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DIRECTORS OFFICERS
Barton M. Biggs James W. Grisham
CHAIRMAN OF THE BOARD VICE PRESIDENT
Chairman and Director, Morgan Stanley Asset Michael F. Klein
Management Inc. and Morgan Stanley Asset Management VICE PRESIDENT
Limited; Managing Director, Morgan Stanley & Co. Harold J. Schaaff, Jr.
Incorporated; Director, Morgan Stanley Group Inc. VICE PRESIDENT
Warren J. Olsen Joseph P. Stadler
DIRECTOR AND PRESIDENT VICE PRESIDENT
Principal, Morgan Stanley Asset Management Inc. and Valerie Y. Lewis
Morgan Stanley & Co. Incorporated SECRETARY
John D. Barrett II Karl O. Hartmann
Chairman and Director, ASSISTANT SECRETARY
Barrett Associates, Inc. James R. Rooney
Gerard E. Jones TREASURER
Partner, Richards & O'Neil LLP Joanna M. Haigney
Andrew McNally IV ASSISTANT TREASURER
Chairman and Chief Executive Officer, Rand McNally
Samuel T. Reeves
Chairman of the Board and CEO, Pinacle L.L.C.
Fergus Reid
Chairman and Chief Executive Officer, LumeLite
Corporation
Frederick O. Robertshaw
Of Counsel, Bryan, Cave LLP
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INVESTMENT ADVISER AND ADMINISTRATOR
Morgan Stanley Asset Management Inc.
1221 Avenue of the Americas
New York, New York 10020
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DISTRIBUTOR
Morgan Stanley & Co. Incorporated
1251 Avenue of the Americas
New York, New York 10020
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CUSTODIANS
The Chase Manhattan Bank
770 Broadway
New York, New York 10003
Morgan Stanley Trust Company
One Pierrepont Plaza
Brooklyn, New York 11210
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LEGAL COUNSEL
Morgan, Lewis & Bockius LLP
2000 One Logan Square
Philadelphia, Pennsylvania 19103
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INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP
1177 Avenue of the Americas
New York, New York 10036
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For current performance, current net asset value, or for assistance with your
account, please contact the Fund at (800) 548-7786. This report is authorized
for distribution only when preceded or accompanied by prospectuses of the Morgan
Stanley Institutional Fund, Inc.
[LOGO] MORGAN STANLEY
INSTITUTIONAL FUND, INC.
P.O. Box 2798
Boston, MA 02208-2798
[LOGO] MORGAN STANLEY
INSTITUTIONAL FUND, INC.
AGGRESSIVE EQUITY PORTFOLIO
FIRST QUARTER REPORT
MARCH 31, 1997
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LETTER TO SHAREHOLDERS
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The Aggressive Equity Portfolio seeks capital appreciation through a
concentrated, non-diversified portfolio of corporate equity and equity-linked
securities. Short sales and options can be used to enhance performance. It is
anticipated that the Portfolio will hold thirty names or less, although it may
hold more from time to time.
For the three months ended March 31, 1997, the Portfolio had a total return of
3.60% for the Class A shares and 3.61% for the Class B shares, as compared to a
total return of -4.54% for the Lipper Capital Appreciation Index and 2.69% for
the S&P 500 Index. The average annual total return for the one year ended March
31, 1997 and for the period from inception on March 8, 1995 through March 31,
1997 was 30.63% and 41.95%, respectively, for the Class A shares, as compared to
4.00% and 16.89%, respectively, for the Lipper Capital Appreciation Index and
19.84% and 27.19%, respectively, for the S&P 500 Index.
PERFORMANCE COMPARED TO THE LIPPER CAPITAL APPRECIATION INDEX AND THE S&P 500
INDEX(1)
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<CAPTION>
TOTAL RETURNS(2)
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AVERAGE ANNUAL
YTD ONE YEAR SINCE INCEPTION
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<S> <C> <C> <C>
PORTFOLIO--CLASS A............... 3.60% 30.63% 41.95%
PORTFOLIO--CLASS B(3)............ 3.61 30.49 34.63
LIPPER CAP. APPRECIATION INDEX... -4.54 4.00 16.89
S&P 500 INDEX.................... 2.69 19.84 27.19
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1. The Lipper Capital Appreciation Index is a composite of mutual funds managed
for maximum capital gains. The S&P 500 Index is an unmanaged index of common
stocks.
2. Total returns for the Portfolio reflect expenses waived and reimbursed, if
applicable, by the Adviser. Without such waiver and reimbursement, total
returns would be lower.
