This year has been one for the record books. Inflation is at its highest level in over 40 years. The S&P 500 is off to its worst start in over 50 years. Interest rates are rising at their fastest pace in 30 years.
Companies went public at a record pace last year, but this year's market weakness has caused initial public offerings (IPOs) to come to a screeching halt. As a result, investment banks have seen earnings from this activity plummet.
While nobody could have seen this coming, Morgan Stanley (MS 1.58%) has put itself in a position to weather the storm while other investment bankers feel the pain from an economic slowdown. Here's what the company did to transform its business.
The problem with investment banking
Morgan Stanley has historically provided investment banking services to companies that want to go public through an IPO or raise money through a debt offering. The company is one of the best at what it does, and is one of the top investment banks in the world, alongside Goldman Sachs, JPMorgan Chase, and Bank of America. However, the company's reliance on investment banking created a feast-or-famine situation, where it thrived when economic conditions were favorable and struggled when things turned south.
In 2009, one year before current CEO James Gorman took the reigns, Morgan Stanley generated 66% of its revenue from its institutional securities segment, which includes investment banking and trading revenue. Since then, the firm has diversified its revenue, so 50% comes from the institutional securities segment, making it less susceptible to the investment banking market cycles. Here's how it did it.
Data source: Morgan Stanley. Chart by author.
Morgan Stanley's solution
Morgan Stanley also provides wealth management services, which include investment advice and brokerage services, along with investment management services, where it provides investment products for retirement plans, foundations, and endowments.
These two services were a smaller portion of the firm's revenue until a few years ago, when it acquired the E*Trade trading platform and the asset manager Eaton Vance for a total of $20 billion.
The purchase of E*Trade gave Morgan Stanley a trading platform that brings in money through transaction fees while growing its deposit base, allowing it to earn extra interest income. Meanwhile, the acquisition of Eaton Vance gives Morgan Stanley a more significant investment business where it collects fees on its assets under management (AUM). Last year Morgan Stanley's AUM grew 85% to $5.6 billion because of this acquisition.
Image source: Getty Images.
Bringing stability to its earnings
Through the first half of this year, Morgan Stanley's investment banking revenue fell 46%, mainly due to a dramatic 70% drop in underwriting income. The bank's other areas saw declines too, but not nearly as big.
Its wealth management segment brought in $11.7 billion in net revenue, down 3% from last year. Asset management fees and net interest income grew in this segment, while transaction fees dropped off. Its institutional management segment brought in $2.7 billion in revenue, down 9% from last year. Asset management fees here were also up from last year, while performance-based fees dropped amid weaker markets.
While both segments saw drops in revenue, they weren't nearly as much as the investment banking portion of its revenue. Both revenue sources are independent of the investment banking cycle, and help provide Morgan Stanley with a more stable revenue base.
Investment takeaway
Morgan Stanley's net revenue through six months is down 8% from last year, and net income is down 19%. To put this in perspective, Goldman Sachs, which relies more on investment banking to drive earnings, saw its net revenue through six months fall by 25%, while its net income fell by 45%. Meanwhile, Jefferies Group, another investment bank-heavy business, saw its net revenue fall by 30%, and net income fall by 53%.
Morgan Stanley has been on a mission to build a more resilient business, and we see that playing out today. The firm currently trades at a price-to-earnings ratio (P/E) of just 10.9, at the lower end of its history. However, you could argue that it deserves a higher valuation after transforming its business through strategic acquisitions -- and it could be an excellent value stock at this price.
