I started a new position in Morgan Stanley during the 1st Quarter. Morgan Stanley is a well-known company, but it seems to have disappeared from investors’ radar. For the last 24 months, the stock has gone nowhere. During this time, the stock market has appreciated 50%. Specific to the company, it is in a much stronger position than 24 months ago having paid back TARP, spent two years integrating Smith Barney, and expanding its footprint in FICC. Plus, in the wake of The Rolling Stone-led backlash against Goldman Sachs, Morgan Stanley has become the go-to investment banker for the federal government. I think Morgan Stanley’s stock is interesting at current levels.
Of Morgan Stanley’s four basic businesses, three are very attractive with high margins, low capital intensity and defensible competitive advantages. These three businesses are Investment Banking, Retail Brokerage and Investment Management. The fourth business is Sales & Trading which is opaque, has high capital intensity, and is cyclical. However, this business does have some positive attributes such as it will grow with the global economy and has reduced competitive intensity since the industry consolidation in 2008.
My investment thesis for Morgan Stanley is a sum-of-the-parts valuation. I believe the catalyst to unlock this value will be earnings reports demonstrating that investors and analysts are too pessimistic about the earnings power of the company:
1. No Credit for Franchise Value of Three Great Businesses – Overall, Morgan Stanley is trading for 1x tangible book value, so investors are not assigning any franchise value to the company’s Investment Banking, Retail Brokerage, and Investment Management businesses. Arguably, each of these businesses could run with little-to-no equity capital, and we could assign all of the equity capital to the Sales & Trading business. If I assigned comparable multiples to the first 3 businesses, I coincidentally calculate each business worth about $8 billion. If Sales & Trading were given a 1x tangible book value, the stock would be worth $41 or more than 50% upside.
2. Investment in Sales & Trading Franchise – Morgan Stanley has been making investments, such as hiring traders in its Sales & Trading franchise to increase market share and balance the sources of revenue. We’ve seen nascent results from this hiring such as in Q4 when Morgan Stanley outperformed Goldman Sachs in Fixed Income, Currency and Commodity trading (FICC). However, a large CDO loss in 2007, the recent losses from the MBIA credit hedges and the now recent trading losses in the Japanese joint venture all hurt investors’ perceptions of this business. Using the values from the previous bullet point to back into an implied current valuation of the Sales & Trading business, I calculate investors assign Morgan Stanley’s Sales & Trading business a valuation of 50% tangible book value. I disagree with this assessment. Investors are extrapolating Sales & Trading’s recent low return on equity too far into the future. Either results will get better or management will dramatically shrink the capital intensity of this business.
3. Discount to Goldman is Too High – Morgan Stanley trades at 1x tangible book value while Goldman Sachs trades at 1.4x tangible book value. I believe this discount is too high. While Goldman may have higher returns currently and in the past, I do not think there is anything structurally different between the two businesses that would accord such a large premium for Goldman. If anything, Morgan Stanley has a more attractive business mix with its large ownership of the Morgan Stanley Smith Barney Joint Venture. The retail brokerage business is more stable and less capital intensive than the institutional brokerage business.
At some point in the coming market cycle, Morgan Stanley will garner a higher multiple because it will have improved execution in its Sales & Trading franchise. Plus, we seem to be on the verge of a new IPO-boom, and I expect Morgan Stanley to garner its fair share of underwriting assignments. In the meantime, I believe the company will continue to increase the franchise value of its Investment Banking, Retail Brokerage and Investment Management divisions.
This is my blog. I founded Gator Capital Management in 2008. In this blog, I will share my thoughts about investing and links that I find interesting during my investment research.
Here’s my bio:
In 2008, Derek Pilecki founded Gator Capital Management. From 2002 through 2008, Derek was a co-Chair of the Investment Committee and a Portfolio Manager for Goldman Sach’s Growth Equity Team, where he helped to manage $30 billion in high quality growth stocks.
Derek was also a member of the portfolio management team responsible for the Goldman Sachs Capital Growth Fund, and provided primary coverage of the financial sector for the Growth Team.
Prior to Goldman, Derek was an Analyst at Clover Capital Management in Rochester, New York and Burridge Growth Partners (now part of Essex Investments) in Chicago, Illinois. Before entering graduate school, Derek worked at Fannie Mae providing risk analysis for the company’s mortgage investment portfolio.
Derek holds an MBA with honors in Finance and Accounting from the University of Chicago and a BA in Economics from Duke University.
