For the past few months, hysteria has been sweeping the financial markets of the U.S. and Europe, driving down virtually all stock prices together, as fears of EU defaults grip the market. This kind of panic selling, however, can provide opportunities for patient, value-focused investors. We believe we have found one stock that presents both great value and great upside.
Morgan Stanley (NYSE:MS) is one of the world's leading investment banks, and is one of the last 2 major stand-alone investment banks left in the U.S. The company's shares have been battered in recent months, and we think this selling is dramatically overdone. Morgan Stanley, like all other financial institutions, has been battered by fears over its exposure to European banks and debt. A ZeroHedge report highlighting the firm's exposure to France triggered a 7% drop in the stock. The report noted that Morgan Stanley had $39 billion in exposure at the end of 2010, as per Federal Financial Institutions Examination Council data. However, this report is flawed in that it does not take into account any hedges, collateral, or the liability side of the balance sheet. Management noted on the second quarter conference call that the firm has just $2 billion of net PIIGS exposure, and $5 billion net exposure.
The stock market is pricing in a catastrophic hit to Morgan Stanley from a Greek (or other) default that, even if it were to occur, it would be an event that Morgan Stanley can withstand. The company's Tier 1 Capital Ratio rose to 14.6% in the last quarter, making us confident that the firm can survive this crisis. Under Basel III, the ratio become 7%, but this is still a strong capital position. Assuming a full write down of the firm's $2 billion in PIIGS exposure, something that would be associated only with an apocalyptic scenario in Europe, the firm's capital base under Basel III would fall to 6.8%. But, the street fears this is not enough. Let us assume for a moment that all of the firm's hedges somehow fail all at once, and the company must write down all $5 billion of its gross PIIGS exposure. Even this event would push the firm's Basel III ratio to 6.4%, and reduce book value by 7%. Given that the firm trades at a 44.7% discount to tangible book value, we think that this perceived downside is priced in.
Unlike Goldman Sachs (NYSE:GS), which depends far more on trading for its profits, Morgan Stanley has a far more diversified revenue base, meaning that disruptions in capital markets will affect the firm less that its perennial rival.
Another important fact to note is that since the financial crisis, Morgan Stanley, and indeed all financial firms, have amassed far more capital and liquidity, both of which are at record levels. No firm wants to be sunk by events outside its control. We think it is highly unlikely that Morgan Stanley has been sitting idly by during this financial market upheaval, and the firm is well prepared for any eventuality.
In summary, we think Morgan Stanley is a great buy for patient, value investors. Even though we are a growth-oriented fund, we will buy value stocks if the opportunity presents itself. And we believe that just such an opportunity exists. The market is treating Morgan Stanley as if it will be bankrupted by the European debt crisis, and this simply will not happen. Morgan Stanley led the industry in completed M&A deals last quarter, leads the industry in capital, and has expanded its presence in China via Morgan Stanley Huaxin Securities. Analysts agree with us on Morgan Stanley's prospects, with almost all noting that at this level, European debt issues are priced into the shares. Credit Suisse sees the stock at $29, an almost doubling from current levels. Argus sees the stock at $32. S&P sees it at a more conservative $26, and the Reuters average target is $25.02, which still represents upside of over 66% from where the stock presently trades. The market is treating this company as if it will be destroyed by European debt issues. We think not. Morgan Stanley is ready for any outcome in Europe, and we think investors who add to or initiate positions at this time will be richly rewarded for their loyalty.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MS over the next 72 hours.