Financial Services: Weighing the Strategic Tradeoffs of the Fiduciary Rule

• The financial services sector is slightly overvalued, trading at a 5% premium to our fair value estimates.
• The move toward increased fiduciary standards across the globe continues on a bumpy road.
• Australia's economic outlook is brighter following the better-than-expected fourth-quarter 2016 national accounts.

The global financial sector is in the midst of financial advice moving toward a fiduciary-like standard and fees becoming more transparent. In Canada, Client Relationship Model Phase 2, or CRM2, which greatly increased fee disclosures and investment performance, has been fully phased in for more than six months, while the European Union's Markets in Financial Instruments Directive, or MiFID II, is set to take effect in January 2018.

In the United States, after an executive order from President Donald Trump, the Department of Labor has proposed to delay the applicability date of its conflict-of-interest rule in order to restudy the rule's costs and benefits. Regardless of when certain financial regulations are implemented, the ongoing shift in business models, financial products, and client demand will cause changes in profits and market share across the sector.

Increased fiduciary standards primarily affect the asset-management and wealth-management industries. We believe that asset managers will increasingly have to demonstrate their value to clients by increasing their investment performance, decreasing their fees, and emphasizing how their products fulfill client goals. Based on the specific regulation, many asset managers will also undergo a change in how they sell their funds, such as eliminating distribution payments. In preparation for the Department of Labor’s rule in the United States, asset managers are creating "T" shares that have more standardized sales charges and "clean" shares where many charges are eliminated.

Wealth-management firms will also increasingly have to justify their fees and value to clients. With the emergence of robo-advisors, or digital advice, the price of basic asset allocation has become fairly transparent. In order for financial advisors to charge more than a robo-advisor, they will have to emphasize the additional value that they add, such as through financial planning and behavioral coaching. Please see Morningstar's paper "Alpha, Beta, and Now...Gamma" for a look at some of our research on quantifying the value of intelligent financial planning.

At the firm level, the increased transparency of fees and restrictions on payments from asset managers could cause revenue pressure, while the new regulations increase costs. For example, we recently estimated that the U.S. Department of Labor's fiduciary rule could lead to an annual $70 million-$150 million of class-action lawsuit settlements.

Australian Banking Outlook by David Ellis Australia's economic outlook is brighter following the better-than-expected fourth-quarter 2016 national accounts. As we have long argued, recession fears are overblown, with exports, consumption, and public-sector spending underpinning broader economic activity, despite soft wage growth.

Respectable real GDP growth of 2.4% for 2016 supports modestly positive operating conditions for Australia's four wide-moat major banks. Despite GDP growth remaining below-trend, it is in line with our medium-term GDP growth rate estimate of approximately 2.5% per year. In February 2017, the Reserve Bank of Australia's updated outlook predicts GDP growth of around 3% in 2017 and 2018, with inflation to slowly return to the 2%-3% target band by 2018 and unemployment likely to remain around 5.75%.

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) trading above our fair value estimates by 10% and 6%, respectively.

Despite the surprising strong December-quarter GDP outcome, the four Australian major banks continue to face challenging conditions, with Australia's below-trend growth economy susceptible to a range of risks. Political uncertainty is not helping business confidence; weak wage growth is a drag on consumption and the RBA's inflation target; businesses continue to underinvest in growth initiatives; and external shocks such as the Brexit vote, the U.S. presidential election, and softer economic conditions globally could detract. Sudden economic shifts in China could have "first order" impacts on the Australia economy, the financial system, and, by extension, the Australian major banks. The most damaging negative risk to future bank earnings is the potential for an exogenous shock triggering a global downturn that drags the Australian economy into recession--but this is not our base case.

Top Picks

Platinum Asset Management

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Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: AUD 6.30

Fair Value Uncertainty: Medium

5-Star Price: AUD 4.41

Platinum Asset Management is a highly successful Australian fund manager specializing in international equities, with a narrow economic moat thanks to its strong brand and customer switching costs. It derives its income predominantly from base management fees on funds with specific mandates, though performance fees can add meaningfully in good years. Earnings growth is primarily driven by growth in funds under management, which is a function of performance and net inflows.

Key positives include strong brand recognition stemming from excellent long-term fund performances and a tailwind from Australia's growing pool of superannuation savings. We believe international equities will be an increasing part of individual retirement savings strategies in Australia, as we expect that over time, Australia's investable asset pool will not be large enough to meet the increasing flow of superannuation fund contribution, as well as the opportunity to invest in a more diverse range of industries offshore than are available on the Australian market. Platinum is well positioned in this regard, with a long presence and investment track record in this space.

With minimal capital expenditures and a very strong balance sheet, the firm can pay out practically all profit as fully franked dividends. Short-term investment underperformance and fear of weakening equity markets are currently weighing on the share price. Platinum is attractively priced, and while there are short-term pressures, we expect earnings to recover, given its strong brand and long-term investment performance track record. The ability of Platinum funds to take short positions provides it with opportunities to outperform in most market conditions. Downside risks come from protracted investment underperformance of key funds and funds' net outflows.

American International Group

AIG

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $74.00

Fair Value Uncertainty: Medium

5-Star Price: $51.80

We believe previous management's focus on growth and lack of discipline are the root causes of AIG's poor historical performance, and the current management team's focus on risk-adjusted returns and operational efficiency sets a course in the opposite direction.

When AIG recently announced that it would be taking a $5.6 billion reserve development charge, the market's confidence in management dimmed, and the stock now trades at a significant discount to book value. Given the shift in strategy and the quantifiable and achievable opportunities for improvement, we think this is overly skeptical and creates an opportunity, especially as the recent reinsurance deal with

We think a valuation close to book value is appropriate, as our view is that AIG will improve returns to a level on par with our estimate of the cost of equity within the next two years. In essence, we assume AIG is able to bring results in line with other no-moat insurers, a fairly low bar to clear. We recognize the uncertainty the nonbank SIFI designation creates, but we see a slim probability of this leading to a material negative impact on our valuation. Further, AIG's plan to return $25 billion to shareholders through 2017 shows that this is not a meaningful obstacle at this point, and buying back large amounts of stock at a substantial discount to book value will allow AIG to further leverage the operational improvements we anticipate.

New York Community Bancorp

NYCB

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $17.00

Fair Value Uncertainty: Medium

5-Star Price: $11.90

New York Community Bancorp recently failed to acquire New York peer Astoria after a 14-month approval process, and it will return to its search for the next deal, an effort that has been in process since 2011.

Without acquired deposits to fuel lending growth, and with the bank's existing 135% loan/deposit ratio hindering organic lending, along with its self-imposed barrier at the $50 billion asset mark, growth and earnings have been stagnant. We expect the bank to use 2017 to continue searching for another acquisition while it also waits for clarity regarding potential new bank regulations from the new administration. If it cannot find a bank to acquire in 2017, we believe the bank will cross over the $50 billion mark organically in 2018, likely becoming a systemically important financial institution in 2019.

The environment for regional banks, particularly ones that have yet to cross the SIFI threshold, is bright. The possibility of raising the CCAR threshold to around $250 billion from $50 billion would allow New York to pursue an aggressive acquisition strategy with limited pushback, and lower taxes and reduced regulations could certainly accelerate the tailwinds for New York Community. One area of concern is the 21% drop in loan originations in 2016, suggesting that New York multifamily developers are operating cautiously in 2017.

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