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Morningstar: Morgan Stanley “Modestly Undervalued”
Aspire, Hot Picks | 28 January 2015
By: Lim Si Jie
Articles (169) Profile

In current times where there exists a lack of trust in the finance sector, there are quite a few worthwhile stocks in the financial industry that is worth looking out for to invest in the long term.

Morgan Stanley has a long standing history since it was founded in 1935. The key drivers of Morgan Stanley’s bottom line have drastically changed over the past several years.

Transforming Key Drivers of Growth
According to Morningstar Research, Morgan Stanley’s institutional securities segment’s investment banking and trading revenue have “traditionally been the key growth driver”. However, the recent acquisition deal of Smith Barney has made the wealth management segment’s asset management fees and net interest income carry a much larger weightage to the company’s “earnings growth story”.

Morgan Stanley possess “unique traditional banking dynamics” related to deposit growth, asset mix shift, and cross-selling that Morningstar believes to be under-appreciated by the market. Morningstar’s evaluation of the “health of the company’s wealth management business” and “the trajectory of its bank” confirms its view of Morgan Stanley’s positive medium-term earnings growth prospects.

Wealth Management Offsets Regulations, Environmental Changes
Since the financial crisis, Basel III rules have significantly increased the amount of high-quality, loss-absorbing capital and liquidity that banks must hold. This has reduced bank balance sheet leverage. Changes to the rules have made it “practically impossible to achieve historical return on equity levels”.

Lower leverage and higher balance sheet liquidity rules have had knock-on effects on Morgan Stanley’s capital-intensive business lines, such as fixed-income trading. The majority of regulations that resulted from the financial crisis affected the trading operations of investment banks.

However, the wealth management, underwriting, financial advisory, or asset management of Morgan Stanley’s business remains largely unaffected by the regulatory or environmental changes. Some would even describe the regulatory changes as beneficiary to Morgan Stanley as the changing regulatory landscape has compelled them to shift towards a more sustainable business model instead of riding on volatility in the markets.

Wealth Management: More Sustainable Profitability
Wealth management is “more profitable now than during the last capital markets peak”. Morningstar forecasts that “more than 70 percent of Morgan Stanley’s earnings growth through 2018” will come from its wealth management segment.

The current cohort of wealth management representatives at Morgan Stanley have more assets, generate more net revenue, and contribute more net income than the financial advisors at Morgan Stanley did before the financial crisis. It is a clear indication of the strength of wealth management as a business segment as wealth management operating margins is higher than at previous capital markets peak.

Source: Company filings, Morningstar Research

Rising Interest Rates a Boon to Morgan Stanley
The company’s forecast growth in net interest income from a higher deposit base and mix shift to more loans is independent of a rise in overall interest rates and unique to Morgan Stanley.

Based on indicative asset yields derived from the forward interest rate curve, Morningstar estimates that the gross yield on the company’s bank assets would be 80 percent higher at around 2.5 percent. This is based on Morgan Stanley’s 2013 asset mix.

Accounting for the compounding effect of the build in deposits, banking asset mix shift, and eventual rise in interest rates leads to Morningstar’s projection of bank net interest income growing from $862 million in 2013 to approximately $2.8 billion in 2018.

Source: Company filings, Morningstar

Morningstar forecasts “close to $5 billion of companywide net interest income in 2018” after including $2 billion of net interest income from non-banking activities. Based on the possibility of material earnings momentum in the coming years as well as its overall fair value, Morningstar strongly believes that Morgan Stanley is “modestly undervalued”.

Si Jie is no stranger to investing having started his journey at a young age. He is heavily influenced by acclaimed investors such as Benjamin Graham, Peter Lynch, and John Rothchild.

Please click here for more information about this author.

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