I have recently written several bullish reports on financials, one for KKR (NYSE:KKR) here, one for Barclays (NYSE:BCS) here, and one for Goldman Sachs (NYSE:GS) here, among others. Each time I was greeted by a skeptic who cautioned me about risk. Yes, I have even dared to call Wall Street firms and U.S. banks "strong" and a "tremendous net positive to society." Go ahead, call me a lap dog for financials - I will accept the title with glee. For whatever it's worth, since the articles were published, Barclays appreciated by 8.4%, Goldman Sachs by 2.1% and KKR by a staggering 20%.
I advise readers to apply a bit of game theory to their investment strategy. The amount of risk that is being factored into the stock is a perfect instance of emotional anomaly. Jefferies (JEF) and Morgan Stanley (NYSE:MS) are two other financials that are unfortunately victims of fear. Over the last 12 months, shareholder value has fallen by 53.1% and 40%, respectively. As their fundamentals prove valuable, investors will stand to benefit from high risk-adjusted returns.
From a multiples perspective, both companies appear cheap. Jefferies trades at a respective 9x and 8.8x past and forward earnings, while Morgan Stanley trades at a respective 9.4x and 7.5x past and forward earnings. Applying this constant multiple to a bear estimate for 2012 EPS evidences little downside, in my view.
On the third quarter earnings call, Jefferies' CEO, Richard Handler, addressed the fears:
"Continued concerns over the deteriorating global economy, combined with the political uncertainty over the U.S. debt ceiling resolution, muted trading activity in June and July. That said, the environment in August was outright brutal. As recently as August 1, we believe we have the opportunity for a satisfactory quarterly result. Beginning in August, however, the ugly reality of the European sovereign debt and bank liquidity crisis drove a period of sustained financial market volatility, as well as interest rates spread widening that led to a significant deterioration in the absolute and relative value of certain assets and hedges.
By the end of August, some fixed-income markets had declined by as much as 15% from May 31 levels, and credit spreads widened significantly. Indeed, August was the third worst month in the history of U.S. credit markets after September and October of 2008, leading to broad-based write-downs in inventory values, which significantly reduced our quarterly fixed income revenues."
In such a volatile environment, the top-line in Investment Banking was nevertheless strong at $294M. Listed commodity derivatives, metals and foreign exchange trading in Jefferies also performed in line with expectations. Trading results are meanwhile further improving. At the same time, capital raising was difficult from the three months ending November due to volatile markets.
Going forward, I anticipate improvements in fixed income and a sequential rise in equities of around 10%. There exists no serious concerns to the balance sheet; a "run on the bank" is not likely to occur.
Consensus estimates for Jefferies' EPS are that it will grow by 15.6% to $1.26 in 2011 and then by 7.9% and 16.9% more in the following two years. Assuming a multiple of 11.5x and a conservative 2012 EPS estimate of $1.33, the rough intrinsic value of the stock is $15.30. This implies 24.5% upside - making it more of a "hold" investment, in my view. If the multiple holds steady at 9x and 2012 EPS is 5.1% below the consensus at $1.29, the rough intrinsic value of the stock is $11.61, indicating 5.5% downside.
While I am mostly conservative on Jefferies, I am entirely bullish on Morgan Stanley. Concerns over the European debt crisis have, in my belief, been overblown. EU politicians will eventually reach an adequate response that does not entangle the dissolution of the euro bloc. Moreover, the firm is not even directly exposed to Europe relative to the United States, which I anticipate experiencing a sooner-than-expected recovery. At the same time, I believe that the CDS curve will ease and the Core Tier 1 ratio will improve to around 13.4 by 2012. While there is high volatility in MS' earnings, this is also anticipated to normalize. Management is additionally cleaning up the balance sheet, which will further de-risk the business.
Consensus estimates for MS' EPS are that it will decline by 35.7% to $1.57 in 2011 and then grow by 35.7% and 17.4% in the following two years. Assuming a multiple of 11.5x and a conservative 2012 EPS estimate of $2.01, the rough intrinsic value of the stock is $23.12. This implies 45.6% upside. Even if the multiple declines to 9x and 2012 EPS turns out to be 15.5% lower than the consensus at $1.80, the rough intrinsic value of the stock is $16.20. This may not be the optimal way to value an investment bank, but nevertheless indicative of considerable discount to intrinsic value.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MS over the next 72 hours.