Morgan Stanley’s uncapped buffered PLUS on the Euro Stoxx 50 to offer value, contrarian says

By Emma Trincal

New York, Aug. 2 – Morgan Stanley Finance LLC’s 0% buffered Performance Leveraged Upside Securities due Aug. 30, 2024 linked to the Euro Stoxx 50 index offer a good entry point and reasonably attractive structure for investors trying to diversify away from U.S. markets trading at all-time highs, said Steven Kaplan, founder of TrueContrarian Investments.

If the index return is positive, the payout at maturity will be par plus at least 200% of the index return, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by up to 25% and will lose 1% for each 1% decline in the index beyond 25%.

The contrarian portfolio manager, when analyzing a structured note, starts with the underlying value of the product before even looking at its terms. He uses both technical and fundamental analysis to assess whether an asset class is overvalued or undervalued, opting for the latter especially if the asset is out-of-favor as the Euro Stoxx 50 index appeared to be for many advisers disappointed by its performance and worried about Brexit.

Euro exit

“I’m moderately bullish on Europe. I’m willing to go long because valuations are OK. It’s not a market that’s as depressed as I would want it to be. But it’s a much better bargain that the U.S. You still start from a lower point and I like that,” he said.

With the Euro Stoxx 50 paying high dividends and government bonds in some countries in the euro zone near zero if not negative, the forwards pricing of notes should be favorable. And yet, the plummeting volume in Euro Stoxx 50-linked notes attest to a new trend this year: Europe is no longer on advisers’ radar. Only $330 million of notes solely linked to the Euro Stoxx 50 index have priced through July 31 this year versus $4.32 billion last year, a 92% drop. The deal count fell to 119 from 725.

Either structured notes buyers have become even more U.S.-centric than they already are, or fears around geopolitical risks in Europe, from Brexit to fiscal deficits and political unrest are overwhelming them, said Kaplan.

For this contrarian, unloved assets spell opportunity.

Buy the unloved

“One big advantage of this note, is that the European markets are much more undervalued than the U.S. I like the fact that it’s Europe, especially with all the negative noise around Brexit. The headlines around Brexit and Europe in general tend to be overstated,” he said.

Last December, Kaplan bought the British pound, which is undervalued versus the U.S. dollar. It was part of his contrarian bet on Brexit.

He also owns the iShares MSCI United Kingdom exchange-traded fund for similar reasons.

“Both the British pound and the euro will rebound,” he said.

The U.K. stock market did recover this year up until the spring but has declined since then in part due to prime minister Theresa May announcing her resignation at the end of May.

Headlines and distractions

The bearish case on the euro zone points not only to Brexit, it also emphasizes Europe’s own problems such as a stagnant economy, structural deficits, rising political risk and declining demographics.

Here again, Kaplan was unconvinced.

“The U.S. has more debt and its budget deficit has been growing at a very fast clip. Day after day we get new headlines about the U.K. and the European Union. It’s just noise. I think a lot of the concerns over Europe are overblown,” said Kaplan.

The European Union recorded a government debt of 80% of its Gross Domestic Product in 2018 compared to 106.1% in the U.S., according to TradingEconomics.com. Between 2000 and 2018, however, the debt-to-GDP ratio was lower in the United States averaging 62.31% versus 71.54% for the European Union.

Part of Kaplan’s methodology is also to assess market sentiment and investors’ behavior.

“Europe is unloved from U.S. investors right now. This is a good thing for us. The U.S. large-cap stock market is overvalued while small-caps have established a downtrend. But everybody is buying the overpriced S&P,” he said.

Still below its peak

Kaplan looked at a five-year chart of the SPDR S&P Euro Stoxx 50 ETF, which tracks the benchmark. He concluded that the index remains somewhat depressed, which is a buy signal for him.

“It’s not as depressed as I would like it to be. Right now, for instance, I’m buying a lot of energy stocks. Those are really down,” he said.

Kaplan used the five-year chart to determine whether buying the index now was appropriate.

In January and July 2016, the fund showed a double bottom at $26.45 a share and $26.25, respectively. From July on that year the fund price soared to $41.95 on January 2018, a new high, which represented a 60% rise in less than a year-and-a-half. Since then, performance has been disappointing. During last Christmas, the euro zone benchmark dropped 26% from that high to $31.20 amid a global sell-off. It has regained some strength since then, up 17% from its December low, but still remains below its high of January 2018. The ETF closed at $36.55 on Friday.

Starting blocks

“The price is still relatively depressed. I would prefer it if the notes were to price later this year rather than in a few weeks,” he said.

The notes will price on Aug. 27 and settle on Aug. 30, according to the prospectus.

Kaplan is a student of the market. One established historical pattern, he said, is that stock prices tend to drop in the fourth quarter.

“There has been a study showing that if you had been buying stocks in October and sold them in May, you would have done better than holding your position all along,” he said.

Risk mitigation

But this was a side note. What Kaplan focused on the most was the margin of safety provided by assets trading below their intrinsic value.

“I still like the timing. The key is the starting point. When you buy the Euro Stoxx, you’re not buying at a high like the S&P. Europe is not trading at a huge discount, but compared to the U.S. large-cap market, it’s almost a bargain,” he said.

Two other factors aside from the lower buy price contributed to mitigate risk in this product.

“The buffer is good because it’s a true buffer. You can only lose beyond 25%,” he said.

“I also think that the five-year maturity is safer. If we’re going to be in a recession, you have time to be out of it,” he said.

If a recession starts soon, as he expects it, time will be plentiful.

“The Presidential Elections will also be behind us. We may be choppy for two years but after that, there is enough time for the market to rebound.”

Trade-off

Naturally the five-year duration has its own negative aspects. For one, exposure to credit risk lasts longer. Also, the Euro Stoxx yields 2.95%, which increases the opportunity cost of holding the notes during that period compared to a similar product on the S&P 500 index whose yield is 1.86% or to a similar note on a shorter term.

“This is clearly the disadvantage of the notes...losing those dividends. But by the same token you have a buffer and two-times leverage without a cap, so it helps. You have a trade-off,” he said.

The note also offers unlimited upside, which is another positive.

“I wish there’d be more leveraged notes with no cap and this type of buffer,” he said.

“Combine this with an asset class that has become less popular and less expensive than it used to be and that’s not a bad trade at all.”

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes (Cusip: 61769HND3) will settle on Aug. 30.

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