Since my recent post on Morgan Stanley (MS), I have gotten a lot of responses from friends and readers, cautioning me about investing in the financial services sector at the moment, with the range of responses running from the risk that companies like MS are staring down a changing business landscape (and thus, will have challenges making money in the future) with less talent in the employee ranks than other peers, to the contention that MS is likely hiding European exposure on the books or just mismarking positions (the fraud claim). I have been thinking about the varying responses today and have decided to step back on this one and provide a broader perspective about my rationale regarding why MS represents a reasonable risk/reward long-term investment. This is especially relevant in light of the stock taking another pummeling, down over 5.0% as of the time of this writing.
I understand that today, Europe has significant challenges (which I am not going to go into here). I also understand that the US banking system is changing, as well as (and specifically) the investment banking sector, on the back of the Dodd-Frank Reform and Consumer Protection Act. Neither of these circumstances (the meaningful problems in Europe, or the uncertainty created by the Dodd-Frank bill) or anything else on the horizon, however, change the fact that: (1) there remains a need for investment advisory services for individuals, (2) there remains a need for the underwriting and placement of public and private securities, (3) there remains a need for large-scale asset management services, (4) there remains a need for corporate hedging and risk management services and (5) there remains a need (at some level) for the sales, trading and research functions in various markets provided by investment banking. The aforementioned businesses can be quite profitable, and while technology has led to margin compression, there is still a lot of business out there to be done.
The past several years have claimed Bear Stearns and Lehman Brothers, as both had inadequate risk measures in place and far too much leverage to bad debt on the balance sheet. Further, UBS AG is scaling down the emphasis on the securities businesses, as are/will other firms in the coming months. There are fewer companies competing for a piece of the global investment banking pie, which, as I already noted, is probably not going away, no matter how bad things are to get in Europe (or if there is a recession anywhere).
MS, despite a good third quarter by most statistical measures, a considerable business emphasis on commission-based businesses (not proprietary trading) and full disclosure around the European exposure, is being priced with considerable risk embedded into the valuation. The stock is trading at almost half of the tangible book value, a considerable discount to Goldman Sachs (GS) and Jefferies Group (JEF). I have yet to read anything credible on why MS is riskier than any other global institution, and if the company's reported results are to be believed, it seems to be weathering the current market malaise ok. That is not to say a default by Italy wouldn't impact the MS balance sheet (the is risk, and it is of course possible that hedges don't mitigate as much risk as forecast). But trading at half of tangible book value, isn't that risk being priced in, assuming that the disclosures in the recent 10-Q are accurate?
My view on MS remains the same, after hearing feedback and giving more thought. If your time horizon is several years out, you are able to withstand volatility (this stock is not a trade, it is an investment), you believe the MS folks are reporting financials and disclosing information in good faith that is true and (most importantly), you believe that despite the challenges currently facing the financial services sector, there will still be a financial services sector in the future (and the capital flow and asset management services remain critical economic functions), then the recent decline in MS presents a good risk/reward opportunity.
Disclosure: I am long MS.