Beating Buffett

With most current ire focused on Goldman Sachs, other similar financial service giants are down a bit in sympathy even though they have not been targeted by the SEC. Morgan Stanley (NYSE:MS) has been in earnings recovery mode since posting losses in fiscal Q4 of 2008 through  Q2 of 2009 when the firm switched to calendar year reporting. EPS turned positive last September and March 2010 earnings turned out well above estimates with $1.03 versus d.0.57.

Zacks now sees 2010 – 2011 earnings of $2.99 and $3.48 per share respectively- numbers that are more or less in line with Standard and Poors and Value Line’s projections. At this morning’s price of $31.10 MS now trades at about 10.4x this year’s and < 9x next year’s expected EPS. Both those multiples are extremely low for MS by historical standards.

Here are Morgan Stanley’s per share results (excluding non-recurring items) as reported by Value Line:

Revenues for 2010 are estimated to rebound to about $6 billion or $42.70 /share taking into account the increased share count from secondary issuance during 2009. Clearly Morgan Stanley appears to have ‘normalized’ earnings power of at least $3 - $4 per share. It also seems logical to expect at least a 13 multiple within the next year or two as the negative June 2009 quarter and the weak results from Q2 and Q3 last year are replaced with what figure to be much improved results.

13x this year’s projection would lead to a 12-month target of almost $39 /share or about 25% appreciation from the current quote. That same multiple on the 2011 estimate would bring MS back up to over $45 by year-end 2011.

Are those achievable goals? Why not? Just a glance at the old 52-week ranges show peak prices well above those targets in each of the seven years preceding the late 2008 –early 2009 market meltdown. In fact, even the old yearly lows from the entire period 2004 through 2007 are above my target prices for this year and 2011.

The tarnishing of Goldman Sachs may lead to increased market share for the other major investment houses.

Dividends were cut from $1.08 to $0.20 annually to conserve cash during the crunch but are now poised to increase gradually with the present rate at under 7% of projected 2010 earnings. Book value may exceed $36 by December 31^st putting MS’s price at a rare discount to B/V. Typically; Morgan Stanley shares have traded at double to triple this valuation measure.

Here’s an options combination that looks good right now:

If Morgan Stanley shares rise to at least $32.50 (+ 4.5%) by Jan. 22, 2011:

·         The $32.50 calls will be exercised.

·         You will sell your shares for $32,500 in cash.

·         The $32.50 puts will expire worthless (a good thing for you as a seller).    

·         You will likely have collected $150 in dividends.

·         You will have no further option obligations.

·         You will end up with no shares and $32,650 in cash.

That would be a best-case scenario profit of $32,650 - $23,460 = $9,190

$9,190 / $23,460 = 39.1%           (cash-on-cash)

achieved in about nine months on shares that only needed to go up by 4.5% from the trade inception price.

What’s the risk?

If Morgan Stanley remains below $32.50 on the Jan. 22, 2011 expiration date:

·         The $32.50 calls will expire worthless.

·         The $32.50 puts will be exercised.

·         You will be forced to buy another 1000 MS shares.

·         You will need to lay out an additional $32,500 in cash.

·         You will likely have collected $150 in dividends.

·         You will have no further option obligations.

·         You will end up with 2000 shares of MS and $150 in cash.

What’s the break-even on the whole trade?

On the original 1000 shares it’s their $31.10 purchase price less the $3.10 /share call premium = $28.00 per share.

On the ‘put’ shares it’s the $32.50 strike price less the $4.55 /share put premium = $27.95 /share.

Your overall break-even would be $27.98 per share (excluding dividends) and slightly less including the yield.

MS could drop by up to 10% from your inception price without causing a loss on this trade.

Dr. Paul Price

Disclosure: Author is long MS shares and short MS options as described in this article.