Why This Undervalued Financial Stock Could Gain 86%

In a Rolling Stone article from April 2010, in a now famous tirade against Wall Street investment banks, journalist Matt Taibbi described Goldman Sachs (NYSE: GS) as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.” This is one of the more negative descriptions of the industry you’re likely to find, but it does illustrate the hostility that people in the press and others still have toward investment banks and the role they played in causing the credit crisis.

The truth is the blame can be spread to a number of participants, be it overzealous home speculators, Freddie Mac and Fannie Mae and a Wall Street that helped fan the housing bubble and subsequent financial crisis. In regard to the investment banks specifically, firms including Lehman Brothers and Bear Stearns paid the ultimate price for their sins and no longer exist.

The remaining firms are seeing much more stringent regulations that should help stave off future disasters. They will also be better off now that a number of archrivals are gone and the survivors have quickly implemented more risk-averse cultures. The pure play winners in the space will likely now include Goldman and Morgan Stanley (NYSE: MS).

Shares of Goldman have more than doubled since the height of the financial crisis in March 2009. This is ahead of the market, which has doubled, but Morgan Stanley, however, continues to lag and is up only 60% since that time. Given the weak stock returns and changes being implemented by new CEO James Gorman, I see potentially big gains for investors going forward.

In March, Fortune magazine profiled Gorman’s strategy to return Morgan Stanley to its roots of earning fees on its investment banking and investment management activities. He is also trying to shift focus away from proprietary trading, where traders try to invest and make money on Morgan Stanley’s own assets. Proprietary trading can be extremely profitable, but it is just as volatile. When trades go against these firms, they can lose big, as evidenced by a $655 million loss on trades made with Japanese trading partner Mitsubishi UFJ Financial Group Inc. (NYSE: MTU) during the first quarter.

The trading loss has sent Morgan Stanley’s stock back toward its lows of the past year and represents an opportunity pick up shares on the cheap. Its investment banking unit remains the most successful in the industry. During the first quarter, Morgan Stanley boasted that it held a “No.1 ranking in global M&A in a robust deal market.”

Its wealth management business also became much stronger during the credit crisis as embattled rival Citigroup (NYSE: C) was forced to sell a 51% stake in its Smith Barney brokerage business to Morgan Stanley to raise capital and survive. Morgan Stanley combined Smith Barney with its own broker business and is now one of the largest brokers in the world.

The combination of a leading investment bank and brokerage business could prove very lucrative for investors going forward. But it’s not yet reflected in earnings. Overall, Morgan Stanley is still in recovery mode from the financial crisis and posted a return on equity (ROE) of only 7.8%, well below the 20.4% it reported before the crisis hit. First quarter ROE was only 6.2% off the firm’s quarter-end book value of $27 per share. 

Action to Take –> Analysts currently project 2011 earnings of $2.40 per share. At the current share price, the forward price-to-earnings (P/E) multiple is quite reasonable at less than 11. Within the next couple of years, I see ROE returning to double digits. An ROE of 12 suggests earnings of $3.24 per share, and maintaining the current P/E would mean a share price of almost $36 per share, or nearly 40% above current levels.

I eventually see an ROE of 15% and earnings north of $4 per share for Morgan Stanley. A reasonable P/E of 12 means the stock can potentially gain more than 86% from current levels. It may take a few years for Morgan Stanley to recover to these profit levels, but this would still mean double-digit annual stock gains for investors.