Today, the Rule Maker Portfolio concludes its study of financial services companies with a look at Morgan Stanley Dean Witter (NYSE: MWD). My colleague Richard McCaffery has already written about Citigroup (NYSE: C) and Goldman Sachs (NYSE: GS), and we've been doing some internal work on J.P. Morgan Chase (NYSE: JPM) and Merrill Lynch (NYSE: MER). The study began after the attacks of September 11th crushed the entire sector, possibly creating what we thought might be an opportunity to buy a Rule Maker financial stock at a good price.
Morgan Stanley has leading market positions in its three main businesses: securities, asset management, and credit services. The company was formed out of the 1997 merger between Dean Witter, Discover & Co. and the Morgan Stanley Group. The deal brought Dean Witter's immense retail business and Morgan Stanley's institutional reach together, creating a vast business with a global reach. Over the past five years, the combined company has averaged annual sales and earnings growth of 19.5% and 30.5%, respectively.
The securities segment, which makes up more than three-quarters of its top-line, includes its high margin investment banking operations, such as advisory services for mergers and acquisitions, restructuring, and privatizations, as well as fixed income and equity underwriting. Morgan Stanley also has research, sales, and trading operations for stocks, bonds, derivatives, foreign exchange instruments, and commodities. Moreover, the company has investment management services for individual investors and high-net-worth clients.
The asset management segment makes up about 10% of total sales and caters to individual and institutional investors through a number of distribution channels. Morgan Stanley Advisors offers proprietary mutual funds to investors through its private client services unit. Van Kampen provides equity and fixed income funds to individual and institutional shareholders. Morgan Stanley Investment Management and Miller Anderson manage financial assets for institutions, including pension funds, corporations, and governmental agencies.
Through its flagship Discover Card brands, Morgan Stanley's credit services business, which accounts for more than 15% of total revenues, has been a real bright spot at the company with consumer spending remaining healthy during the current difficult economic conditions. The Discover unit has roughly 44 million cards in circulation, and through the Discover/NOVUS network -- the largest independent credit card network in the U.S. -- has more than 3 million merchant and cash access locations. The unit has also been expanding overseas.
We like the company's diversification, which should stabilize its profitability and allow it to not rely too much on a particular business. Goldman Sachs' primary businesses -- investment banking, trading and principal investments, and asset management -- have little consumer reach, for example, while Morgan Stanley does through Discover. This has added significance in that the high quality fee-based income that Morgan Stanley derives from its credit services segment is unrelated to the markets, something Goldman Sachs and Merrill Lynch can't claim.
Morgan Stanley is also well positioned overseas, where analysts expect the demand for investment banking advisory and underwriting to mirror the growth experienced in the U.S. over the past 10 years. Last year, Morgan Stanley acted as underwriter in more European merger and acquisition deals than any other company, for example. With key acquisitions like AB Asesores, the largest financial services firm in Spain, strategic partnerships in Italy and Japan, and a recognized global bard, the company expects significant growth abroad.
Clearly, Morgan Stanley is a diverse and global Rule Maker financial services stock with leading positions in investment banking underwriting and advisory, asset management, and the retail space. With the exception of Merrill Lynch, few firms can compare with this far-reaching business model. Simply identifying Morgan Stanley as a Rule Maker is the easy part, however. To beat the market averages, we must make sure that we're buying the stock at a good price.
Looking at the company's historical prices, I'm not sure Morgan Stanley is a screaming bargain. I like to begin any valuation study looking at historical valuation ratios. It's a good idea to look how the market has priced a particular stock in the past, and then compare it to the current price. Morgan Stanley closed yesterday at $42.80 per share, leaving it with a market cap of $47.35 billion and trading at 12 times trailing 12-month (TTM) earnings.
Here's a look at its historical price-to-book, price-to-earnings, and price-to-sales ratios:
MWD TTM '00 '99 '98 '97 5Y Avg P/E 12.3 16.8 17.4 14.3 13.9 14.6 P/B 2.4 4.7 4.8 3.0 2.7 3.4 P/S 1.0 1.9 2.2 1.3 1.2 1.5 *calculated at year-end
Morgan Stanley trades below all three five-year averages, but rather than argue that the stock looks cheap on historical standards, I think Morgan Stanley is fairly valued. There's no way it deserves to trade at a multiple anywhere near where it did over the past couple of years. The robust growth in the capital markets had led to significant revenue expansion, but with slowing advisory and underwriting activity, an increasingly ugly outlook for the economy, and falling market averages, Morgan Stanley deserves a much lower multiple.
That said, it's no secret Morgan Stanley's business runs with the economy. The company derives a significant amount of revenue from investment banking, for example, and underwriting and mergers and acquisition activity has been slowing, and is expected to fall even further following the World Trade Center attacks. The asset management unit could also weaken if investors leave equities for fixed income and money market accounts. With this much business uncertainty, we're simply uncomfortable buying the stock at the current price.
Hence, I think the Rule Maker Portfolio could get more return for its investment looking elsewhere. We'll keep our eye on the financial services stocks, but the prices will have to come down further for us to seriously consider any of them. For those of you keeping score at home, other firms we're taking a look at include TMP Worldwide (Nasdaq: TMPW), Starbucks (Nasdaq: SBUX), Capital One (NYSE: COF), and Adobe (Nasdaq: ADBE). We welcome your thoughts on these stocks and other potential Rule Makers on our message board.