Portfolio holding Morgan Stanley (MS) reported weaker-than-expected results for its third-quarter before the opening bell Thursday. But the stock, which fell nearly 5%, was being punished too harshly, given much of the difficulties reflect the realities of this year’s tough macroeconomic backdrop and terrible equity market.

Earnings per share of $1.47 missed the $1.49 expected by Wall Street analysts. Revenue of $12.99 billion came up short of the $13.3 billion consensus.Breaking things down further: Net-interest income rose 10% to $2.51 billion, beating expectations of $2.48 billion. Non-interest revenue fell 3% to $10.48 billion, missing expectations of $11.01 billion.

Key metrics

Before digging into the various operating segments, let’s look at some key overall metrics. 

• CET1 (Common Equity Tier 1 - a measure of bank capital versus risk-weighted assets, and a sign of bank's ability to endure financial stress) capital ratio was 14.8% versus 15% expected.

• ROTCE (Return on average tangible common shareholders’ equity - a measure of annualized earnings applicable to Morgan Stanley common shareholders as a percentage of average tangible common equity) in the third-quarter was 14.6% versus 15.1% expected. ROTCE was 15.2% ex-integration costs.

• Expense efficiency ratio (a measure of efficiency that is calculated as total non-interest expenses divided by net revenues) was 74% versus 72% expected. The ratio was 73% ex-integration costs. Lower is better on this front.

• TBVPS (Tangible blook value per share is a measure of intrinsic liquidation value that removes intangibles such as goodwill - the value of the Morgan Stanley brand) was $39.93 versus $40.24 expected.

Segment results

Institutional Securities net revenue of $5.82 billion for Q3 missed expectations of nearly $6 billion. Total expenses came in at $4.17 billion, with nearly half related to compensation.

• Investment Banking revenue: $1.28 billion, down 55% year over year. Investment banking was hampered by a decline in M&A transactions. Equity underwriting was hurt by lower global equity volumes. Fixed-income underwriting was hit by a difficult macro environment that led to lower issuances.

• Equity revenue: $2.46 billion, down 14% from year-ago period, versus $2.72 billion expected. The year-over-year decline was driven by equity markets declines and less client activity.

• Fixed Income revenue: $2.18 billion, up 33% from last year and in line with expectations. The increase was attributed to “strength in macro products on high client engagement and volatility in the markets.” This was the highest third quarter result for fixed income in over a decade.

Importantly, on the call, management said, “Underwriting activity has not gone away, it is simply being deferred.”

Wealth Management net revenue of $6.12 billion for Q3 came up a bit short versus expectations of $6.15 billion. Total expenses for the segment came in at $4.46 billion, with nearly three quarters attributable to compensation and the rest driven by technology investments along with increased marketing and business development costs that reflect normalization as Covid-related restrictions abate.

• Asset management revenue: $3.39 billion, down 7% year over year, primarily reflecting lower market levels.

• Transactional revenue: $616 million, down 18%, excluding mark-to-market losses on certain employee deferred compensation plan investments.

• Net interest income revenue: $2 billion, up 49% thanks to higher interest rates.

• Other revenue: $111 million.

As a reminder, net interest income (NII) is the income generated as a result of the difference between what the bank pays you in interest to keep funds with them and what they can turn around and generate on those funds. For example, the spread between what you are paid on the deposits in your savings account and what the bank charges for loans.

Notably, Wealth Management added $65 billion in net new assets “in one of the most difficult quarters that [Morgan Stanley] had in 15 years,” Gorman said. That brings total year-to-date net new assets to $260 billion and showcases Morgan Stanley’s ability to continue to attract new assets despite the market volatility we have seen year-to-date.

Investment Management net revenue of $1.17 billion for Q3 missed the $1.34 billion consensus. Total expenses for the segment came in at $1.05 billion, split nearly in half between compensation and non-compensation.

• Asset management and related fees: $1.27 billion, down 14%, as a result of lower assets under management (AUMs).

• Performance-based income and other: a net loss of $101 million, primarily driven by the markdown of a single underlying public investment in one of the bank’s Asia private equity funds.

• Total assets under management in Q3 came in at $1.28 trillion, down 16% year over year, and down 5% from the second quarter.

Capital Returns

Morgan Stanley repurchased 30 million shares in its third quarter at an average purchase price of $85.79 per share, resulting in a return of capital to shareholders of $2.56 billion. Remember, back in June, the board authorized a multiyear buyback program of up to $20 billion, with no expiration date, to start in Q3. At the time, it also declared a quarterly dividend of $0.775 per share, payable on Nov. 15 to shareholders of record on Oct. 31.

Bottom line

It was not the best quarter. At the firm level, management continues to execute well against massive external headwinds — and as a result, we believe Morgan Stanley remains a good investment because it stands to benefit greatly as the operating environment improves.

Until that improvement, however, our patience will be rewarded via dividend payments and share buybacks, which remember are even more effective and accretive in the long-term at lower share prices. Near-term pain does lead to long-term gains when you have a buyback program at work. We sleep easier knowing the firm is well capitalized to weather an economic downturn, as indicated by its healthy Common Equity Tier 1 ratio (CET1), a measure of bank capital versus risk-weighted assets and a sign of the bank’s ability to endure financial stress.

On the earnings call, CEO James Gorman said, “From a markets perspective, we expect continued volatility as the Federal Reserve continues to tighten policy such to bring down inflation to acceptable long-term levels. This is an environment where it behooves management to be prudent, but balanced. Our wholesale retreat from the markets is not called for but at the same time, I must be more cautious in credit-sensitive parts of the business. Fortunately, the business model changes for the past decade or more, plus the acquisitions of Smith Barney, E-Trade and Eaton Vance put us in a position of significant relative strength and should support solid absolute performance in the months ahead.”

We think the stock will provide a solid risk/reward should it break below the $75-per-share level, at which point you’re looking at roughly 10x 2023 earnings estimates and locking in about a 4.1% annual dividend yield.