☀️☕ An Aussie Virgin, back on the market

18 January 2023

Happy Wednesday! 🐪

📊 In the Markets

• MS > GS

• An Aussie Virgin, back on the market

• China growth slows and population shrinks!

• India, the world's future manufacturing hub?

📝 Focus

• Morgan Stanley's crushing Goldman Sachs

📊 In the Markets

MS > GS

US markets were generally soft on Tuesday after 4Q results from the two premier investment banking 🎓 giants, Morgan Stanley and Goldman Sachs. MS earnings were down 41% and traded up 6%, adding US$9 billion to its market capitalisation (share price X number of shares) while GS profits were down 69% and dropped 6%, losing US$8 billion in market value.

Deal-making data and reports last week from big commercial banks with large investment banking units had already flagged a tough period for the two, but Morgan beat estimates by 6% on strength in its wealth management and trading businesses (even with big losses on its loan to Twitter) while Goldman missed by 40% largely due to heavy losses in its consumer businesses (mainly the Marcus neobank) as well as, more surprisingly, a drop in asset and wealth management revenue. Trading at both MS and GS was strong, though only in fixed income, currency and commodities. The different results were reflected in the recent cuts in headcount, with MS shedding 2% and GS axing 6%. (See Focus.)

An Aussie Virgin, back on the market

With the recovery of the global airline industry (SouthWest and FAA debacles in the US aside) on Covid reopening, US private equity firm Bain Capital is preparing to relist Virgin Australia, the country’s second-largest airline.

Virgin Australia went spectacularly busted in April 2020 as a result of the pandemic and the closing of internal state borders after the government and its then-shareholders refused a A$1.4 billion loan to rescue the company. At the time, ​​Singapore Airlines, Etihad, HNA, and China’s Nanshan Group each owned about 20% while founder Richard Branson’s Virgin Group held 10 per cent. (Virgin Aus had reported annual losses for seven consecutive years even before the pandemic.)

In a classic private equity move, Bain Capital then stepped in and bought it out of administration for A$3.5 billion, including debt. The airline has benefited from the rebound in travel since then, even increasing its market share from 20% to 30% (while exiting most of its international routes.) The IPO valuation (and Bain's remaining stake) remain to be seen.

🎓Private Equity (PE) - a mini-explainer

• PE firms operate in a very lucrative part of the financial world, buying and selling companies whether listed on an exchange or not, often using enormous amounts of debt that can get loaded onto the balance sheet of the target company (such as in a "leveraged buyout" or LBO.)

• Investors invest in PE funds as limited partners (LPs) in a fund run by general partners (GPs) and pay an annual fee (usually 2%) and a share of gross profits (usually 20%, known as "carried interest".)

• The fund invests in undervalued companies and using connections, management skills and financial engineering, make them more valuable to sell off at a profit, potentially in an IPO (initial public offering, a new listing on a stock market.) The GPs can give guidance, replace management, change the amount of debt and workers it has or transform the business in any other way.

China growth slows and population shrinks!

China's economy grew 2.9% in the fourth quarter of 2022 from a year earlier, which was higher than the 1.8% growth expected but at 3.0% for the full year, far below the official target of about 5.5% and the worst showing (excluding 2020's initial Covid hit) in close to 50 years - particularly coming after 2021's 8.4% rebound. Compared to the third quarter, China didn't grow at all. The numbers reflect the toll taken by the zero-Covid policy lockdowns and the ongoing train-wreck property market slump, and raise pressure on Beijing to unveil more stimulus plans this year. Weak global demand means a rebound in growth would need China's consumers, now released but facing an unfolding health crisis, to step up.

Hong Kong's Hang Seng Index dropped 1.2% while China's benchmark CSI300 was off by 0.3% in response, as well as a derisking of portfolios after a strong rally and ahead of the Lunar New Year, which starts on Sunday. The Shanghai Stock Exchange will be shut every day next week and HK will be shut from Monday to Wednesday. Taiwan is shut from today till the end of next week (!), while poor Singapore, Malaysia and Korea only get next Monday and Tuesday off.

