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The Stock Market Determines the Earnings Potential of Banks

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

Morgan Stanley (NYSE: MS) recently reported a stronger quarter, primarily driven by growth in asset management and wealth management revenue. The growth in revenue was primarily driven by the rallying stock market and rotations from commodities and bonds into stocks. The demand for stocks is likely to improve due to the better yields stocks tend to have when compared to bonds.

Morgan Stanley meets estimates

Morgan Stanley grew revenue 30% in its institutional securities. The company also experienced 21% growth in revenue from asset management. The consolidated net revenue grew 18% year-over-year. The growth in asset management was driven by the bull market in equities.

Morgan Stanley’s costs declined over the same period as it cut its head count in order to improve efficiencies. The total non-interest expenses declined 3% year-over-year, which contributed to the sudden surge in earnings.

The company’s bottom line grew from a loss of $119 million in the previous fiscal year to a profit of $977 million for the current fiscal year, which is really impressive. The growth was a whopping 900% year-over-year. More importantly, the company was able to grow its earnings in a quarter that is seasonally slow.

Key macro indicators lift the stock

The broader stock market experienced a rather strong rally for the first quarter, and this boosted Morgan Stanley’s trading income. The company’s asset management division was able to benefit from equity inflows. The equity inflows resulted in an increase in the assets under management. Assets under management increased to $621 billion, with the total clients assets increasing 6% to $1.8 trillion.

According to the ICI, mutual fund flows increased $80.33 billion in January, and $42.86 billion in February. Total mutual funds inflows have increased $122 billion in the first two months of the year. In the first quarter, investors rotated into stocks which led to the broader market rally, and resulted in increased trading income for Morgan Stanley. Morgan Stanley’s trading income grew 12%,

Peers benefit from stock rallies

Larry D. Fink of BlackRock (NYSE: BLK) believes that investors are rotating into stocks, but are looking to invest capital into low-beta dividend yielding equities. Asset managers, more particularly hedge funds, have been chasing higher beta stocks. In general, the demand for equities led to BlackRock being able to report earnings growth of 11%. The growth in earnings is likely to be sustainable as the company’s guidance (outlook on earnings for the rest of the year) remained stable.

Goldman Sachs (NYSE: GS), like Morgan Stanley, had no trouble growing revenue over the past quarter. The strong stock market certainly padded Goldman’s trading division and asset management activities. Like the rest of the Wall Street investment banks, Goldman’s asset management saw reasonable growth in fees.

Performance driven fees were the key behind Goldman’s strong asset management growth. Hedge funds tend to charge a certain percentage fee for growth (around 20% for every percentage above the initial buy-in price).

The negative to the recent earnings announcements is the stock market volatility. Goldman Sachs, BlackRock, and Morgan Stanley depend heavily on the stock market for income. There are many macro risks that could potentially cause the stock market to crash. For whatever reason, stock investors are extremely fickle. If something negative were to happen, similar to the Japanese tsunami, Greece default, or a repeat of Cyprus, the stock market could be hit with some volatility that could hurt quarterly earnings.

Financial stocks tend to fall with the stock market, and fall precipitously. This is driven by the fact that investment firms are generally net-long the stock market, meaning that if the broader stock market were to rally, financial institutions will benefit more from that than if the stock market were to fall. Generally speaking, it is safe to assume that a market rally will dramatically improve the amount of earnings investment banks will be able to report.

Conclusion

Investors in Morgan Stanley are essentially making a bet on the economy. The bet is that the economy will recover quite substantially. If that were the case, (which I believe the economy will continue to grow) then it is a good opportunity to invest in Morgan Stanley.

The stock sports a fairly hefty valuation (36.5 P/E multiple). The high earnings multiple is justified by the 1,515% earnings growth analysts are anticipating for the current fiscal year. Morgan Stanley seems to be on the right track as it was able to grow earnings by over 900% year-over-year in the first quarter.

It is fair to assume further cost-cutting and continual revenue growth from improving fund inflows. Based on these assumptions, Morgan Stanley will be able to report a fairly strong year. If that is the case, then a 36.5 earnings multiple is quite cheap in respect to the high earnings growth. The stock is undervalued and it also offers a 0.97% dividend yield. Morgan Stanley is a worthy member of a value focused stock portfolio based on the high growth rates analysts estimate for the current fiscal year.


Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends BlackRock and Goldman Sachs. 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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