The credit crisis-induced recession has battered stock markets and altered long-held beliefs. Companies that felt they could always finance themselves in the commercial paper market disappeared. Those that believed a low stock price would encourage corporate buyers to acquire them now stare at single-digit prices. As the rules have been rewritten, entire industries have disappeared. No example is as obvious as the heart of Wall Street—the independent investment bank.
One year ago, markets were recovering from Bear Stearns’ forced sale to JPMorgan. Despite this shock, four independent firms remained—Merrill Lynch, Lehman Brothers, Goldman Sachs (GS), and Morgan Stanley (MS). Within a few days in mid-September, Lehman was bankrupt, Merrill was sold to Bank of America, and Morgan and Goldman had converted to commercial banks. Wall Street as we knew it was over.
While GS and MS changed their corporate structures and regulators, many things remained the same. Their cultures were intact and their lines of business were as well. In general, each firm receives revenue from trading, asset management, and advisory services. During boom times, the asset-management business grows, traders earn large gains by bringing product to market, and the advisory business thrives as companies seek merger advice and look to take themselves public. But these are not boom times.
Having recently read both GS’s and MS’s annual reports, I am left with more questions than answers. Over the last three years, GS enjoyed operating margins of 60% versus 20% between 2003 and 2005. Which is more indicative of what they will earn in the future? MS has $86 billion of Level 3 assets on its balance sheet (27% of total assets). Are these marked correctly or is danger lurking? Conventional metrics says MS trades for 50% of book and 6.5 times 2010 earnings. Similarly, GS trades for book value and 10 times 2010 earnings. Looking at these metrics, the shares appear to be compelling.
However, I am uncertain. Turning to their businesses, both companies saw their investment-management businesses shrink with the market. The advisory arm is nonexistent at the moment. Neither has shown the will or intent to grow a traditional lending business that would allow for consistent interest income. That leaves them with trading and indicates where our opportunity exists.
GS has long been known as the best trading firm. In the first quarter, GS earned $6.6 billion from fixed income trading while MS earned $1.3 billion. In an environment where spreads are wide and competition low, MS has decided to curtail risk. By doing so, it begs the question where does it expect to generate income in the future. I have similar concerns when looking at each firm’s balance sheet. As mentioned, 27% of MS’s fair value assets are Level 3. By comparison, only 11% of GS’s assets are marked this way. Level 3 valuation is used when market inputs are not observable. This increases the possibility that the assets are mismarked. With such a high percentage of Level 3 assets, any mistake would cause great damage to MS’s equity position.
All of these facts clearly point in GS’s favor. While its premium valuation versus MS addresses some of these issues, I believe there is more difference to come. Over the last six months, the shares of MS and GS have moved in line. When markets realize GS has a better financial position and stronger earnings power, this link will sever.
The best way to position for this difference is from a pair trade. By being long of GS and short an equal amount of MS, you eliminate the broad market and focus on the difference between the firms. Following this strategy in my weekly newsletter EPIC Insights, I recommend a long position in GS and a short position in MS as this week’s fundamental trade.