Like several other major banks that reported earnings last week, Morgan Stanley's (MS -0.57%) first-quarter earnings report blew analysts' expectations out of the water. However, a closer look reveals a sizable loss tied to the scandalous implosion of Archegos Capital Management, one of Morgan's institutional clients. While this shock to investors has kept the stock's price down since it was disclosed last week, digging into the company's record-setting results reveals that Morgan Stanley may currently be the best financial sector stock for your portfolio. Here's why investors may be missing Morgan Stanley's forest for its trees.

A hand with a hammer smashes a glass piggy bank, releasing gold coins inside.

Image source: Getty Images.

What really happened

Archegos Capital Management was a family office: an investment management firm operating similarly to a hedge fund, but managing only the wealth of one family. It used services from Morgan Stanley and several other prime banks worldwide. While the firm managed approximately $10 billion in assets, its exposure to the stock market was approaching $30 billion -- partly thanks to risky strategies like total return swaps, in which banks essentially loan money to investors in order to allow them large positions in the market without paying upfront for them. 

In this case, that risk was not rewarded. Archegos defaulted on its margin calls -- in other words, it was unable to pay back banks like Morgan Stanley, triggering those banks to sell off the firm's holdings. In a matter of days, the firm had collapsed and the banks were suffering from major losses. Morgan Stanley avoided a potential $10 billion loss by responding more swiftly than most banks, leading to an immaterial loss that it more than made up for with stellar financial performance. 

A good time for bad news

All things considered, Morgan Stanley picked a pretty good time to take this loss. Considering its record-breaking Q1 report, CEO James Gorman didn't view the loss as material -- and I'd argue that he's not wrong. The company achieved record revenue of $15.7 billion, up 60% from the prior-year quarter, and record net income of $4.1 billion, more than doubling net income in the same period. 

An important detail in the earnings report is the company's performance in its institutional securities business (i.e., investment banking for ultra-high-net-worth individuals and institutions) -- the same segment in which it lost $911 million selling off Archegos's positions in the market. Despite that Archegos-shaped hole, Morgan Stanley's institutional securities segment boosted net revenue 66% and tripled pre-tax income over the prior-year period. 

Morgan's strong quarter can be attributed in part to record-high equity underwriting activity (i.e., raising equity capital for corporations), as well as fees earned from facilitating IPOs and SPAC mergers, fixed income investing, and stock market investing. While these external market factors played a role, the bank's results were also driven by its recent acquisitions of E*Trade and Eaton Vance, as well as a 7% reduction in expense ratio (i.e., expenses as a percentage of revenue).

The company's performance -- not only overall, but also in its institutional securities business -- more than recoups its losses related to the collapse of Archegos. While that implosion came as a surprise to the public, it was reasonable to consider it immaterial ahead of the regularly scheduled earnings report.

Growth opportunities

Morgan Stanley acquired E*Trade (a discount stock brokerage) in Q4 2020 and Eaton Vance (an investment management firm) on March 1, 2021. The company's acquisition of E*Trade will help it expand into a broader customer base, including the middle-class market -- and keep the broker out of longtime competitor Goldman Sachs's (GS -1.27%) hands. 

It was no secret on Wall Street that E*Trade was available before Morgan bought it for $13 billion last year -- and that analysts expected Goldman to make the same move with the same strategy. Now, Goldman will likely have to build its own retail brokerage operation to effectively compete with Morgan's new E*Trade arm -- taking valuable time to achieve. 

Morgan Stanley's Eaton Vance acquisition brings the company's assets under management across the $1 trillion milestone, further sharpening its competitive edge. 

The price is right

Morgan Stanley's stock is below its 52-week high by about 9%, currently trading at a P/E ratio of 10.5 -- compared to JP Morgan Chase's 12.2, Bank of America's 16.8, Charles Schwab's 29.2, and Goldman Sachs's 8.5. Despite Goldman Sachs's lower P/E ratio, Morningstar has rated Morgan Stanley stock as fairly valued and Goldman Sachs stock as overvalued following Q1 2021 earnings reports.

Overall, the company's fundamentals are strong and the stock is positioned for a fairly priced value investment. As always, take news headlines like the Archegos story in context and look to financial performance for the full picture while making investment decisions.