AMM Dividend Letter Issue 31: Pokemon Go, Substitution Effect, & Morgan Stanley (MS)
If you didn’t hear, Pokemon Go was a huge hit this past summer. Pokemon GO is an augmented reality smart-phone based game that integrates the classic Pokemon video and card game into the world around you.
Pokemon Go was released on July 6, 2016 and it was an overnight sensation. So many people started playing the game that the servers supporting it kept crashing. This was a worldwide phenomenon with servers crashing in every country where Pokemon Go had launched.
Based on the popularity of the game, Nintendo’s share price more than doubled by July 18.
And rightfully so, as such a popular product means Nintendo is a great investment.
The substitution Heuristic happens when we are faced with a hard question. If the question is too hard or requires too much effort to figure out we subconsciously swap the hard question with an easier question.
The hard question in the above scenario is: What will be Nintendo’s actual share in the profit of Pokemon Go?
Pokemon is owned by The Pokemon Company, a privately held company. Nintendo owns a third of The Pokemon Company. The game Pokemon Go was created by another privately held company Niantic. Nintendo owns a piece of Niantic too along with Google. Like all apps and games offered on iPhones and Android phones, Google and Apple get a cut of all revenue generated through in-app purchases.
Nintendo only receives a fraction of the revenue and profits Pokemon Go generates. Figuring out that share is hard but it’s not impossible. It just takes time and effort.
The Easier Question
Why Nintendo’s shares doubled is because investors substituted the hard question, “how much will Nintendo actually earn”, with the much easier question, “is Pokemon associated with Nintendo?”
When it comes to investing, substituting the hard question with an easier question causes problems . Nintendo’s ADR share price dropped more than 10% the day after Nintendo answered the hard question for everyone.
On Friday, Nintendo sent out a warning to stockholders explaining all this: “Because of this accounting scheme, the income reflected on the Company’s consolidated business results is limited.” Skittish investors started to sell immediately
Substituting an easy question for a hard one happens all the time. People buy Starbucks’ stock because they drink the coffee, people buy Apple because they own its phone. What they don’t do is determine the value of a company based on its current and expected cash flows and then determine a fair price to pay for the company. It’s tedious work to figure this out. It is far easier to determine whether you like a product or not.
The substitution effect doesn’t just happen with investing. Every hard decision we make is subject to the Substitution Effect and we can’t eliminate it. It is a quirk in the way we think. When we believe we’ve made a completely rational decision we have in fact made a completely irrational decision.
The only checks we can place on the substitution effect is to slow down and review our decision making process. Have we really weighed all the pertinent factors? We can also enlist the help of a devil’s advocate, someone to challenge our rationale.
At American Money Management we do one other thing to counteract the substitution effect. We like to write about our investment decisions. If we can’t articulate our investment choices in a clear easy-to-understand way then we haven’t done our research. We haven’t asked the hard questions.
This issue we discuss Morgan Stanley, a semi-controversial “wall street” stock – and competitor of AMM. While we think our client offering is superior to the Morgan Stanley broker model, the stock still looks attractive on a number of levels.
Dividend Stock in Focus
Morgan Stanley (MS): $38.49*
*price as of the close November 11, 2016
We invest in in three types of dividend paying stocks for your portfolio.
1) Dividend Stalwarts: Companies that have strong dependable market positions, that pay a reasonable dividend (~2-3%), and have shown an ability to grow their dividends over a long period of time at a pace far faster than inflation. While the current yield is modest, we expect the growth in the dividend payout to provide a more robust yield (on original cost) in the future.
2) Restructuring/Special Situations: Companies undergoing a restructuring, spin-off, or other special situation. If we see value in the restructuring and the parent company pays a reasonable dividend we will invest. Our initial time frame for these investments is one year but if, after the restructuring, one of the companies’ appears to offer good odds of becoming a dividend stalwart we may hold our investment for a longer time frame.
3) New Dividend Payers: Companies that have recently initiated a dividend policy. While these companies do not have the long history of paying and growing their dividend like the stalwarts, they do have a strong market position and the cash flow to become a stalwart in the future.
