I-Bank Pair Trade: Buy Morgan Stanley (NYSE: MS), Sell Goldman Sachs (NYSE: GS)

(Stocks in this article: NYSE: GS, NYSE: MS, NYSE: C, NYSE: MER, NYSE: LEH, NYSE: BSC, NYSE: BCS, NYSE: JPM)

Happenings in the hectic financial sector have created a special opportunity, in my opinion. A recent event and nonevent have created opportunity to weed out systemic risk, and still enjoy profits from contrasting positions in a couple investment bank stocks. The pair trade I'm recommending is to buy Morgan Stanley (NYSE: MS) and sell short Goldman Sachs (NYSE: GS).

First let’s look at the short side of the trade and the “nonevent”

Is Goldman Sachs (NYSE: GS) really that much better than its peers to justify its outstanding stock performance and premium valuation? If you have been reading me, you should already know the answer to that rhetorical question. I do not believe Goldman’s shares deserve to be on an island, as the company operates in the same markets as Citigroup (NYSE: C) and Merrill Lynch (NYSE: MER), and likely partook of the same sins, in my opinion and by the logic of the common man. In a glance of the chart above, any eyebrow should arise. Something’s wrong here. Is Goldman that much better at managing risk?

As you can see, while GS shares were up nearly 20% through the twelve months ended on November 7, each of its peers are at least 20% under water during that same span. Even after their recent backtracking, Goldman Sachs shares still offered a total return 8.2% year-to-date through the 7th of the month. There’s a very good reason for this, as long as it’s true. It’s the nonevent mentioned previously. Unlike peers Bear Stearns, Citigroup, Merrill Lynch and Morgan Stanley, Goldman has yet to announce a significant financial asset write-down and has reportedly denied rumors that it would. If GS really managed risk that well, then its stock probably deserves the reward its shareholders have enjoyed. However, I think this premise is false, and GS investors stand a decent chance of seeing a charge at their firm as well.

When comparing the valuations of this group, we have to take one important thing into consideration. Some of the firms have seen more significant adjustment to their earnings and growth estimates than have others. Also, Morgan’s data is not updated for the charge yet, as analysts are still likely updating their models at this very hour.

Company	Ticker-	Ytd. Return Nov 7-	P/E ‘07-	P/E ‘08-	P/E/G ‘08
Goldman Sachs	GS	8.2%	8.8X	9.4X	0.71
Morgan Stanley	MS	(23%)	6.7	6.3	0.47
Lehman Brothers	LEH	(28)	7.5	7.2	0.67
Bear Stearns	BSC	(40)	8.7	7.8	0.71
Merrill Lynch	MER	(41)	19	6.9	0.66
Citigroup	C	(37)	13	7.6	0.94
Barclays	BCS	(24)	7.7	7.3	0.6

With the fourth quarter nearing its end for these firms, including the marred and the unmarred, things may even out as most of them potentially seek to get their at risk assets charged off in the current fiscal year. The fourth quarter is notorious for kitchen sink write-offs, and the investment banks have good reason to write-off as much as possible now, since they would want to reduce risk of write-offs in 2008. So, in the table that follows, I took earnings estimate change into account, so as to show you where change may yet occur.

Company	Ticker -	90-Day Change in ’07 Est. -	90-Day Change in ’08 Est.
Goldman Sachs	GS	+10.8%	+3.2%
Morgan Stanley	MS	-3.4	-5.6
Lehman Brothers	LEH	-5.5	-6.3
Bear Stearns	BSC	-18	-15
Merrill Lynch	MER	-67	-16
Citigroup	C	-44	-14
Barclays	BCS	-10	-13

The tables above show the main difference between Goldman and its peers, but can Goldman really being doing that well of a risk management job, or is the news of Goldman’s write-off pending? One thing seems certain, if the company has assets to burn, its stock is going to approach that of its peers. Thus, the upside potential for the shares seems not worth the near-term event risk. I would go so far as to bet on it, and suggest shorting GS alone or as part of the pair trade this article outlines.

The long end of the trade

Wednesday night, Morgan Stanley (NYSE: MS) announced that it would also post a charge of $3.7 billion in its fourth quarter, but the shares were up on November 8th, the day following the press release. What’s more impressive about this is that all of the firms discussed in this article were lower that same day. Why, you ask?

Morgan wisely declared its total remaining risk measured only $6.0 billion. This offering of information, or event we alluded to, brought clarity to a frighteningly uncertain outlook, and gave investors an idea of the size of future risk. The value of this declaration was especially powerful because of the activities of Morgan’s peers. Citigroup (NYSE: C) recently revised its initial charge significantly higher not long after first announcing what was a record breaking write-off. Merrill Lynch (NYSE: MER), after surpassing Citigroup’s initial charge, is now under investigation by the SEC, but more importantly to MS investors, declared its at risk assets at $27 billion, significantly greater than Morgan’s announced risk. Summarizing, Morgan’s provision of clarity to a previously uncertain outlook has solidified expectations.

In our valuation table above, the impact of the pending charge is not yet reflected in Morgan’s FY 07 EPS estimate. But, with the fiscal year nearing end, and ongoing operations the main concern of investors, it’s ’08 that really matters. Based on the ’08 estimate, which could be revised a little lower as analysts update their models, MS shares trade at significant discount to peers on a P/E/G basis. Now, its long-term growth outlook could be revised lower as well, bringing its valuation toward peers. Even so, I think risk here is limited and the stock looks cheap. Analysts like to look at price-to-book and price to assets under administration for firms like these, but we expect the asset uncertainty is at play in devaluing these ratios. However, this also illustrates the reason why MS shares are rising today; we know the risk, and it’s relatively low.

In buying MS and shorting GS, you effectively reduce systemic risk, while potentially benefiting from alpha return on both ideas. To the laymen, if the market goes down or up, you should still generate a profit from this position while limiting risk. This holds as long as you close out both sides of the trade after the anticipated write-off is announced. If no asset impairment is declared, your risk should still be limited by the offsetting positions.

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