- By Dilantha De Silva
Big banks came under pressure upon the release of third-quarter earnings even though numbers were better than expected. This did not come as a surprise to investors who were paying close attention to this sector as the historically low interest rate environment is making it difficult for banks to attract investors regardless of their commendable efforts to improve the liquidity position. Morgan Stanley (NYSE:MS), however, has weathered the storm much better than its closest rivals, which warrants a close inspection of its financial statements to ascertain whether the stock is an attractive investment despite the macroeconomic challenges faced by the industry.
The S&P 500 took a massive hit in the first quarter of the year as the U.S. economy entered a recession, but the broad market is up about 55% from the lows reported in March. Banking sector stocks, however, are still reeling from the losses. As illustrated below, Morgan Stanley's shares have remained flat in the year-to-date period, which is a significant outperformance of its peer group.
Morgan Stanley has not moved anywhere this year, but that itself is a victory considering the billions of dollars in market value lost by other big banks.
The secret sauce to success
The bank's renewed focus on the investment management segment and the securities trading business has been key to its outperformance this year. For the three months ended on Sept. 30, Morgan Stanley reported a 20% year-over-year increase in sales and trading revenue. The investment banking division reported sales growth of 11% in comparison to the corresponding period last year. This positive performance helped the bank grow its net income by over 53% in the third quarter. The acquisition of E*Trade played an important role in helping the bank generate record revenue from the sales and trading segment. The all-stock deal that valued E*Trade at $13 billion was announced in February, and CEO James Gorman recently wrote:
"The addition of E*TRADE positions us as an industry leader in Wealth Management across all channels and segments and significantly increases the scale and breadth of our Wealth Management franchise, which now oversees $3.3 trillion in assets. E*TRADE has built a best-in-class, direct-to-consumer digital channel and a strong brand over the past 38 years. The addition of their premier offering will provide enhanced capabilities to all our clients and Financial Advisors."
In early October, the bank announced the acquisition of Eaton Vance Corp. (NYSE:EV) for $7 billion, which will further help it diversify into the investment management industry.
The bank might continue to look for acquisition targets as its excess capital cannot be returned to shareholders under the rules imposed by the Federal Reserve earlier this year. These investments could prove to be the differentiator between Morgan Stanley and its peers in the long run.
The Federal Reserve imposed restrictions on the ability of banks to distribute capital to its shareholders in a bid to increase the liquidity position of the industry. Regulators took early action this time around to avoid having to bail out banks the way they were forced to do during the global financial crisis of 2008. The decision to halt dividend hikes and share buyback plans, however, can be expected to reverse in 2021 if economic growth picks up steam.
In a conference call with analysts on Oct. 15, Gorman said:
"At some point, we have to do something with this capital. Our shareholders rightfully who own the company are entitled to generate a decent return on their capital investment in the company. We have to do something with it."
This statement highlights two possibilities in the near future.
The bank is likely to search for more acquisition opportunities to drive earnings growth as sitting on cash would destroy shareholder wealth in the long run.
An increase to the current level of dividends per share and the resumption of the buyback program can be taken for granted once the Fed eases restrictions imposed on the sector.
Both of these outcomes would be welcome moves for investors and the market value of the bank is likely to get a boost if the bank goes down one of these paths, if not both, in the coming months.
From a macroeconomic perspective, things are bound to improve in 2021 regardless of the outcome of the vaccine trials. According to data from Bloomberg, a recovery is taking shape already, but at a measured pace due to the ongoing threat of the pandemic.
Source: Bloomberg (the pre-recession level is indicated by "100" in the Y-axis)
Governments, business owners and consumers are all embracing the unpleasant reality that health concerns might be a feature through the end of 2022, and safety measures have been introduced in every corner of the world to instill some form of normalcy.
Commercial banks that generate the bulk of revenue from interest income are likely to remain under pressure even if global business activities increase, but Morgan Stanley as a bank that specializes in providing other financial services will thrive under such an environment. This difference in the operating model might lead to a valuation premium in favor of the bank in the coming months, and the stock might continue to beat its rivals.
According to data from Reuters, Morgan Stanley traded at a forward price-earnings ratio of 8.90 on Oct. 20, which is well below the industry average of 11.62. From a financial performance perspective, however, the bank has been more resilient than its rivals over the last six months, which indicates an anomaly in the valuation level that could soon diminish once the majority of investors identify this opportunity.
Investing in a troubled sector might not be for every investor. The returns associated with such a strategy are arguably higher than investing in companies that are considered safe havens. Big banks are going through one of the most challenging times in history, and the response has been mixed. Morgan Stanley is aggressively positioning itself as a bank that is immune to interest rate cuts by focusing on the lucrative wealth management and trading segments. The market has so far rewarded this effort, which is evident from its outperformance of the sector in 2020.
The valuation multiples are very attractive, and the bank can be expected to deliver strong numbers in the coming years as the American economy recovers from the current downturn. The bank's strategy to prioritize investment management is likely to come in handy in the long run as well because of the stability it adds to the financial performance. Both value and growth-oriented investors might find Morgan Stanley shares attractive.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.