Morgan Stanley: IPO Mania Is Over, Grab 5.36% Yield Preferreds

Summary

• In 2020, I wrote a bullish article on Morgan Stanley, arguing that it was a better way of playing that year's "IPO Frenzy" than buying overpriced offerings.
• I recently checked up on it and discovered that the pick performed well and outperformed the S&P 500 by 12%.
• I was actually surprised that my Morgan Stanley recommendation did so well, as investment banking fees cratered in 2022 and 2023.
• Nevertheless, the company is financially sound, making its preferred shares desirable investment options.
• In this article I explain why I consider Morgan Stanley's 5.3% yield preferred shares superior to its equity.

In 2020, I wrote an article about Morgan Stanley (NYSE:MS), which argued that the company’s common stock was a good bet on the IPO frenzy that was happening at the time. That year saw many companies go public, including Airbnb (ABNB), Palantir (PLTR), DoorDash (DASH) and Upstart Holdings (UPST). I wrote at the time that most of these IPOs were overpriced, and that Morgan Stanley’s cheap exposure to the frenzy by way of underwriting and advisory fees, was preferable to buying the issues.

The article’s thesis worked out well. When I checked up on my Morgan Stanley article, I noticed that most of 2020’s IPO stocks were either below their first day closing prices, or up just a little in a period when stocks rallied. Also, I noticed my article's sidebar showed that the stock had outperformed the S&P 500 in the period since I checked on it. I was a little surprised to see this. I knew that Morgan Stanley was a good business, but had assumed that its stock would have crashed when investment banking fees cratered in 2022 and 2023. I was pleasantly surprised to see that it hadn’t. Though I was right in my thesis that the IPO boom would continue into 2021, I figured that the subsequent weakness would have erased the gains.

Flash forward to today. Morgan Stanley is still very strong in tech underwriting and advisory, but it isn’t growing like it was in 2020 when I wrote my article. In 2022 and 2022, investment banking fees declined, and although Morgan Stanley today does more than just investment banking, its revenue trajectory has been consistent with the industry-wide decline in investment banking fees. Its revenue declined in 2022, then did near 0% growth in 2023.

This year, investors are expecting investment bank earnings to ramp up. Citing generative AI deals, renewable energy and blockchain, industry insiders have a fairly rosy outlook. Indeed, this is reflected in investment bank earnings estimates: investors expect MS to do $6.36 in EPS next year, which would be growth of 22.77% if achieved. Obviously, a stock growing at 22.77% merits a steeper price than a no growth company, but estimates are merely products of human judgment. They can be wrong, and often miss the mark. In the meantime, here are Morgan Stanley’s trailing growth figures and multiples:

So we’ve got Morgan Stanley here at 15.2 times earnings, with earnings down, and 13.7 times forward earnings. The forward multiple might look reasonable, but look at the same multiples for the S&P financials index:

Here we have banks as a whole with much lower multiples than Morgan Stanley, but on a trailing basis and on a forward basis. True, MS is expected to grow more than the average bank is, but its forward multiple is nevertheless higher than that of its peer group. It would appear that MS is overvalued relative to its sector.

The AI Catalyst: A Big Deal For Morgan Stanley

One reason for optimism toward MS stock is this year’s expected increase in artificial intelligence (“AI”) related deals. MS is one of three bulge bracket banks considered to have particular expertise in tech underwriting and advisory. With UBS’ (UBS) acquisition of Credit Suisse, there are now eight bulge bracket banks in total, meaning that MS’s position in the top three puts it into 63rd percentile for investment banks when it comes to tech. IPOs it underwrote or advised on included Facebook (META), Google (GOOG) and Salesforce (CRM).

This is a big deal for Morgan Stanley, because AI-related M&A is expected to heat up this year. According to Retail Banker International, tech related dealmaking rose 100% year-over-year in the fourth quarter. Industry experts forecast that AI related dealmaking will increase on a full-year basis in 2024. They are probably right. In 2023, 2,500 AI startups raised money from venture capitalists. Some of them will likely be acquired, which may lead to some advisory fees for companies like Morgan Stanley. MS has a competitive edge, with its well known tech expertise. So, it should get a larger share of any such deals that arise, compared to a typical investment bank.

The expected increase in AI-related M&A should lead to a rise in investment banking fees at Morgan Stanley. However, it’s hard to say exactly how much. Many AI deals are expected for 2024, but few have been announced. What we know is that MS remains relatively expensive for its sector, even if 2024’s expected earnings growth is achieved. Should earnings growth be 20% this year, as analysts expect, then MS is approximately 37% pricier than its sector, even on a forward basis. So, MS stock appears expensive based on what analysts are expecting.

Preferred Shares - a Cheaper Way to Play Morgan Stanley

When I wrote about Morgan Stanley years ago, I called it a “cheaper way” to play IPO Frenzy. Today, I want to discuss a “cheaper” way to play Morgan Stanley itself:

The company’s fixed-pay preferred shares (NYSE:MS.PR.L). These shares pay 4.875% of par (“liquidation preference”), which results in a yield of 5.36%. The shares are callable at $25, which means that if you buy them today and they are called, you will realize a 10% capital gain.

In a recent article, I covered Goldman Sachs’ Series ‘A’ preferred shares, arguing that they were better than that company’s equity because of its steep valuation. By annualizing the most recent dividend, GS.PR.A has a yield of 7.31%, which is quite high. However, those preferreds are floaters, meaning that they have floating rates, which is calculated as the SOFR rate plus a fixed portion. Such preferreds can do well when rates rise, but they pay less income when rates fall. Personally, I am expecting relatively high long term interest rates, so I’m comfortable with GS.PR.A’s floating characteristic. Others may not be, though, so it’s worth exploring alternatives.

Morgan Stanley’s fixed rate preferreds are one such alternative.

First, their yield, although not as high as that of MS floaters, is nonetheless higher than that of Morgan Stanley equity. A 5.36% yield is nothing to sneeze at. Let’s imagine that you buy MS, collect four dividends, and in a year your preferreds get called at the $25 liquidation preference. In this case you get a 15.36% total return in a year, which is better than what the S&P 500 does most years.

There are other factors that make MS.PR.L an intriguing preferred stock. Like all preferred shares, MS.PR.L enjoys payment priority over the company’s common shares. When we look at the dividend safety characteristics of MS’s common stock, we see that it has a 0.585 payout ratio, a five year CAGR dividend growth rate of 23.7%, and ten years of dividend growth. The common stock dividend is safe if MS can grow its earnings at just 0%--and analysts expect 20% growth this year. Now, when we look at the preferred stock, we see that it (ALL of Morgan Stanley’s preferred stock) pays out just $557 million per year, on net income of $8.5 billion. Earnings could decline 93%, and Morgan Stanley would still have enough money coming in to cover its preferred stock dividends!

The Bottom Line

The bottom line on Morgan Stanley is that its preferred stock is simply looking more intriguing than its common stock right now. Higher yielding and safer, it makes more sense than trying to bet on high earnings growth at Morgan Stanley. The highest yields are found among Morgan Stanley floating rate preferreds, but a much safer yield can be had with the fixed rate preferreds. A mix of both might be ideal.