ValueAct has a long history of being a “friendly” activist that studies troubled industry situations and seeks to “work with” management and boards to make useful improvements. In this case, ValueAct has expressed confidence in chief executive James Gorman and the Morgan Stanley management team and notes that at 70% of book value, its Morgan Stanley investment has been made at an attractive price no matter what happens.
But there has to be more to the ValueAct story than a simple value play. Morgan Stanley’s price to book valuation is low, but so is its return on equity. In 2015, the firm delivered an ROE of 6.5%, which was 7.9% less than its cost of equity capital. And in its most recent quarter, returns were still 6.8% below a reasonable equity return.
Indeed, since 2008 Morgan Stanley’s return on equity has averaged 7.1% below its cost of equity. This is because the company’s beta – and thus its cost of capital – has remained stubbornly high (>2.0) despite Gorman’s successful strategic transformation and derisking of the firm’s business model.
Morgan Stanley acquired the Smith Barney retail brokerage business from Citigroup in 2010. Today, about half Morgan Stanley’s revenue stream is from capital markets, and half is from wealth management and asset management. Its struggling fixed income unit has been triaged and its balance sheet trimmed. Morgan Stanley has maintained leading shares in M&A advisory and equity underwriting and increased its share of the institutional equity trading market. The separate Dean Witter, Morgan Stanley, and Smith Barney retail units have been integrated and margins in the wealth management business are now averaging more than 22%. The company’s capital ratios have been strengthened and management has stated that the firm is committed to returning capital through dividends (2.6% yield) and sizeable stock repurchases.
Altogether, Morgan Stanley has good story. But, based on the high beta of its stock, the equity market appears sceptical. Or, put another way, the strategic changes have not been enough to deliver acceptable levels of profitability given the perception of risks associated with the capital markets business that the firm has retained.
The capital markets businesses of all the large banks have been struggling to deliver reasonable returns since 2009. Their continuing regulatory burdens and litigation challenges have led some investors to question their long-term economic viability. Morgan Stanley investors’ concerns focus mainly on the capital markets business, which is heavily dependent on trading units that require a massive balance sheet (roughly $ 800 billion of assets).Further, capital markets activities must squeeze through a new regulatory labyrinth of capital reserves, operating restrictions, and exceptional levels of oversight that constrain profits significantly.
ValueAct has not said what it hopes to accomplish with its investment, but a change in business mix seems likely. Morgan Stanley’s capital markets business consumes about 60% of the firm’s capital, and 35% of its revenues are from trading that drags down returns.
But capital markets require a mix of activities with different profit margins. Equity new issues and mergers and acquisitions advisory historically have generated high margins (approximately 40% pretax), but debt capital markets and institutional equity execution have generated relatively low margins (6% and 15% respectively). Fixed income sales and trading generate 18% to 20% pretax margins but require large capital levels to support market-making activities, and can be very volatile.
The low-hanging fruit for any activist investor is to slash or even shutter the highly capital intensive, low ROE trading units and return the capital to shareholders. Certainly if Morgan Stanley could grow its low risk and low capital intensity wealth and asset management units, while shrinking the capital intensive businesses, ROE would improve.
Capital markets products and services are tied together through multiple client relationships across product lines. Institutional clients demand full-service offerings. Security issuers often demand medium-term note programmes and low-margin debt capital market services as quid pro quo for the promise of high-margin engagements.
These inter-business connections make changing or exiting businesses such as institutional equities or fixed income trading a risky proposition for a major investment bank. This is especially true if the bank’s major competitors are firms like JP Morgan or Goldman Sachs that are not reducing capital market services.
Given these considerations, the most that ValueAct may be able to achieve is to “prune” the market-making business units hard. UBS has been successfully pursuing this strategy, thus freeing capital and reducing compensation expenses. Such a strategy at Morgan Stanley, if believed by investors, could reduce the beta of the firm and substantially reduce its cost of equity capital. This could allow Morgan’s net return on equity to recover to a much more viable positive number.
Indeed, ValueAct may see the real prize to be in derisking the firm sufficiently to escape designation as a “systemically important financial institution” (Sifi), the real cause of the stresses on Morgan’s existing business model. (Lazard Frères, a leading M&A firm that is not a Sifi, trades at four times book value). The regulatory burden on Sifis is very high and costly, and because of high capital thresholds and the unpredictable nature of stress tests, it has become very difficult for all Sifis to establish a viable long-term business model within permitted areas of operations.
Avoiding this burden as a result of eliminating trading might recapture a great deal of market value, but, even though MetLife has successfully appealed against its Sifi designation, and GE Capital has had its repealed because it broke up the firm, there has been absolutely no indication that such a move would be acceptable to the Financial Stability Oversight Council or the Federal Reserve in the foreseeable future.
But we welcome ValueAct on to the scene. After eight years of underperformance, Morgan Stanley (and the rest of the industry) needs out-of-the-box thinking and external pressure to help accelerate and complete the transition of the firm from what it was before the crisis to what it needs to be in the future.
• Roy C Smith is a finance professor at NYU Stern School of Business and former partner at Goldman Sachs. Brad Hintz is an adjunct finance professor at NYU Stern and former CFO at Lehman Brothers and top-ranked banks analyst with Sanford Bernstein