Our Outlook for Business & Financial Services Stocks
Asset managers might need to bulk up.
Quarter-End Insights
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- Asset managers are likely to see a more tangible impact this year from the consolidation that has taken place in the broker-dealer channel.
- Based on relative intermediate fund performance coming into 2010, we believe BlackRock, T. Rowe Price, Waddell & Reed, and Janus are best positioned to drive equity inflows in the near term, but expect the payback from Janus' stronger fund performance to be weaker given the limited reach of its distribution network.
- Most of the sectors in our coverage are trading close to fair value, but education and insurance brokers look fairly cheap.
Our business and financial services team covers a wide range of industries. In this discussion, we are going to focus on the asset managers. It has certainly been an intense year and a half for the asset management industry. The collapse of the credit and equity markets in the fall of 2008 had a significant impact on most of the asset managers we cover, as market depreciation and investor redemptions reduced the level of assets under management at these firms.
Asset managers that had heavier exposure to equity markets were affected the most, with the world's stock markets declining by more than 30% during 2008 and investors pulling out nearly $200 billion from U.S. stock, international stock and balanced funds during the year. Those with more diversified portfolios may have been affected less dramatically, but still felt the impact of the market collapse as the fees generated by their fixed-income and money market offerings (which were viewed as safe havens during the market decline) tend to be significantly lower than those earned on equity and balanced funds.
With revenue forecasted to be much lower during 2009, most of the asset managers we cover took drastic measures to cut costs, as the operating leverage inherent in their business models tends to work both ways. That said, employee compensation and benefits are the single-largest expense items for asset managers, making it difficult to cut costs without running the risk of losing top performers or disrupting their operations to the point where investment performance would suffer.
As a result, operating profits for most of the asset managers we cover were cut in half last year (even with the dramatic runup in the global stock markets), which had a significant impact on the financial health of firms that were carrying heavier amounts of debt coming into the bear market. The net result was a deleveraging of balance sheets for most of these asset managers, with several of them drastically rethinking what their optimal level of debt should be going forward.
Equity-heavy firms that had their managed assets savaged during the bear market saw their AUM and revenue rebound nicely through the last three quarters of 2009 as the U.S. stock markets posted one of their strongest rallies in the last century. This could prove to be a double-edged sword, however, for firms such as Janus Capital Group and Gamco Investors (GBL) where the majority of the improvement in AUM was coming from market gains as opposed to investor inflows.
Looking at the asset management industry as a whole, investors pulled $28 billion out of U.S. stock and balanced funds during 2009 (a trend that has not abated all that much during the first couple of months of 2010). Based on relative intermediate fund performance coming into 2010, we believe BlackRock (BLK), T. Rowe Price (TROW), Waddell & Reed , and Janus are best positioned to drive equity inflows in the near term but expect the payback from Janus' stronger fund performance to be weaker given the limited reach of its distribution network. With the majority of investor inflows continuing to be directed to fixed-income funds, firms with heavier exposure to the asset class--BlackRock, Legg Mason , AllianceBernstein (AB), and Franklin Resources (BEN)--should be the biggest beneficiaries. That said, we expect Legg Mason to struggle, as issues with intermediate fund performance have led to a steady exodus of institutional and high-net-worth clients during the last year.
We're likely to see a more tangible impact this year from the consolidation that has taken place in the broker-dealer channel, which to date has been muted as Bank of America (BAC) and Merrill Lynch, Wells Fargo (WFC) and Wachovia, and Morgan Stanley (MS) and Citigroup (C) have been far more focused on integrating their brokerage operations. The combination of these firms will consolidate distribution into the hands of a few larger broker-dealers, decreasing the amount of leverage asset managers have traditionally had when negotiating for shelf space. This could lead to further consolidation in the asset management industry--highlighted by BlackRock's purchase of Barclays Global Investors and Invesco's (IVZ) acquisition of Morgan Stanley's retail fund operations (which include the Van Kampen family of funds)--as the industry comes to view increased size as a means of recovering some negotiating power.
Industry-Level Insights
Most of the sectors included in our business and financial services coverage are trading close to fair value, but there are two sectors that do look relatively cheap to us: education and insurance brokers. Education stocks are suffering from worries about possible regulatory changes. It's still much too early in the process to determine the final result with precision, but our belief is that dramatic changes are not on the way. Further, we think the trends that have driven this sector's growth historically remain in place, though the rapid growth the education firms are enjoying now will taper off when the economy improves. As such, we think this current bout of market pessimism creates some opportunities.
Insurance brokers have been struggling under multiple headwinds recently, as low insurance volumes, weak pricing, and low interest rates have all worked to damp their bottom lines. Although we don't expect a quick pickup in the insurance market, it is worth noting that the regulatory environment for the brokers has improved, with the ban on taking contingent commissions recently lifted. We also think the brokers are a safer place to wait for a recovery in the insurance market because they have less exposure to investment losses if capital markets turn south again and they are not materially exposed to unexpected catastrophes.
Our Top Business & Financial Services Picks
| Top Business & Financial Services Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Forward P/E | |
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| Apollo Group |  | $106.00 | Wide | Medium | 13.1 |
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| Arthur J Gallagher |  | $35.00 | Narrow | Medium | 17.0 |
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| Invesco | | $27.00 | Narrow | Medium | 15.9 |
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| Western Union | | $28.00 | Wide | Medium | 12.8 |
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| Data as of 3/22/10. |
Apollo Group
Like other education companies, Apollo's stock has been weighted down because of worries about possible regulatory changes. An informal inquiry by the SEC into the company's revenue-recognition practices has created additional headwinds for the stock. But Apollo's free cash flow in relation to its reported earnings is actually very good, muting any concerns that its results have been inflated through aggressive accounting. The strong growth the company is currently experiencing will moderate, in our opinion, when the employment market recovers. But we think Apollo still has room to grow long term, making the current market valuation very attractive at only about 12 times fiscal 2009 free cash flow.
Arthur J. Gallagher (AJG)
We think the insurance brokers look cheap as a group, and Arthur Gallagher looks like the most attractive to us from a valuation perspective. Although we don't expect significant improvement soon, we do think that Gallagher will ultimately benefit from an upturn in insurance prices and volumes and any increase in interest rates (the company's operations generate some float), and a 5% dividend yield provides incentive to wait for better times. Additionally, the company recently worked out a deal with the Illinois attorney general that opens the door to contingent commissions, removing an operational handcuff the firm has had to deal with in recent years.
Invesco (IVZ)
We like the potential that could be unleashed at Invesco, whose acquisition of Morgan Stanley's retail fund operations puts it on par with other industry heavyweights, as it increases the firm's AUM to more than $500 billion and could have a dramatic impact on its revenue, profitability, and cash flows in the near term. We don't think the market has fully factored in the positives from this deal, and the stock is trading close to 5-star territory.
Western Union (WU)
A disappointing 2010 forecast pushed down Western Union recently, but we think this just made this undervalued stock even cheaper. We don't expect much growth until the employment market recovers, but we also think that the historical drivers behind immigration remain in place and will reassert themselves when the economic situation stabilizes. The gap in economic opportunities between rich and poor countries remains very wide, and the lack of native population growth makes immigration a necessity for developed countries that want economic growth. As the largest player in a scalable industry, Western Union is the company best positioned to exploit this situation. With the stock trading at a little less than 10 times 2009 free cash flow, we think there is significant upside for patient investors.
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