Morgan Stanley has been around since 1935. Henry S. Morgan (Grandson of J.P. Morgan) and Harold Stanley formed the company in response to the Glass-Steagall act, which required the separation of commercial and investment banking businesses after the Great Depression.
Morgan Stanley already pays a dividend and has paid one for a long time but we are classifying Morgan Stanley as a New Dividend Payer. As you’ll see in the dividend history section below, Morgan Stanley cut its dividend during the financial crisis and kept it at the new lower rate until 2014. During that time Morgan Stanley has changed the focus of its core business and only recently started raising its dividend again. It is the shift in Morgan Stanley’s core business that we think will allow the company to grow its dividend well into the future.
The chart below is not what you would expect of a dividend growth investment. A company with a massive dividend cut during the financial crisis and only two years of recent dividend growth, albeit; growth of 50% each year and an increase this quarter of 33%. This is why, even though Morgan Stanley has paid a dividend for a long time, we classify it as a “New Dividend Payer”.
We see the company continuing to grow its dividend at an above-average rate over the next few years because of its changing business focus and its large capital reserves.
Catalysts for Dividend Growth and Price Appreciation:
Before the 2008 financial crisis Morgan Stanley’s profitability relied on its investment banking and trading activities. After surviving the 2008 financial crisis Morgan Stanley’s management realized they could no longer rely on the erratic nature of its trading business or the cyclicality of its investment banking operations. Morgan Stanley needed a more stable revenue and profit stream and they found it in their wealth management division.
Revenue from its wealth management division has become a bigger percentage of the Morgan Stanley’s total revenue.
But it is the net profits before tax from the Wealth Management division that has provided the biggest boost to Morgan Stanley’s overall profitability.
The profits from Morgan Stanley’s wealth management division will still fluctuate with the overall market but they shouldn’t fluctuate to the extremes that its trading and investment banking divisions do.
While Returns on equity and capital will be lower than its trading business, Morgan Stanley’s wealth management should provide a more consistent and dependable revenue and profit stream that will flow through to a more consistent dividend policy.
Recently, assets under management in Morgan Stanley’s wealth management division surpassed $2 trillion and this division is expected to continue to keep growing because of its focus on high net worth clients.
High Net Worth Clients
Morgan Stanley’s Wealth Management division has increased its profitability by focusing on high net worth individuals and families. This focus allows Morgan Stanley to trim its roster of advisors while increasing assets. A recipe for increased profitability.
Morgan Stanley is already the leading wealth manager in the U.S. based on assets under management for high net worth individuals and families. This market segment, both domestic and globally, is expected to keep growing.
From Mckinsey’s 2014 report on the wealth management industry.
- Despite slower global economic growth, the number of millionaires is expected to rise by 7.1 percent by 2018 to more than 18 million.
- By 2018, total HNW assets are expected to rise by 49 percent to USD 76 trillion. We expect Asia (excluding Japan) to create about USD 9 trillion in net new millionaire wealth.
As the leading high net worth wealth manager in the U.S., Morgan Stanley has the brand recognition, the network, and the expertise to serve this very profitable and growing segment. Morgan Stanley’s leading wealth management attributes in the U.S. also offers Morgan Stanley a great opportunity to grow globally.
Morgan Stanley’s focus and expertise on high net worth households allows it to add profitable ancillary services. Like lending.
High net worth households come with an array of assets. And a lot of those assets are illiquid and hard to lend against in the traditional way. Through the existing relationship with their high net worth client Morgan Stanley is willing to lend against those assets. If interest rates rise Morgan Stanley’s net interest margin, lending profitability, will rise too.
Increased Capital Return to Shareholders
As a result of the 2008 financial crisis, Morgan Stanley has to submit a capital return plan to the Federal Reserve for approval. Before approving a capital return plan the Federal Reserve is making sure Morgan Stanley is well capitalized and reserved against future potential losses.
The current requirement for Common Equity Tier 1 Ratio is 6.5%. Morgan Stanley’s Common Equity Tier 1 Ratio currently stands at 15.8% well above current requirements. This even exceeds the Total Minimum Regulatory Capital Ratio of 9.375%.
Morgan Stanley is more than well reserved. It has excess capital in reserve and we expect the company to return this excess capital to shareholders through increased dividends and share buybacks.
