Merrill Lynch's New CEO: John Thain

Beginning yesterday afternoon, the biggest story in the US financial sector was John Thain's departure from the job of CEO at the NYSE, to take the same position at troubled retail brokerage giant Merrill Lynch.

You can read or hear any number of accolades for Thain today in the business media. And everyone, except, apparently, Dan Tully, a Merrill ex-CEO, seems to believe Merrill is lucky to have retained Thain for the job.

I think the more interesting question is,

Where will Thain take Merrill Lynch, and what will the firm look like when he's finished?

In over ten years of using my quantitative, S&P500-beating equity management strategy, Merrill Lynch has only appeared in a portfolio once. Goldman Sachs, on the other hand, has been a periodic member since a year ago, most recently with increasing frequency.

Were Thain to attempt to take Merrill to the same heights of consistently superior shareholder return performance that Goldman has enjoyed, he'll be taking it somewhere it's really never been.

For example, simply comparing Merrill's stock price to that of the S&P500 since 1978 shows that Merrill has bettered the index, but not consistently.

The brokerage firm was no better than the index, in totality, for the first 12 years of the period. It had some brief runs of superior performance in the early 1990s, then sagged, doing so again in the latter half of the decade. Since 2000, Merrill's return has been fairly flat, though volatile, while the S&P has dipped, then risen steadily.

What kind of financial firm will Thain create from the wreckage of Merrill Lynch? Well, he is on record in the past 24 hours as saying the problems are with the mortgage finance area, in which he has substantial experience.

While that may be true, that doesn't mean he'll simply repair that unit and continue to manage the rest as he finds it.

My partner and I discussed Thain's move into the Merrill CEO job last night, and agreed that he probably took the job because it will allow him to build something himself. He inherited a senior management post at the already-smoothly functioning Goldman. He transformed the NYSE, but, again, from an already-powerful position.

Perhaps at Merrill, he feels he can retool a company and be credited with the entire value creation job.

I wrote here, recently, that I thought there was no chance Thain would be interested in the Merrill job. I was dead wrong when I wrote,

"Does anyone, besides Susanne Craig, who authored the Wall Street Journal piece, really think (any) Goldman executive among the top three managers of the firm, past or present, would really be interested in running Merrill?"

Evidently, at least Thain thought otherwise.

However, in the same post, I also observed,

"Merrill represents the last of an otherwise dead model, the retail wire house. Sure, Merrill bought and grafted on investment banking in the past decade. But it hasn't internalized the risk management skills which seem to have prevented Goldman Sachs, Morgan Stanley, and Blackstone from suffering the same losses during this year's financial crises."

I wrote in another post that Stan O'Neal was forced to turn to a risky bet on mortgage finance in part because his brokerage operation wasn't going to get the job done when it came to consistent, profitable growth at Merrill. That has not changed.

Thain's experience at Goldman involves heavy doses of risk management, capital commitment, and modeling with a workforce of the truly 'best and brightest.' None of that is true of Merrill Lynch.

I think everyone, including my partner and me, expect Thain to begin importing talent he knows from Goldman, and, probably, various private equity groups and hedge funds around Wall Street. Surely he has some favorite 'number twos' elsewhere who would be happy to come to Merrill to run one of its businesses for him.

As my partner and I realized, Thain is in the position to effectively implement an idea I first put forth in this post, this past February,

"Suppose private equity firm partners offered their services to a publicly-held company. Would they not, in effect, take board positions, in exchange for options to own much of the firm, or be paid a percentage of the value they created over, say, a function of the firm's prior total returns, relative to the S&P500? In effect, like my idea, they'd commit their financial fortunes to, and align them with those of the firm's. But what mechanism exists for shareholders to do this? None.

It would, in fact, be a sort of return to the days of the original form of shareholder capitalism. A few wealthy, skilled owners running the boards of large companies. Since, instead, many boards are infested with lesser lights, faded failures of other boards (look at Microsoft for a great example of this tendency), or "politically correct" members with absolutely no business skills, corporate performances are often appallingly bad, while CEOs and board members are still handsomely compensated."

We see Thain about to bring a band of corporate buccaneers aboard Merrill, and be compensated for the value they create.

But among all the talk about Thain's ascension to the Merrill CEO post is that lingering doubt about his ability to win over, lead, and otherwise develop cultural commonality with the vaunted 16,000 strong band of Merrill retail reps.

My own prediction is likely to be seen as nonsensical. But, here it is. I think there's a significant probability that Thain will simply sell the brokerage business to another firm. Perhaps Wachovia. He could sell it to Citigroup, if it finds a new CEO and can afford the price.

But I think Thain will consider it. First, it doesn't involve firing anyone- simply divesting Merrill of a dead-end business. As I've written elsewhere in this column, who trades with full-price, full-service brokers anymore except older, and/or less sophisticated clients? It's not a business with a future. There's a reason Merrill is the only surviving predominantly retail wire house.

As the Yahoo-sourced chart nearby shows, the stock prices of investment-type banks, such as Goldman Sachs, Lehman and even Bear Stearns have outperformed the hapless Merrill over the past five years. Only Morgan Stanley, beset by various organizational woes in the past, and, more recently, its own fixed income losses, has underperformed the retail firm.

Looking over a longer timeframe, the result is similar. All of the firms outperformed the S&P500 since 1994, but Goldman and Lehman have steeper curves in the past five years.

In short, Merrill's distinguishing feature as a business model, a large retail brokerage sales force, seems to be related to its inability to outperform other non-commercial banks.

Thain is used to managing highly intellectual, risk-oriented businesses. Merrill's retail side leans heavily to the old backslapping, ingratiating model of entertaining clients more than serving them.

In a world with Fidelity Investments, Vanguard, E*Trade, Scott Trade and Schwab, how many observers of this sector believe that full-service, personal retail brokerage is a business with a profitable, growth-generating future?

I was wrong about Thain taking the Merrill job. But he's a very smart, seasoned, tough manager. I don't think he believes he can take Merrill to where Goldman has been without throwing the retail business over the side.

My partner and I believe that Thain sees an opportunity to recruit top talent to join him in building the next Goldman Sachs or Blackstone. Coming from the NYSE, rather than directly from Goldman, he's probably not operating under any sort of agreement not to poach Goldman employees. None of them, nor Thain, has managed retail brokerage, nor has needed it to become the best-performing investment bank in recent years.