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Morgan Stanley and Goldman Sachs Look Good Amid Bank Earnings

With retail banks’ second-quarter earnings reports freshly out of the way, Wall Street is now prepped for investment banks Goldman Sachs (GS) and Morgan Stanley (MS) to announce in the next few days.

Expect big beats from these guys, too.

On Monday, Citigroup (C) reported strong quarterly earnings, beating estimates on both revenue and profits. These results mirrored Friday’s strong numbers from JPMorgan Chase (JPM) and Wells Fargo (WFC), which also beat nicely thanks in part to scaled-back operations and restructuring to gain efficiencies.

And, of course, thanks to some shrewd trading — including a 68% jump in equity-trading revenue at JPM.

It’s this trading dimension that might appeal to Goldman and Morgan Stanley investors, since these investment banks continue to make most of their cash from these operations. A beat at these other banks thanks to profitable trading could bode well for GS and MS shares, as hinted at by roughly 3% gains in the the past two trading days.

Investment banks like Goldman and Morgan Stanley operate differently than their retail counterparts because of this focus on trading. But even beyond that, the takeaway is that a slow healing in the broader economy and capital markets is sending bigger business to the financial sector.

So while trading is crucial and GS stock doesn’t really move based on mortgage origination or small-business lending as retail banks do, a cyclical recovery does benefit the bottom line.

And longer-term, as Morgan Stanley and Goldman look to diversify their operations — both for revenue opportunities as well as avoiding regulators’ ire — other elements of their business will become even more important. Consider the expansion of Morgan Stanley’s wealth management division as one opportunity this financial stock is pursuing.

Of course, it’s not all rosy for banks, in either the investment or retail flavor. A lot of the earnings gains at major financials has been through cost-cutting and layoffs. Job-slashing has been commonplace for Goldman since the financial crisis as a way to juice profits, and in 2013, GS expanded its normal housecleaning efforts beyond just the bottom 5% of its work force to include equity traders and others. Morgan Stanley slashed 1,600 jobs to start the year, too.

But since 2011, when MS and GS stock both lost more than 40% apiece in the calendar year, things have been looking up. Revenue has started to move higher and profits have been picking up.

And since their January 2012 lows, Morgan Stanley and Goldman Sachs are both up more than 70%.

It’s fair to wonder whether the bargain valuations of two-and-a-half years ago have been replaced, whether the recovery in these investment banking stocks is now baked in, and whether the upside is limited. Morgan Stanley trades at modest discount to its book value (85% or so as of this writing) and Goldman is pretty much on par; both have forward price-to-earnings ratios of about 11.

Furthermore, Morgan Stanley and Goldman hit headwinds despite decent profits in April — including a 7% decline for their shares in about a week.

Those declines were short-lived, of course, but hint at the kind of pessimism that can creep in as investors digest challenges for these financial stocks as they transition away from old prop trading models and into more diversified financial operations.

The wild card, of course, is trading risk. Goldman still relies heavily on its trading division, and just recently it made a bad bet on volatility that could offset any other gains made elsewhere in the business.

Plus longer-term, nobody knows how financial reform and regulations could limit the profitability of these investment banks going forward.

That dimension makes these stocks very hard to read. But as for this earnings season, it seems that the strength in the financial sector and the economy at large will benefit Morgan Stanley and Goldman in their upcoming profits.

Beyond that is anybody’s guess.

Goldman Sachs reports Tuesday morning, and Morgan Stanley reports before the bell Thursday.

Related Reading

  • Citi’s investment banking group scored big gains this quarter … will MS and GS follow? (WSJ)
  • Marie Palumbo thinks MS is a buy before earnings. (The Motley Fool)
  • Goldman has two years to separate its riskier derivatives units from those backstopped by the federal government. So don’t expect trading to disappear anytime soon. (Bloomberg)

Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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