Friday, 05 November 2010 04:58

An Explanation of the Pitfalls of Relying on Accounting Earnings In Analyzing the Investment Banks - Starting with Morgan Stanley

Summary: A more in depth look at Morgan Stanley’s returns on equity reveal an even uglier snapshot of performance than the unimpressive, cursory annual overview illustrated in our quarterly analysis released yesterday. Bubblicious credit, QE x 2, and regulators that look the other way from rotting assets still result in piss poor economic performance. What do you think will happen when rates resume their upward move?

Yesterday I released our quarterly opinion and valuation update for Morgan Stanley. They had a horrible quarter, and we feel the mainstream financial media failed to illustrate just how bad the quarter actually was. In our attempt to demonstrate Morgan's performance to the public I included some excerpts from the subscription report, namely the page below (click to expand to print quality) from which I quote James Gorman, CEO Morgan Stanley:

"We certainly aren’t going to measure our ROE over a summer month quarter where the world was trying to understand whether we would have a sovereign debt crisis in Europe and whether we would have a double-dip recession in the U.S., and whether China would be in for a hard landing. So, we have to take a longer-term view, as I'm sure and I know you understand. "

With all due respect Mr. Gorman, it matters little what period you measure your ROE over, it has drastically underperformed both its peer group and Morgan's cost of capital. Let's take a closer look, shall we...

BoomBustblogger Taylor inquired about an apparent anomaly in the MS Peer Group ROE comparison chart:

Hi Reggie,

Maybe I am reading your chart wrong but in your last page you say that MS has the lowest ROE of the three and it is “clearly trending down”. If MS is the green line, it looks like it made a U-shaped dip and is now trending up, while GS is clearly trending down and JPM is kind of flat-lining if not trending mildly up. Also, according to the chart which ends at 2010e, MS has the highest ROE.

Did I misread the chart or did you mislabel it? What is going on here?

Great work either way, I appreciated the compare/contrast to the MSM coverage. Just reading the CEO’s comments made me think “This is not confidence inspiring, comes across as fluffy” as an initial reaction. Never a good sign. I want to hear a Jamie Dimon-esque “I’ve got Obama by the balls!”, if anything. Kidding :)

The fact that MS ROE for 2010 is marginally higher than GS and JPM comes from the fact that they had strong trading revenues in Q1 and Q2 which has distorted ROE in favour of MS for full year 2010. MS had principal transaction revenues of $7.4bn and they generated a higher return in Q1 and Q2 (23% and 15%). However, if we extrapolate the chart to 2011-2012, their normalized ROE is expected at c8% at best. Also, to note that these financial ratios are accounting ratios. I believe a real return on equity should be on market cap and not book value which is the return for the investors. If a company has book value of $100 and market cap of $150 and earns $10, the implied return for investors is not 10% but 6.6%. Book value if taken should be economic book value. But most of these banks don’t mark up their long term investments to market value as accounting policy permits banks to keep these long term investments at book value even if market value is 50% off. That said, the point of analysis was to demonstrate how banks are faring with respec to their capital (accounting) and show a trend analysis with peers.
The tightening regulatory standards, rising bars on capital requirements, curb on prop trading, difficult trading conditions, risk aversion, deleveraging is definitely going to challenge investment banks' ability to earn excess return on cost of capital. Most sell side valuations do not reflect the such factors. We have done a detailed analysis of MS valuation including the pitfalls of Basel III compliance in the subscription report - File Icon Morgan Stanley Q3 2010 Analysis and Updated Valuation (click here to subscribe).

I will open up a portion of the model that I am offering to Pro and Institutional subscribers next week to illustrate MS ROE performance on a more granular basis.

On a quarter by quarter basis, you can see how poorly MS performs regarding ROE. In addition, it is apparent that Morgan Stanley is truly juicing the leverage in an attempt to generate those middling returns. This is dangerous! Take note that as leverage tapers, ROE plummets - and this is return on accounting earnings. Let's take a look at things from a more realistic, economic perspective...

Next week is professional and institutional subscriber week, wherein I will drill down into several companies and topics with even more precision than I normally do, including the offering of proprietary model output and an actual model or two.

Relevant subscription material:

Relevant free blog posts:

Last modified on Friday, 05 November 2010 08:10

5 comments

  • Comment Link Taylor Friday, 05 November 2010 11:23 posted by Taylor

    Reggie,

    Thank you for engaging me on my question. I appreciated your elucidation. MS certainly looks like a mess. Their true economic returns are going to be a train wreck if and when their cost of equity starts rising.

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  • Comment Link Reggie Middleton Friday, 05 November 2010 10:46 posted by Reggie Middleton

    We're going to get a liquidity spike, but if history is any indicator, it will be much less effective than the last one. In addition, QE is not repairing the damage to the banks, it is just allowing them to muddle along with decreasing revenues. The assets in question are still impaired and still on balance sheet.

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  • Comment Link Andrew Macpherson Friday, 05 November 2010 10:40 posted by Andrew Macpherson

    Is it to early to short them and this sector? My sense is QE2 will take us to 1550 S&P in the spring, and all boats will rise on that tide.

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  • Comment Link Reggie Middleton Friday, 05 November 2010 08:26 posted by Reggie Middleton

    Thank you sir!

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  • Comment Link Rod Friday, 05 November 2010 08:20 posted by Rod

    Reggie, you put the rest to shame, I enjoy the truth of your blog. Thanks

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