3. The Portfolio began offering Class B shares on January 2, 1996.
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
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THE PERFORMANCE RESULTS PROVIDED ARE FOR INFORMATIONAL PURPOSES ONLY AND SHOULD
NOT BE CONSTRUED AS A GUARANTEE OF THE PORTFOLIO'S FUTURE PERFORMANCE. PAST
PERFORMANCE SHOWN IS NOT PREDICTIVE OF FUTURE PERFORMANCE. INVESTMENT RETURN AND
PRINCIPAL VALUE WILL FLUCTUATE SO THAT AN INVESTOR'S SHARES, WHEN REDEEMED, MAY
BE WORTH MORE OR LESS THAN THEIR ORIGINAL COST.
The Portfolio seeks capital appreciation by creating a concentrated
(non-diversified) portfolio of growth equity holdings. A single position can be
as large as 25% and typically the Portfolio's ten largest holdings will
represent between 50% and 75% of the total market value of the Portfolio. This
practice of "opportunistic concentration" has contributed significantly to the
Portfolio's returns over time. In the first quarter of 1997, for example,
substantial positions in large capitalization, lower beta growth stocks such as
United Technologies (approximately a 4% position which rose about 14% in the
quarter) added substantially to the return.
The Portfolio is generally comprised of a balance of lower beta, large
capitalization growth issues and higher beta, higher growth equities. At present
we are shifting away from the "blue chip" lower beta names which have led the
market lately to what we are terming "green chips", meaning mid-capitalization,
higher growth, higher beta equity securities. In the higher beta, higher growth
segment of the market we have seen some company pre-announcements of earning
disappointments and investor redemptions from "momentum" mutual funds which have
helped fuel the decline of the NASDAQ-oriented names. The "good news" however,
is that many of these higher beta, higher growth names have corrected without
any downward adjustments to earnings estimates.
To paraphrase Warren Buffett, the see-through earnings growth of a portfolio
will, over time, drive the growth in value of that portfolio. We believe, like
Buffett, that a stock becomes more attractive when it grows more slowly than the
company's earnings, assuming growth and financial fundamentals remain strong. In
early 1994, with Coca Cola stock having been flat for nearly three years against
a backdrop of 18% compounded annual EPS growth, Buffett added to his holding,
stating that fears of private label competition and slowing international volume
growth were overdone and that the stock's underperformance of the company made
for a compelling investment. The same could have been said for many other large
multinational, stable growth stocks, such as Merck, Proctor and Gamble, Gillette
and Disney. The stocks of these companies had done very little for
2
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2-3 years despite double-digit annual earnings gains, as investors feared that
growth had slowed and placed their bets "on cyclicals, technology, financials
and small caps in general. Practically from the moment that Buffett added to his
Coke holdings, these large cap stable growth stocks have led the powerful U.S.
bull market. Coke and Merck, for example, have both tripled in the three years
since Buffett's investment.
For the first two of these three years, smaller and higher beta growth stocks
moved up along with their larger, stable growth counterparts. But the smaller,
riskier growth stocks topped out in May of 1996 and have been brutalized
relative to the overall market since then. The decoupling of the performance of
"high fliers" and "low fliers" can be explained by the confluence of several
factors including extended valuations for some small growth companies, the
waning popularity of momentum-driven mutual funds where redemptions have caused
selling of already depressed stocks, and the prevalence of indexing which
clearly benefits the largest U.S. stocks.
However, there are signs that the secondary growth stocks are mounting a
comeback. Over the last twelve months as stable growth stocks have dramatically
outperformed higher beta growth issues, the dollar has been strengthening. This
is clearly a negative for multinationals but a non-event for many smaller high
growth companies. In addition, investors will begin to pay much more attention
to 1998 earnings estimates. Then, in the last few months of 1997, Wall Street
analysts will begin to publish 1999 projections. The stock market is
characterized by the struggle between fear and greed. As the second quarter of
1997 begins, fear is clearly prevailing in the over-the-counter and secondary
stock sectors. It is a buyers' market. The IPO calendar has dried up noticeably.
Negative surprises are devastating stocks and positive surprises are having only
a modest impact. Our strong belief is that over the next few months, as
investors focus on 1998 and begin to look out to 1999, greed will reassert
itself. In particular, the high beta stocks that got hit hard but which have
strong growth fundamentals should begin to again outperform.
Our biggest holding at March 31, and a perfect example of the former "high
fliers" that we think will take off again, is HFS. HFS is a global consumer
services company. The company is the largest franchiser of hotels (eight brands)
and residential real-estate offices (three brands), owns Avis (second largest
rental car system), owns RCI (largest provider of vacation timeshare exchanges
worldwide) and has a merger agreement with PHH Corp. (a larger mortgage &
relocation service provider). The stock has recently underperformed earnings
substantially, down approximately 31% from its high and up only 37% from the
beginning of 1996 although earnings per share rose 84% last year and are
expected to grow over 100% this year.