More importantly, China's total population shrank by 850k in 2022 to 1.41175 billion, marking the first decline since 1961, and could get much worse as Covid-related deaths outstrip births as the trend of couples delaying or deciding against children continued. The birth rate was the lowest ever, and the death rate China's highest since 1976.

The government could see the writing on the wall from one of the lowest fertility rates in the world and belatedly lifted its one-child policy in 2015, adding incentives like tax deductions, housing subsidies and longer maternity leave in 2021 to try and encourage the population to have more babies.

This depressing demographic trend raises the age of the population and its dependency ratio (the number of those working to those not working) and poses the question of whether China will get old before it gets rich.

India, the world's future manufacturing hub?

In its World Population Report, the UN projected that in 2023, China will lose its status as the world's most populous country to India, whose population is still growing quickly. India is going to have the largest working-age population in the world, which could lead to opportunities as the world's manufacturing hub going forward, a long-term trend that adds to the more recent moves to diversify the global manufacturing supply chain (and geo-political onshoring and "friend-shoring.")

China's one-child policy was in effect from 1979 to 2015, as an effort to curb its rapidly growing population, restricting the number of children that a family could have, with some exceptions made for ethnic minorities and rural families. Many point to China's gender imbalance as an unintended consequence, with about 34 million more men in the country than women. Even now, China still boasts the world's most skewed sex ratio at birth at around 110 males born for every 100 females as of 2021. The policy also led to an ageing population and a shortage of workers, a legacy that will continue to be felt for generations, even though two children are now permitted per family. Some also attribute higher savings rates, lower consumption and an increase in violent crime to the gender imbalance.

India never implemented a one-child policy like China, though it has had population control policies in place for several decades, focused on providing access to family planning services, including contraception and education about its use. Various programmes to address population growth have had mixed success, with a decline in the population growth rate but still a higher fertility rate than in China: from 2015-20, India's fertility rate was 2.24 compared to 1.69 in China. (The forced sterilization programme targeting men and women, especially in the lower socio-economic and rural areas during the 1970s and 1980s, is recognized now as a dark chapter in India's population control history.)

India is projected by the UN to have a population of 1.67 billion in 2050, ahead of China's 1.32 billion people by 2050.

📝 Focus

Morgan Stanley's crushing Goldman Sachs

From the outside, these storied American investment banks 🎓 may seem quite similar, particularly compared to peers which are parts of larger financial institutions like JP Morgan, Citi and Bank of America (and even Deutsche Bank, Credit Suisse and UBS), but the long term share price performance tells a quite different story.

Differences in the CEOs can be exaggerated, but the McKinsey consulting, Merrill Lynch and wealth management background of MS CEO since 2009, Aussie James Gorman (and perhaps his MBA from Columbia) contrasts with the Drexel, Bear Stearns and junk bond investment banking background of GS CEO since 2018, New Yorker David Solomon (also an EDM DJ aka DJ D-Sol.)

Goldman Sachs has traditionally been focused on investment banking and trading activities, with a particular emphasis on serving large institutional clients. This includes underwriting securities, trading in financial markets, and providing financial advisory services. The firm also has a strong presence in the private equity and asset management businesses. The relatively recent push into consumer banking with its Marcus branded neobank as well as its unsecured lending business through issuing the Apple Card have been quite costly thus far, and both have been part of a recent organisational reshuffle.

Morgan Stanley, on the other hand, has historically had a more balanced business model, with significant operations in both investment banking and wealth management. Morgan Stanley also has a presence in the institutional securities and asset management businesses. The firm has a large retail brokerage business, which includes a large number of financial advisors serving individual investors from buying retail brokerage powerhouses such as Dean Witter and Smith Barney, acquired from Citi (plus the more recent purchase of online broker E-Trade.)

Along with an earlier push into private banking/ wealth management, these have given MS a more stable source of income over the years, which is reflected in the higher valuations investors have given to their shares, at 14x price to the last 12 month's earnings (historical P/E ratio) and 1.7x price to balance sheet book value (P/B ratio) compared to 9x P/E and 1.2x P/B for GS, with its greater reliance on less stable dealmaking and trading earnings.