The other big opportunity for Morgan Stanley is large cost reductions. The company is currently initiating a large technology overhaul to reduce costs and streamline operations. Hence the name “Project Streamline”.
Reducing costs is a large component of increasing Morgan Stanley’s efficiency ratio. The lower the ratio the better because it shows increasing profitability.
Pre-Mortem (Potential Risks to our Thesis):
DOL Fiduciary Rule
The big news in the financial advice industry has been the announcement of the new Fiduciary Rule by the Department of Labor. A financial advisor that is a fiduciary, like American Money Management, works with and acts in the best interest of their clients. Any financial advisor who isn’t a fiduciary, someone who sells securities, insurance, or other financial products and earns a commission on them operates under the suitability rule. The product they sold to you has to be suitable to your needs.
It may sound like a minor difference but it has huge ramifications for your portfolio. The broker could sell you investment products that pay them a large commission but do not serve your long-term best interest and it would be OK if that product was “suitable” to your situation.
This isn’t right.
The Department of Labor’s new rule states that any person that advises on retirement accounts has to operate as a Fiduciary. This essentially ends the use of commissioned products in retirement accounts. Why sell them if you can’t get paid on them?
A broker advising on retirement accounts can still sell commissioned products but they have to get consent from the client and maintain more paperwork to ensure that they are in compliance with the new rule. Some of the large brokerages are switching to a fee only model citing the regulatory burden. Others, like Morgan Stanley, will still allow its advisors to sell commissioned products in retirement accounts.
Morgan Stanley will also have the fee-only models. The continued selling of commissioned products in retirement accounts under the new Fiduciary Rule increases the chances for more lawsuits. It potentially puts Morgan Stanley at a competitive disadvantage to firms that offer fee-only advice.
*This was written before the outcome of the 2016 Presidential election. It is a distinct possibility that the DOL Fiduciary rule will not go through with Trump winning the Presidency.
American Money Management
We would like to think that American Money Management LLC is a direct threat to Morgan Stanley but it is the collection of firms like us: boutique fee-only wealth managers. Also known as independent Registered Investment Advisors (RIAs). RIAs are the fastest growing segment in the wealth management industry and collectively manage well over a $1 trillion in assets
We think you understand the appeal; clear and fair pricing, high touch and individualized service, acting as fiduciaries.
Wealthy individuals and the mass affluent are moving their assets away from the large well-known brokerages to independent RIAs. Brokers are leaving too as they see the appeal in conflict free advice. The departing brokers are either taking their book of business to established RIAs or starting their own boutique firms. The large brokerage houses like Morgan Stanley have a lot more competition.
Increased Regulation & Capital Requirements
Morgan Stanley has to submit a capital return plan to the Federal Reserve each year before the company can increase its dividend and/or share buybacks. Right now Morgan Stanley has reserves in excess of its requirement. We think shareholders are going to be rewarded with a larger dividend and a larger share buyback over the next few years.
If those reserve requirements change then the potential capital returned to shareholders will be reduced. Higher reserve requirements lead to lower returns on equity. Morgan Stanley would like to use its capital to make more loans to its high net worth individuals and reinvest more in its business. Reserve capital can not be put at risk and it can not generate a return for the company. It is a drag on growth. Higher reserves would lower the returns Morgan Stanley can generate for its shareholders.
When we made our first purchase in Morgan Stanley near the end of September shares were trading around $31-32 per share. We valued the company at $40 per share. In the wake of the Presidential election and Donald Trump’s victory financial companies have staged a strong rebound. The prevailing thought is that higher interest rates are coming when President-elect Donald Trump replaces Janet Yellen at the end of her term. Another belief is that recent increased regulation on financial companies will be rolled back. We think it is unlikely that Dodd-Frank will be repealed, but some of the regulations under its framework may be lessened. For Morgan Stanley specifically, we expect the Fiduciary Rule created under President Obama’s administration, but not yet implemented, will not go through.
Less regulation and increased interest rates will drive our valuation of Morgan Stanley higher. Right now that environment doesn’t exist and we have to wait and see if this scenario plays out under Trump’s Presidency. We’re maintaining our fair value of $40 per share for now and given recent strength we’ll wait for a pullback to buy more.
All previous letters are archived here.