Morgan Stanley is well placed and undervalued

In a similar vein, we hope we don’t sound like perma-bulls when we say that prior to the election there were solid reasons to believe investment banking giant Morgan Stanley (US:MS) might outperform its Wall Street peers – and that this still remains the case. We say this in full knowledge that the US economy continues to quake under the pandemic, and will bear the scars long after (and if, rather than when) Pfizer’s vaccine candidate is rolled out. In its ‘double-hit’ scenario, the OECD expects America’s real GDP to contract 8.5 per cent this year, and rise by just 1.9 per cent in 2021.

This, in combination with the monetary policy response to the crisis, has created several big reasons to avoid most banking stocks: income generation prospects battered by ultra-low interest rates, deep uncertainty around when and whether businesses and consumers will start spending again, frozen dividends and deteriorating credit quality. For investment banks, one can add to that list low revenue visibility, high compensation costs and an ever-shifting and complicated regulatory backdrop.

However, Morgan Stanley’s strategy and operating structure already provide good answers to these challenges. For a start, the bank has very little exposure to consumer credit and mortgages, which helps to explain why it has booked far fewer credit loss provisions than peers so far this year.  

Three-legged stool

The origins of this tilt are in the regulation that followed the Great Depression, when the Glass-Steagall Act of 1933 forced the holding entities of American lenders to choose between commercial and investment banking. Two years later JP Morgan (US:JPM) picked the former, several of its dealmakers split from the firm to form Morgan Stanley.

Today, JP Morgan carries a juggernaut-like presence across all banking lines, while Morgan Stanley has taken a third way. Although around half of all revenues are drawn from its institutional securities division – short-hand for the M&A, advisory, capital raising and securities trading it carries out for governments, corporates and other financial institutions – the group has spent the past decade beefing up its presence in wealth management and investment management (see chart).

This ‘three-legged stool’ approach brings four specific benefits. First, by steering clear of mortgages, the group swaps slightly higher lending risk for better margins, lower capital intensity and a less politically fraught loan book. Second, it increases exposure to areas that are less likely to attract regulatory ire, however Joe Biden ultimately configures his approach to Wall Street oversight.

Third, a greater weighting to wealth and investment management provides recurring revenues, thereby smoothing the heightened risk and cyclicality of capital markets work (which as the chart below shows can sometimes prove unreliable). Fourth – and perhaps most critically for shareholders – the pivot from trading and raising money to managing it means Morgan Stanley is a bank underpinned by solid growth trends: the demand for investing advice and services.

This year the firm doubled down on this strategy, by agreeing to buy retail investment platform E-Trade and investment manager Eaton Vance in deals worth $13bn (£10bn) and $7bn, respectively, in February and October.

The timing of the E-Trade offer was not ideal, coming just days before markets began their meltdown at the end of February. But they also demonstrate management resolve to place big bets regardless of the immediate price.

The timing of the moves also echo chief executive James Gorman’s audacious purchase of retail brokerage Smith Barney from Citigroup in 2009. Now folded into Morgan Stanley’s wealth management arm, the transaction has proved an unqualified success for shareholders, and helped to smooth sometimes volatile capital markets work in the past decade.

This time around, deals could help the bank’s shares to re-rate. Analysts at DA Davidson & Co reckon that with the wealth management and investment divisions soon to make up around three-fifths of group profits, the stock should tilt towards the 14 times price-to-earnings multiple that this sub-sector commands.

Capital and earnings power

To us, the bids also look like a smarter use of capital than juicing the lending book at such an economically fraught time. It also means management has not simply waited – like the UK high street banks – for capital ratios to rise further above both regulatory minima and the peer group average (see table).

The Federal Reserve’s decision to curtail dividends and share buybacks has provided extra support to those emergency buffers. So too has the bank's performance this year, as third-quarter results showed. With net income up 25 per cent yea on year to $2.7bn, figures for the three months to September smashed consensus estimates by more than a third, as rising revenues from equity underwriting and bond and equity trading were complemented by a gain on loans held for sale.

Management was keen to play down the “extraordinarily positive...backdrop” for its trading teams, and reduce expectations for the quarters ahead – a request that appears to have been taken on by analysts, given consensus forecasts do not anticipate quarterly earnings to match or pass the $1.59 per share recorded for the three months to September anytime before 2022.

Annual forecasts have nonetheless rebounded since the spring (see chart), when the market was worried about investment banks’ exposure to toxic loans and whether hard-to-fathom financial products would again serve as tinder under the financial system.

That hasn’t happened, and a combination of excess capital and forward-looking provisions means banks like Morgan Stanley are far better prepared this time around. Anecdotal evidence also suggests the industry may be more restrained when it comes to banker pay. The Financial Times has reported that staff at rivals JPM, Citigroup and BoA have all been told to lower their hopes for big paydays this year. Even Wall Street knows it can’t be seen to be swimming in green at a time when tens of millions suddenly find themselves out of work.

For once, however, this should benefit shareholders, particularly with regulators yet to press go on renewed distributions. On this front, Mr Gorman said he hopes to get permission to restart buybacks in the first quarter of 2021. For UK investors, Wall Street’s preferred method of returning capital is arguably a better – and more tax-efficient – alternative to special dividend payments.

Nonetheless, we would expect Morgan Stanley to be ahead of its peers when it comes to capital returns, the cost of the E-Trade and Eaton Vance deals notwithstanding. With little exposure to consumer credit, the group is less likely to be snagged by the next round of Covid-19 stress tests, which in turn could bode well for closing the valuation gap with JPMorgan.

Given the latter’s pre-eminence, this could take time. But Morgan Stanley has built a strategy, capital position and track record of growth that is unrewarded by a price to book value of one.