Stanley's rose 9%, and it was evenly split between equities trading and fixed-income trading, which really made investors happy. 

Wealth management and investment management, revenues were up by about 4% in both those categories. Not quite what the market wanted to see, but the trading revenue and great investment banking results really overshadowed that.

Douglass: One of the interesting things here is, usually, you see equity and fixed-income trading, to some extent, correlating negatively with each other. When one is up, the other one is down. For them to both grow at the same time is a really interesting outcome.

Frankel: They both grew at 9%, which was great. Like Michael said, normally one goes up and one is kind of weak. So, those are great all-around results. It seems like they're taking market share in trading from some of their rivals. 

It was a really great quarter. Like I said, revenue growth, not quite as strong as Goldman's, so it seems like their earnings growth was more pulled from tax reform than Goldman's was. But, trading was a big differentiator, and that's why Morgan Stanley was the best performer of the bank stocks right after earnings.

Douglass: It's interesting, because when thinking about both Goldman and Morgan Stanley -- analysts were asking, on the Goldman call, "Why do you think the market hasn't rewarded you?" Management's response was, essentially, "Because these things need more time to play out. We don't really care about stock price today or tomorrow or next quarter. What we're really thinking about is, what business value are we driving several years down the road? And what will that mean for book value? And, therefore ... and everything kind of falls from that." 

Morgan Stanley was interesting. One analyst essentially asked, "Hey, you all have had a lot of change. You've done a lot of new things. But it feels like everybody else is doing more new things." And Morgan Stanley's management was essentially like, "Listen, we're going to continue executing on the growth plan we have. We're obviously going to be looking into understanding better things like the digital bank," for example, which they really haven't played in much. But, "We're going to focus on the things that we know are going to be winners, and also keep in mind," I'm paraphrasing, "we've changed more in the last few years than in the previous 80. Give us some time to digest that change and really make sure we've gotten it right top to bottom." 

I really liked management's response to those questions with both banks. I think that speaks to a mindset that can hopefully be a really good value driver for the companies long-term.

Frankel: That's actually a very interesting point to note. Both of these banks are evolving more in the past couple of years than they have throughout their whole history. It's really interesting to see how this is going to play out. I think that might be part of the reduced valuation. The market doesn't know what to expect with Goldman, consumer banking-wise. Are they going to get a little bit bigger, or are they going to become a consumer bank like Bank of America is? Similar with Morgan Stanley, they just don't know what to expect yet. These could be great revenue drivers, or they could just be experiments that don't go anywhere. That's one of the reasons you might see a depressed valuation right now.

Douglass: Yeah, makes a lot of sense. Of course, depressed valuations, because the market doesn't know what to expect, can be opportunities for those of us who think we know what we can expect. Of course, predicting the future is notoriously difficult.

Let's turn to our second topic, which is more of an overview of investment banking. First off, folks, head back to our December 11th, 2017 episode on the investment banks if you want more discussion as to how all this interplays with their underlying business model. That's where we did our deep dive on investment banks, and really understanding, running through our framework, figuring out how exactly all that works. 

But we figured we would talk a little bit about investment banking itself, what those actions look like and how that all works, today. Matt, take it away.

Frankel: After we did that episode, I got a bunch of questions to the effect of, what is trading revenue? What exactly does M&A advisory mean? Things like that. I figured we would take a few minutes and discuss the ins and outs of the main ways investment banks make money. 

It can especially be confusing because different banks generally have different names for their business segments that do the same thing. In fact, I don't think any of the big banks have the same names for all of their business segments. For example, Goldman calls its trading desk Institutional Securities. Some other banks just call it Trading. 

Generally, you can break down investment banking activities into four key areas that all investment banks generally participate in -- advisory revenues, underwriting revenues, trading revenues and wealth management. To go through those one at a time, let's start with advisory. Advisory generally refers to when companies want to acquire another company, when two companies want to merge. There's a whole lot that happens behind the scenes. For example, When AT&T and Time Warner merged recently, it wasn't just like a couple of people met in the room and said, "OK, all Time Warner Shares are going to be AT&T shares, let's all go home." There's quite a process to it. This is where investment banks come in. They do the behind-the-scenes of mergers and acquisitions and collect fee revenue for those services.

Douglass: To unpack that a little bit further, imagine that you're a business owner and you're looking to purchase another business that is operating in a similar area to what you do. You're going to want to understand, how much are you paying people? What costs do you have that I need to understand? How exactly does the business work? All that due diligence work. 

Some of that is where the investment banks come in, and some of it's done by legal experts and things like that. It's a really powerful thing, in terms of modeling out, "If we paid this amount for this business, at what point are we going to have recouped our investment? What's the opportunity?" That's where the investment banks can come in with that strategy mindset, to help you understand both quantitatively and qualitatively what that looks like.

