Morgan Stanley's buffered notes linked to S&P MidCap target bullish yet cautious investors

By Emma Trincal

New York, May 5 - An upcoming note from Morgan Stanley gives moderately bullish and more conservative investors access to midcap U.S. equity, a sector that has attracted aggressive bulls for its strong run and excess returns over the broader market.

Morgan Stanley plans to price 0% buffered return optimization securities due May 31, 2013 linked to the S&P MidCap 400 index, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus 1.25 times any gain in the index, up to a maximum return of 18.5% to 22.5%. The exact cap will be set at pricing.

Investors will receive par if the index falls by up to 10% and will lose 1% for each 1% that it declines beyond 10%.

Play it safe

"It's a very conservative approach for a midcap play. It would be for a prudentially bullish investor," said Matt Medeiros, president of the Institute for Wealth Management. "It's for someone bullish on midcaps but cautious of the overall market over the next 24 months."

The S&P MidCap 400 index is the benchmark for midsized companies. It covers 7% of the U.S. equity market.

The SPDR S&P MidCap 400 ETF Trust, which tracks the performance of the S&P MidCap 400 index, is up 9.5% year to date and has gained 23.5% over the past 12 months.

"These notes are for cautious investors who see more growth ahead for small caps but are concerned about a correction," said Steve Doucette, financial adviser at Proctor Financial. "So they're willing to give up some of the upside for the protection.

"The leverage is a nice feature too."

Midcap space

"I like it. I like the midcap space," said Medeiros.

"A lot of the underlying economics of the midcap companies look relatively positive. Margins are improving. Revenues are relatively consistent. Balance sheets have stabilized substantially. While the improvement of these companies over the past 12 months may suggest a possible bubble, the sector still looks relatively attractive in terms of PE ratio and balance sheets."

Medeiros said that the note was attractive as part of an overall view on equities.

"We are optimistic for equity over the next two years, but we do so with a sense of caution," he said.

"Where we are in the economic cycle supports most equity. We are past the recovery and at the early stage of growth.

"We wouldn't overweight midcap relative to large cap or small cap, though. But midcap has a place in an equity allocation."

Not so fast

Doucette said that he would need to do more research before allocating more assets to the midcap sector via this note.

He mentioned two possible objections. The first one was the entry point of the trade in the midst of a strong rally.

"People tend to invest in the outperforming asset class. Midcap equity has been outperforming the market. But historically, things reverse to the mean, and outperforming asset classes are going to be the next underperforming asset class," he said.

The other objection was that other equity asset classes may be better suited for the current economic cycle.

"It would be smarter to add to large cap at this point. Historically, large-cap equity is going to take off as you get to the top of the economic cycle," he said.

The notes will price on May 25 and settle on May 31.

The Cusip number is 61760E689.

UBS Financial Services Inc. is the underwriter, and Morgan Stanley & Co. Inc. is the agent.

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