It’s been a difficult year for the U.S.-based asset managers, with the 12 companies we cover down close to 20% on average since the start of 2018, compared with a nearly 8% price gain for the S&P 500 index. While valuations have become depressed across the group, they’ve also bifurcated between perceived “haves”--wide-moat-rated BlackRock (BLK) and T. Rowe Price (TROW) and narrow-moat-rated Eaton Vance (EV) and Cohen & Steers (CNS)--which are generating above-average rates of organic growth and operating margins (and trading at 25%-plus premiums to the group on a price/earnings basis), and those viewed as “have nots”--narrow-moat-rated Invesco (IVZ), Affiliated Managers Group (AMG), Franklin Resources (BEN), Legg Mason (LM), and Janus Henderson (JHG) and no-moat Waddell & Reed (WDR)--some of which deserve to be trading at steep discounts (of more than 25%) to the group.
We think the industry itself is at a bit of a crossroads, with a handful of different forces--including increased regulation of asset and wealth management globally, distribution channel disruption on the retail-advised side of the business in the United States and other developed markets, the ongoing shift from active to passive products, and a greater focus on relative and absolute fund investment performance and fees--having an impact on asset manager fees and expenses, which is working against the ability of these companies to generate sustainable levels of organic growth and increase profitability. Given this environment, we still recommend that long-term investors focus on BlackRock, the leading provider of exchange-traded funds, with two thirds of managed assets and half of revenue coming from passive products, as well as garnering more than 80% of its assets under management from institutional clients, and T. Rowe Price, which has the best and most consistent active investment performance in the group (and is a leader in the industry as a whole) and derives two thirds of its assets under management from retirement-based products.
We recently removed Invesco from the Best Ideas list. Its shares are down more than 35% since the start of the year and are currently trading at less than 9 times this year’s and next year’s earnings estimates (and at a more than 30% discount to our $35 fair value estimate) with no real fundamental issues with the business, other than the fact that its margins are lower than the industry average, which has been known for quite some time now. We had added Invesco to the Best Ideas list earlier in the year on our belief that the sell-off in the shares would be reversed over time, once investors realized how much the share price was undervaluing the company’s level of assets under management, revenue, and profitability. We considered Invesco to be the best of the bunch of “have nots,” all of which are down more than 25% year to date, noting that the company’s three- and five-year aggregate investment performance should be good enough to spur 0%-2% annual organic growth during our five-year forecast period, even with all of the negative headwinds for the industry.
During the past five years, Invesco generated an average annual organic growth rate of 1.8% with one of the lowest standard deviations (1.6%) relative to peers. That said, we’ve struggled of late to find a catalyst that would get investors back into the shares in a meaningful way, with organic growth expected to be weak in the near term, the company suffering from fee compression and rising costs (both of which are in our near- and long-term forecasts in levels greater than Invesco has been forecasting), and the company holding back on share repurchases while it pays down the more than $850 million outstanding on its credit facility related to its purchase of Source (a European specialist exchange-traded fund provider) at the end of last year and Guggenheim’s ETF operations during the second quarter of 2018. With rumors now circulating that Invesco may be purchasing OppenheimerFunds for $5 billion (which we view as a rich price to pay for what looks to be no more than a scale-driven deal), we believe it is more prudent right now to step back until we have greater clarity on the company’s near-term movements, despite the fact that it is trading at historically low multiples (not seen since the third quarter of 2011 and the third and fourth quarters of 2008) with a dividend yield of 5.2% (based on a quarterly dividend of $0.30 per share).
We replaced Invesco on the Best Ideas list with BlackRock. While BlackRock is currently trading at a premium to the group of 12 U.S.-based asset managers we cover, the shares are undervalued relative to our $580 fair value estimate and are trading at a greater discount to our fair value estimate than T. Rowe Price is right now. The market tends to reward both organic growth and operating profits in the U.S.-based asset managers, which explains why BlackRock (generating a 3.3% compound annual growth rate for organic growth, with a 3.3% standard deviation, during 2008-17 with operating margins averaging 36.2% annually and reaching 38.6% during 2017) and T. Rowe Price (with a 2.6% CAGR for organic growth, with a 3.3% standard deviation, over the past 10 years and annual operating margins of 43.6% on average, with the company closing out 2017 with margins at 44.2%) have tended to trade at premiums to the group. As a reference point, the group of 12 U.S.-based asset managers we cover had an average annual organic growth rate of 0.7% during 2008-17, with a standard deviation of 6.2%, and operating margins of 27.4% on average the past 10 years.
We expect BlackRock will continue to generate above-average organic growth of 3%-5% on average annually during 2018-22, with a standard deviation of 1.9%, with operating margins of 39%-40% over our five-year forecast (a period that includes a 20% decline in equity market values midway through our projection timeline). Our fair value estimate implies a price/earnings multiple of 20.6 times our 2018 earnings estimate and 18.5 times our 2019 earnings estimate. For some perspective, during the past five and ten calendar years, the shares have traded at an average of 20.0 and 20.8 times trailing earnings.
BlackRock is at its core a passive investor. Through its iShares exchange-traded fund platform and institutional index fund offerings, the wide-moat company sources two thirds of its managed assets (and half its annual revenue) from passive products. In an environment where investors and the advisors that serve them are expected to seek out providers of passive products, as well as active asset managers that have greater scale, established brands, solid long-term performance, and reasonable fees, BlackRock is well positioned. The biggest differentiators for the company are its scale, ability to offer both passive and active products, greater focus on institutional investors, strong brands, and reasonable fees. We believe the iShares ETF platform, as well as the technology the company offers to clients that provides risk management and product/portfolio construction tools directly to end users (which makes them stickier in the long run), should allow BlackRock to generate higher and more stable levels of organic growth, operating profitability, and free cash flows than its publicly traded peers over the next five years.
Greggory Warren, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.