Frankel: Right. So, that's M&A advisory. It's a big deal for investment banks. I mentioned, Goldman had the No. 1 M&A market share. Morgan Stanley is definitely up there. JPMorgan is a big player in this market, too. This is a very key revenue stream for investment banks.

Underwriting is another one. Advisory and underwriting are generally what's traditionally called investment banking, even though investment banks can engage in other businesses, which we're about to talk about. Underwriting is a term that most people are familiar in more of an insurance context than in a banking context. In a banking context, this generally refers to an IPO when companies are making a follow-on offering of stock or when they're issuing debt. 

It means that the investment bank is committing to sell a certain amount of shares or bonds on the open market on behalf of the company. When a company goes public, they don't just have a sale of their shares, they have investment banks. Generally, it's more than one, if it's a reasonably sized IPO. And they have these investment banks commit to sell certain numbers of shares each. For example, Goldman might commit to sell 1 million shares of a company's stock. No matter what the market conditions are, they say, "We're going to sell 1 million shares of your stock." That's how IPOs take place. 

Goldman gets fee revenue for that, as well. Investment banking is very fee-driven, as opposed to interest-driven, traditionally, as we mentioned in that other episode. Underwriting is the other big area of traditional investment banking that people need to know about.

Douglass: Right. Thinking about investment banking underwriting, there's equity, there's IPO, as we've talked about, there's debt underwriting. There are a lot of opportunities for banks to make fee income, helping the company sell whatever it is it's looking to sell here. 

Let's turn to our third piece, which is trading revenue. Investment banks will manage money for clients and trade on their behalf, and they'll also trade for themselves so that they can make money both ways.

Frankel: This is the least understood part of investment banking, among retail investors, at least. It's also very unpredictable. As we saw from Morgan Stanley's report this quarter, analysts usually get this wrong when they're predicting trading revenue one way or another, either on the plus side or the bottom side. It's very unpredictable. 

There are two main ways that trading revenue comes about. The first is client trading. Investment banks will call their institutional clients or high-net-worth clients and suggest investments to them. The clients will then order the investments, the salespeople will call the bank's traders, and the traders will place the trades on the open market and earn commission revenue that way. The other way is called proprietary trading, where banks for trading on their own behalf to try to earn a profit. If you hear of high-frequency trading, algorithmic trading --

Douglass: Flash crashes. [laughs] 

Frankel: Right. There are a bunch of different forms this can take, and there are way too many ins and outs of proprietary trading, too many things that can go wrong, to mention in just a short podcast. Proprietary trading is the reason why this is very unpredictable. That's why they call it proprietary, because no one really knows how it works for each individual bank and how they're trying to make money. It's very unpredictable how they're going to convert their proprietary trading strategies into revenue.

Douglass: As you noted, trading revenues are generally higher during volatile periods, lower during calm markets. That's one of the interesting countercyclical things that happens with these investment banks. 

Let's turn to No. 4, wealth management. This is one that most people, probably, on some level, get. You give your money to one of these investment banks, they manage it for you, they charge a fee for doing so.

Frankel: It's not that different from when, say, you deposit money into your brokerage account, except that they're doing it for you. It's a fee-for-services business. They're earning commissions, they're earning asset management fees, depending on the exact arrangement. A lot of investment managers, I think 1% is still the standard fee for an actively managed investment account with one of these investment banks. So, these banks are earning recurring revenues from that. As their clients are authorizing trades, they're getting trading revenue, as I just mentioned. 

Wealth management and trading complement each other nicely. They actually offset each other during volatile times. When trading revenue goes down because the market's doing really well, just going up and up, trading revenue tends to drop, wealth management revenue tends to rise, because clients' assets are growing. They have more assets under management, the securities in their portfolios are more valuable, etc., so they're generating higher asset management fees. On the other hand, when markets crash or get really volatile, wealth management revenue tends to drop, because the value of the assets they're managing tends to go down; but trading revenue tends to pick up, because traders like to take advantage of volatility. That's where the money is to be made, especially in proprietary trading. The wealth management and trading revenue of investment banks tend to offset each other and are very complementary. That's one big key for investors to know. Generally, one of those is stronger than the other.

Douglass: Right, and it just depends on how the broader market is doing, and how the bank is executing on its particular priorities. That's really the main stuff that goes into this investment banking stuff that we keep talking about. Hopefully that's helped you understand how all of that interacts and exactly how banks are making money when they're talking about things like trading revenue.

That's it for this week's Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the show 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 owns shares of AAPL, T, and BAC. Michael Douglass owns shares of AAPL. The Motley Fool owns shares of and recommends AAPL. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.