The stock has weakened in the wake of a difficult market for higher p/e stocks
and, most recently, a negative article concerning chairman Henry Silverman's
compensation. (He owns 12 million shares and options, and gets 2 million options
per year through the year 2000). He had never sold a share before the third
quarter of 1996 and is now selling about 150,000 per quarter. We believe this is
"non-news" and because it has been accompanied by robust fundamentals and rising
earnings estimates we have added significantly to our position in the stock.
With free cash flow expected to be $630 million in 1997 and $800 million in
1998, and an underleveraged balance sheet, HFS is well positioned to continue
its acquisition strategy if management finds good businesses that mesh with
their franchise systems and strategy. In short, we believe we have in HFS a
classic decoupling of stock price performance and business fundamentals. We
expect positive news from the company concerning PHH (acquisition expected to
close April 30), Value Rent-a-Car (acquisition expected to close in second
quarter) or other business initiatives to drive earnings estimates higher and
ultimately be the catalyst to jump-start the stock. Other large high beta
holdings include Home Depot, Boston Chicken, Gtech, Clear Channel Communications
and Einstein Brothers Bagels.
Two groups in which we have had a major commitment over the past few years are
tobacco and financials. Both have performed extremely well and we have cut our
positions significantly, taking profits. We took profits in tobacco beginning in
late 1996 but especially in February of this year, as the stocks surged on
positive business trends and talk of a possible global settlement of litigation
claims. Philip Morris and RJR Nabisco peaked at $139 and $39, respectively, but
closed out the quarter at $114 and $32. Our weighting at March 31 was
approximately 6% in Philip Morris and about 7% in tobacco in
3
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general. We still like this group but have cut back for several reasons. First,
there have been modest downward earnings revisions at Philip Morris due to
currency, at RJR due to weak international cigarette shipments and at Loews due
to softness at CNA Financial. These downward revisions followed well over one
year of upward revisions. Second, the litigation calendar for the remainder of
1997 looks pretty heavy. And third, as already mentioned, we see a much better
risk/reward in high beta growth. We expect to increase our weighting in tobacco
at some point, believing that long-term fundamentals are great and that legal
and political issues will ultimately fade.
Financial stocks made up about one-third of our Portfolio in 1996. They had
corrected sharply amid fears of higher rates and higher consumer debt
delinquencies, but earnings estimates were rising and growth fundamentals were
strong. As the stocks surged in late 1996, we cut back our position and as of
March 31 had approximately 15% of the Portfolio in these stocks. Lately,
financials have come under pressure in response to higher interest rates. We
hope to increase our weighting over the next few months, particularly in banks.
Contrary to popular perception, selected banks and other financial institutions
are not sensitive to interest rates. Rising rates are bad for all stocks, but
the implication of calling a stock "interest sensitive" is that when rates go
up, earnings estimates are vulnerable. This is simply not the case for a long
list of financial services companies. And besides being less sensitive to rising
rates than perceived, many financial companies are buying back stock very
aggressively. This makes the group defensive and a beneficiary of a weak stock
market brought on by rising rates. Wells Fargo, for example, which at March 31
was our largest finance-banking holding at about 2% of the Portfolio, is buying
1-1.5 million shares per quarter on a base of 92 million shares.
We maintain a modest weighting in both "growth cyclicals" and technology. In
growth cyclicals, our major bets are United Technologies, Boeing/McDonnell
Douglas, Allied Signal and U.S. Industries. United Technologies has been one of
our largest holdings for some time. It continues to be a compelling investment
despite the stock's strength as management executes a quiet, GE-type
restructuring: improving margins, buying back stock and driving global growth in
its various businesses. Boeing announced the acquisition of McDonnell Douglas
late in 1996. We owned both stocks at the time, and we have continued to hold
our position. Our feeling is that this is a powerful combination which creates a
juggernaut that will lead the world in commercial aircraft. In addition, the
company is experiencing a huge cyclical upturn, is a strong defense and space
company, and throws off a tremendous amount of free cash flow.
