The Daily Interview
With earnings season in high gear, we talked to
Henry McVey at
Morgan Stanley Dean Witter
to get a sense of how things are shaping up for financials. Though most of the financial companies reporting have met or exceeded expectations, some of those estimates had previously been adjusted downward.
inaugural Daily Interview, we've picked McVey's brains on the state of the economy, the latest batch of earnings results, the looming concerns about credit quality and how these matters affect financials in 2001. To find out which stocks he likes -- and dislikes -- read on.
TSC: What's your take on earnings so far? Are they better or worse than you expected?
report a couple of weeks ago and expectations were exceeded. That, in combination with the move by the
Fed, has given us a nice rally in brokerage stocks. Tuesday, we had
, obviously a bellwether, come through, and its earnings were solid and it had no major credit issues. So I think right now, generally, people feel good about financials, particularly in light of an easing Federal Reserve.
In general, when we take a step back, we like financials in a declining interest-rate environment. We think some of the stocks are attractive, but not dirt cheap, and that security selection is going to be of paramount importance. I think what makes this different than the early '90s is the stocks are not at the same low valuation levels. So we still think there's upside to the names, particularly going into the month end, but we're not talking about going from trough to peak valuations.
When you think about the group right now on the brokerage side, there are basically three buckets. There are institutional buckets like Lehman or Bear Sterns or
, and then diversified buckets like
or Citigroup, and then retail like
. Our recommendation to investors is to own the institutional and diversified names and to lighten up on the retail sector because we believe interest-rate cuts by the Federal Reserve will stimulate the quickest snapback in the institutional firms with capital markets exposure.
In addition, we believe that the large diversified names like Merrill and Citigroup can outperform, barring a serious economic recession.
On asset management, we favor small-cap over large-cap names. We think they have better fundamentals, the ability to buy back stocks and better fund flows. Our top picks are
Waddell & Reed
Affiliated Managers Group
. (Note: Morgan Stanley has done investment banking work for AMG within the last two years.)
TSC: To go back a minute, if you like the institutional side with capital markets exposure, you must be pretty bullish in terms of the economy?
I think that as investors learn more about the institutional brokerage story, including growth in Europe, capital raising and fixed-income issuance, the propensity to turn more positive will increase.
TSC: What do you mean in terms of fixed-income issuance?
The fixed-income market didn't have a pulse in 2000. Lower rates have led to spread contraction, which has driven fixed-income issuance. I'd say activity in the convertible market has been quite robust in recent weeks. Obviously, fixed income is not as compelling as equity in terms of profitability, but it underscores that there are parts of the capital markets machine that are turning.
TSC: What's your take on credit problems among financials?
Credit is likely to be an issue that doesn't go away over the next six months. At Morgan Stanley, we think problems will peak in the second half of the year, not the first half. That's why I underscore that stock selection is extremely important amid a period of slowing economic growth.
What can make financials underperform, I think, are two major issues: One is expense control, the second is credit. Those are two things we're spending a lot of time focusing on.
TSC: Can you elaborate on expense control?
In the near term, most investors know revenue growth is going to be sluggish, but we are betting firm management can keep compensation and operating expenses in line. For investment banks or commercial banks that can't do that, the potential for multiple contraction is significant.
TSC: In terms of bad credit exposure, who's in the worst shape?
I can't comment on somebody else's
area of coverage. But I think firms with credit issues have begun to at least raise their hands
at this point.
Our thesis is based on slowing economic growth, but not outright economic recession. If the economy drops off substantially, then there's the potential that financials face a stiff headwind.
TSC: If that happened, wouldn't the institutional side get hurt?
Our case is slowing economic growth in the first half of the year and a rebound in the second half. We're not forecasting a global recession. Should one occur, I think credit risk as well as slowing fund flows will turn us much more cautious on the whole sector.
TSC: What do you think of valuations at this point? This group did pretty well last year.
Lehman was at $50 in mid-December; it's at $78 today. Our target is $88. Citigroup was right around $50; we have a target of $63 on that one. We upgraded Merrill Lynch in October at $58, and today it's at $75. So we've already had some pretty strong moves.
I think going into February, it's extremely important for earnings growth to accelerate so the stocks can catch up with their earnings multiples. If earnings don't come through, there's the potential for weakness in the group.