Goldman Sachs Group Inc (GS), Morgan Stanley (MS): Should You Invest in the Investment Bank Survivors?

The financial crisis irrevocably changed the investment banking landscape, leading to the demise of Lehman Brothers and the acquisition of Bear Stearns and Merrill Lynch by commercial banks. The two major survivors, Goldman Sachs Group Inc (NYSE:GS) and Morgan Stanley (NYSE:MS), were able to maintain their independence thanks to federal liquidity programs and timely conversions to bank holding companies in 2008. However, the devil is in the details, as the companies’ bank status limits their future profit making activities. So, should investors place a bet on the sector’s leaders?

The vampire squid

Rolling Stone magazine famously called Goldman Sachs Group Inc (NYSE:GS) a vampire squid, which brought notoriety but not too much damage to its overall business. The company continues to be a league leader in securities underwriting and is one of the few competitors that is expanding offices globally. Warren Buffett has maintained a large stake in the firm, as part of his 2008 strategic investment, adding further credence to Goldman Sachs Group Inc (NYSE:GS)’s story.

In its latest fiscal year, Goldman posted solid financial results, with increases in revenues and operating income of 18.6% and 81.7%, respectively, versus the prior year. While its revenue growth was affected by one-time asset sales, Goldman Sachs Group Inc (NYSE:GS) generated revenue increases in all of its business segments, including its all-important institutional client services unit. More importantly, Goldman’s operating margin increased significantly, due to its renewed focus on effectively managing its compensation costs, an area of intense media scrutiny during the financial crisis.

Morgan’s legacy

Meanwhile, Morgan Stanley (NYSE:MS) has also benefited from the multi-year rebound in equity markets, despite still working through its past issues. The company has sold off non-core businesses over the past few years, like its Van Kampen mutual fund and Saxon mortgage servicing units, while further investing in its wealth management joint venture with Citigroup. In addition, Morgan Stanley (NYSE:MS) continues to try to reduce its loss exposure to legacy residential mortgage backed securities, with roughly $20 billion in remaining exposure as of December 2012.

In its latest fiscal year, Morgan Stanley (NYSE:MS)’s reported results showed substantial year-over-year declines, due to debt valuation adjustment charges in its securities businesses. However, its adjusted performance painted a better picture, as principal trading revenues rose and assets in its large wealth management venture reached $1.9 trillion. Like Goldman Sachs Group Inc (NYSE:GS), Morgan Stanley (NYSE:MS) is revamping its compensation practices, its largest cost center, which should lead to more rational pay rates and a more profitable company.

The industry’s future

All is not rosy for the investment banking giants, though, as more stringent restrictions on the companies’ activities are still being phased in over time. Specifically, the federal Dodd-Frank Act’s requirement to eliminate proprietary trading and to move over-the-counter derivative markets onto regulated exchanges will undoubtedly eliminate profit centers for both Goldman Sachs Group Inc (NYSE:GS) and Morgan Stanley (NYSE:MS). In addition, the companies’ recent results show continued deterioration in commission revenue, as a portion of their customer base opt for cheaper trading platforms.