How A Boring Morgan Stanley Made ValueAct Capital $650 Million Since The Summer

Gone are the days when the trading desks at Morgan Stanley made multi-billion dollar bets on the market that could pay off big, or fail spectacularly. Also gone from the investment bank are some money minting quantitative traders who've since become Wall Street powerhouses in their own right.

But a somewhat boring and safer post-crisis iteration of Morgan Stanley is beginning to pay off in a major way for one of Wall Street's savviest investors. This spring and summer, activist hedge fund ValueAct Capital bet over $1 billion on Morgan Stanley and has seen its holding rise roughly 60%, or $650 million, in a matter of months as stock-pickers rush back into the banking sector in the wake of the election.

In August, ValueAct disclosed a 38 million share position in Morgan Stanley it built during the second quarter when the firm traded between $23 and $28 a share. All told, the hedge fund reportedly made a $1.1 billion bet on Morgan Stanley and its most recent filings show a 41.9 million share position indicating an average price north of $26 a share. (ValueAct declined to comment)

Less than four months later, Morgan Stanley now trades at over $42 a share as investors begin to embrace bargain-priced bank stocks in anticipation of president-elect Donald Trump's agenda of tax cuts, infrastructure spending and a rolling back of regulations in the financial sector. Expectations of stimulative and pro-growth policies have also steepened the yield curve, creating a 10%-plus tailwind to Morgan Stanley's 2017 profits, according to some bank analysts.

Since Election Day Morgan Stanley's stock is up nearly 30%. Those gains came on the heels of a series of strong earnings reports from the bank, which now breaches new post-crisis highs with each passing trading day.

ValueAct often takes activist positions when making investments and its success can come from helping to guide a company through major change. Such was the case for both Adobe and Microsoft, as they shifted from a license to a subscription business model and diversified their businesses from the PC. ValueAct has also targeted stocks in the grips of industry consolidation like Willis Towers Watson, Baker Hughes and embattled pharma roll-up Valeant Pharmaceuticals.

But when it comes to Morgan Stanley the credit behind ValueAct's bumper gains goes to the hedge fund's timing and its ability to see strength in the bank's business model at a time of uncertainty.

After all, it was Morgan Stanley CEO James Gorman who has worked for years to reconfigure the bank so it can thrive in times of volatility and falling markets, instead of losing billions. Under Gorman, Morgan Stanley rebuilt its capital and jettisoned or trimmed risky and capital intensive trading businesses. A crisis time bet on wealth management has yielded the bank's number two money maker, after trading. Gorman's fast growing wealth management lending business now generates over $3 billion in annual revenues. The transformation is profound.

"We went from a period of fragility, to healing, to stability. Now we're moving into a period of growth" Gorman told FORBES for our Money Masters issue in May. "The wheels don't fall off in a difficult environment. That is a huge positive," Gorman added, reflecting on the firm's $1.1 billion first quarter profit despite cratering commodities, stock and junk bond markets at the time.

Few seemed to have Gorman's confidence, or give Morgan Stanley credit for making money at a time when hedge funds and oil drillers were going bust by the day. Between the spring and mid-summer, ValueAct built its stake in Morgan Stanley when shares were trading in the mid-to-high $20s, at nearly a 25% discount to the bank's book value, and a discount the firm's liquidation value.

At that time, investors were cool investment bank stocks because of the specter of negative interest rates and a slowing in fee-generating M&A and issuance activity across Corporate America. Negative interest rates were widespread in Japan and Europe for much of 2016 and when the Fed delayed a hike in June, fears emerged of a contagion in the United States. Many banks earn half their revenue from interest income, thus negative rates undermine their earnings power.

What banks like Morgan Stanley weren't getting credit for, however, was their new business models. A crisis-like three month stretch in the first quarter yielded a $1.1 billion profit. Even with rates at historic lows and IPO activity in a freeze, Morgan Stanley earned $1.5 billion in profits last quarter. If shares were offering growing but bond-like dividends and little downside risk based on valuation, then there was an opportunity for big profits in a normal market.

Trump's election spurred one of the most sudden market moves in a generation and optimism of that normal market has arrived earlier than imagined. Bank stocks like Morgan Stanley, JPMorgan, Bank of America and Goldman Sachs are skyrocketing and the investors like ValueAct that placed their bets ahead of time are seeing a big windfall.

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