3 Reasons to Buy This Battered Bank

Marie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Since the recession, banks have been on the long road to recovery. Though all have improved, some seemed to hit more potholes than others. Morgan Stanley (NYSE: MS)(NYSE: MS)(NYSE: MS) is an example of a firm that had considerable difficulty. During the crisis, the US’s sixth largest-bank (by assets) narrowly escaped being sold, then proceeded to struggle through the next few years.

In 2010, the bank survived the European bond scare while being roundly criticized for being too exposed to weak European economies. Then, last year Morgan Stanley backpedaled as Moody’s threatened to downgrade the bank’s debt.

Now, in 2013, Morgan Stanley is coming back. For a more negative outlook, please see “Interest Rates Are Squeezing the Life Out of These Banks.” However, here are three reasons why I think you should buy this bank.

Smaller is better

Last week, Morgan Stanley’s president of institutional securities Colm Kelleher said that the firm would keep its fixed-income unit small. According to Kelleher, the business must remain small in order to improve profitability.

Smart move. Morgan Stanley’s fixed-income, currency and commodities unit experienced significant volatility in recent years. Most notably, the unit lost $9 billion in 2007 when it made a bad bet on mortgage-backed securities. As the unit continued to struggle, CEO James Gorman shifted its focus from growth to profitability. Higher revenue can be a bad thing if high margins are not present to support the growth.

According to executives, Morgan Stanley’s new goal for the unit is a 10% return on equity. That would be an improvement considering the unit had a return of only 7.5% last year. This return lagged the competition as Goldman Sachs (NYSE: GS)(NYSE: GS)(NYSE: GS) posted a return of 12% and JPMorgan Chase (NYSE: JPM)(NYSE: JPM)(NYSE: JPM) boasted an impressive 18% return on equity.

Scaling back the FICC unit will increase Morgan Stanley’s profitability while also freeing capital to be put to work elsewhere in the firm.

Focus on wealth management

In the first quarter, Morgan Stanley posted a profit of $958 million, much of which came from the bank’s wealth management business. Comparatively, during the first quarter of last year, the firm reported a loss of $119 million.

Revenue in the wealth management division increased by 5.4% to $3.47 billion – 41% of total sales. Morgan Stanley is playing to its advantage here because JPMorgan and Goldman Sachs focus on high net worth wealth management instead of retail wealth management, leaving a gap that Morgan Stanley can fill. The high net worth clients of Goldman Sachs and JPMorgan Chase core wealth management businesses often need investible assets of at least $2 million, or $25 million for the ultra-high net worth business.

Morgan Stanley’s successful start to 2013 is a testament to Gorman doing what he said he would do: turn the bank around. According to Gorman, the firm will rely heavily on its wealth management business to offset the more dangerous trading and investment banking business. In fact, Morgan Stanley’s revenue from its wealth management business grew to $13.5 billion last year. Comparatively, revenues from the same unit were only $5.5 billion in 2006, one year before the financial crisis. That’s a 145% increase over six years.

Furthermore, Morgan Stanley is going through a $4.7 billion purchase of Citigroup’s stake in Morgan Stanley’s wealth management business. The move was approved by the Fed in March and is expected to be finalized this year. The purchase was one of Gorman’s chief goals and accentuates his commitment to Morgan Stanley’s wealth management segment.

Earnings per share

Last week, Deutsche Bank upgraded Morgan Stanley from hold to buy. Why? Earnings per share. Deutsche Bank analyst Matt O’Conner said he anticipates a jump in Morgan Stanley’s EPS due to gains in equity markets so far this year. Translation: Morgan Stanley’s stock is expected to move higher.

In the first quarter, Morgan Stanley earned $0.49 per share, up from a loss of $0.06 a year ago. That beats JPMorgan's EPS increase of just $0.28 and Goldman Sachs' $0.37. I don't think JPMorgan and Goldman Sachs performed poorly, but I think the numbers show that Morgan Stanley had the superior quarter. 

Not including a charge related to debt value adjustment, or changes in the value of the company's debt, Morgan Stanley earned $0.61 per share – $0.04 higher than analysts predicted for the first quarter. If the markets continue to go up, O’Conner sees the bank’s annual EPS increasing by about $0.20. Even if the markets stay put, he still sees growth of about $0.10. And I agree with him.

EPS is useful because it allows us to more clearly see how Morgan Stanley’s changes are affecting shareholders. I think the EPS picture is clear, Morgan Stanley is headed up.

Bottom line

Morgan Stanley is a great buy right now. Already in 2013, its shares have increased by 33% and have outperformed he S&P 500 ETF, by 18%.

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Morgan Stanley’s returns may not be as flashy as those of JPMorgan or Goldman Sachs, but the bank’s safe wealth management strategy translates into a solid investment. Gorman worked hard since taking over the CEO position in 2010. He weathered the storm. Now, Morgan Stanley is ready to shine.

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This article was written by Randy Holcombe and edited by Chris Marasco. Chris Marasco is Head Editor of ADifferentAngle. Neither has a position in any stocks mentioned.The Motley Fool recommends Goldman Sachs. The Motley Fool owns shares of JPMorgan Chase & Co.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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