Kurt A. Feuerman
PORTFOLIO MANAGER
April 1997
4
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INVESTMENTS (UNAUDITED)
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MARCH 31, 1997
<TABLE>
<CAPTION>
VALUE
SHARES (000)
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<C> <S> <C>
COMMON STOCKS (95.1%)
CAPITAL GOODS-CONSTRUCTION (7.8%)
AEROSPACE & DEFENSE (7.8%)
17,525 Loral Space & Communications $ 248
24,300 McDonnell Douglas Corp. 1,482
25,200 Textron, Inc. 2,646
71,600 United Technologies Corp. 5,388
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TOTAL CAPITAL GOODS-CONSTRUCTION 9,764
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CONSUMER-CYCLICAL (47.3%)
AUTOMOTIVE (0.7%)
25,500 O'Reilly Automotive, Inc. 937
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BROADCAST-RADIO & TELEVISION (3.9%)
85,500 Clear Channel Communications, Inc. 3,666
26,500 Heftel Broadcasting Corp., Class A 1,232
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4,898
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ENTERTAINMENT & LEISURE (4.2%)
176,800 GTECH Holdings Corp. 5,326
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FOOD SERVICE (8.4%)
180,500 Boston Chicken, Inc. 5,505
94,500 Cracker Barrel Old Country Store,
Inc. 2,469
88,800 Einstein/Noah Bagel Corp. 2,231
19,600 Lone Star Steakhouse & Saloon,
Inc. 448
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10,653
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GAMING & LODGING (20.6%)
441,100 HFS, Inc. 25,970
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LEISURE RELATED (0.9%)
69,400 International Game Technology 1,119
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PUBLISHING (2.9%)
321,000 K-III Communications Corp. 3,611
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RETAIL-FOODS (0.4%)
62,300 Food Lion Inc., Class B 500
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RETAIL-GENERAL (5.3%)
124,400 Home Depot, Inc. 6,655
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TOTAL CONSUMER-CYCLICAL 59,669
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CONSUMER-STAPLES (7.2%)
BEVERAGES & TOBACCO (0.1%)
3,800 RJR Nabisco Holdings Corp. 123
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<CAPTION>
VALUE
SHARES (000)
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<C> <S> <C>
CIGARETTES (7.1%)
62,100 Consolidated Cigar Holdings Inc. $ 1,467
65,300 Philip Morris Cos., Inc. 7,452
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8,919
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TOTAL CONSUMER-STAPLES 9,042
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DIVERSIFIED (13.4%)
172 Berkshire Hathaway, Inc., Class A 6,226
87,700 Hillenbrand Industries 3,497
24,500 Loews Corp. 2,178
71,400 Service Corp. International 2,124
23,300 U.S. Industries, Inc. 821
126,100 Viad Corp. 2,018
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TOTAL DIVERSIFIED 16,864
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ENERGY (0.8%)
18,400 AES Corp. 1,030
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FINANCE (16.3%)
BANKING (4.5%)
18,900 Chase Manhattan Corp. 1,770
11,400 Citicorp 1,234
9,600 Wells Fargo & Co. 2,728
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5,732
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FINANCIAL SERVICES (4.2%)
23,300 American Express Co. 1,395
15,250 Franklin Resources, Inc. 778
12,000 Merrill Lynch & Co. 1,031
22,500 Student Loan Marketing Association 2,143
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5,347
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INSURANCE (7.6%)
40,200 Ace Ltd. 2,573
37,000 Aetna, Inc. 3,177
101,400 CMAC Investment Corp. 3,384
7,700 Equitable Of Iowa Cos. 385
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9,519
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TOTAL FINANCE 20,598
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</TABLE>
5
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<TABLE>
<CAPTION>
VALUE
SHARES (000)
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<C> <S> <C>
TECHNOLOGY (2.3%)
OFFICE EQUIPMENT (2.3%)
21,100 International Business Machines
Corp. $ 2,899
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TOTAL TECHNOLOGY 2,899
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TOTAL COMMON STOCKS (Cost $120,936) 119,866
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<CAPTION>
FACE
AMOUNT
(000)
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<C> <S> <C>
SHORT-TERM INVESTMENTS (6.7%)
REPURCHASE AGREEMENT (6.7%)
$ 8,515 Chase Securities, Inc. 6.00%,
dated 3/31/97, due 4/1/97, to be
repurchased at $8,821,
collateralized by U.S. Treasury
Notes, 5.50%, due 12/31/00,
valued at $8,600 (Cost $8,515) 8,515
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TOTAL INVESTMENTS (101.8%) (Cost $129,451) 128,381
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OTHER ASSETS AND LIABILITIES (-1.8%)
Other Assets 7,452
Liabilities (9,754)
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(2,302)
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NET ASSETS (100%) $126,079
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CLASS A:
NET ASSETS $116,310
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 7,777,626 outstanding $0.001 par
value shares (authorized 500,000,000 shares) $14.95
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CLASS B:
NET ASSETS $9,769
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 654,013 outstanding $0.001 par value
shares (authorized 500,000,000 shares) $14.94
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