BlackRock is the world’s largest asset manager, with $5.7 trillion in AUM. In a classic scale industry, BlackRock is an asset-gathering machine, with organic net inflows of over 7% annualized2. Coupled with a tailwind from rising markets, AUM grew 17% year-over-year in the second quarter, which remains a key input for earnings power. Yet we see BlackRock as far more than an asset manager dependent on market movements. It is increasingly becoming a network or index-like business, with earnings power driven by ETFs (via iShares) and data & analytic services (via Aladdin). These are oligopoly businesses with faster growth and much higher incremental margins than traditional asset management – and thus deserve much higher P/E multiples over time. With shares at less than 15x our 2019 EPS forecast, and an outlook for consistent mid-teens EPS growth, we think BlackRock is a misunderstood franchise that is just beginning to inflect.
BlackRock’s iShares business has over 38% global market share in ETFs, and rising. It took in a record $74 billion of net flows in 2Q – a 21% organic growth rate – and had nearly as many inflows in the first half of 2017 ($138 billion) as all of last year. In the US, iShares had more inflows in 1H17 than the next 10 competitors combined. We think this acceleration in ETFs is just getting started, as regulatory change globally pushes lower-cost, transparent investment products, and institutional investors use ETFs as investment solutions, particularly in fixed income – an area where BlackRock has an even higher global market share for ETF products (~50%). We see iShares delivering mid-teens topline growth over the next 3 years and producing over half of BlackRock’s earnings by 2019. More importantly, this is a business with significant operating leverage as it scales, with far less variable costs from compensation and benefits, which limit the margins of traditional asset managers.
BlackRock’s Aladdin business is a data, analytics, and risk management platform originally built for internal use that now services over 25,000 external users. Historically, Aladdin was focused on institutional investors and corporates but we see a huge opportunity to bring it directly to retail financial advisor networks. This new product, called Aladdin Risk for Wealth Management, will link the world’s biggest asset manager and ETF provider directly to the desktops of thousands of financial advisors and their customers. As with other data and analytics providers in which we have made investments, these services become sticky, must-have products for users, with upside from ancillary fees. We see Technology and Risk Management revenue, which became a new line-item on BlackRock’s P&L in 1Q17, continuing to grow at 12-15%, and delivering 20% of incremental operating income growth in 2019.
BlackRock is valued like a traditional asset manager but it has much greater potential for structural revenue growth and operating margin expansion. Previous headwinds like USD strength have now become tailwinds, helping recent performance, but we are much more excited that higher-margin, higher-multiple businesses like iShares and Aladdin will become almost 2/3 of BlackRock’s earnings power within 3 years. This evolution in business mix should deliver 20x+ forward P/E multiples for the stock as well as faster, more consistent mid-teens EPS growth – a combination which drives ~40% total return potential for shares over the next 2 years.
On Tuesday, BlackRock laid out an ambitious plan to consolidate a large number of actively managed mutual funds with peers that rely more on algorithms and models to pick stocks.
The initiative is the most explicit action by a major fund management firm in reaction to the exodus of investors from actively managed stock funds to cheaper funds that track every variety of index and investment theme.
Some $30 billion in assets (about 11 percent of active equity funds) will be targeted, with $6 billion rebranded BlackRock Advantage funds. These funds focus on quantitative and other strategies that adopt a more rules-based approach to investing.
The Big Trend
We like big trends. We like investing in companies that are riding and leading these trends.
One of the big trends out there is the rise of ETFs and passive investing over active investing.
The index and ETF leader is Vanguard but they are not a publically traded company. The second biggest ETF player, BlackRock (BLK), is. We own BlackRock.
Active management generates far more revenue than passive investing because they have higher management fees than ETFs and index funds. Active management also has more costs. People cost a lot of money to employ.
Shifting towards index funds, ETFs, and factor-based investing means fewer people needed to run the funds and more computers. The gain in profitability outweighs giving up the extra revenue. The chart below is BlackRock’s operating profit margin going back to 1998.
The usual order is a small company with a new bright idea disrupting an established industry. It is interesting to see BlackRock, one of the largest asset managers, leading the charge and refocusing its core competency.
We like the move. It further BlackRock’s position to ride the big trend in asset management.
BlackRock Bets on Robots to Improve Its Stock Picking (WSJ)
One industry benefiting from the election of Donald Trump is asset management. Specifically, active fund managers. Companies like T.Rowe Price (TROW) and Franklin Resources (BEN) have outperformed the broad index since election day.
In simple terms, the Labor Department rule requires that financial advisers act in their clients’ best interest when guiding them on retirement-savings options, replacing a looser standard that their advice merely be suitable. In practice, this might steer more savings into cheaper passive investments. It also will favor fee-based investment products over those that pay advisers a commission.
Many interested parties, and at least one prominent member of Donald Trump’s transition team, want to step in before new rules take effect in April. The expectation they will succeed is one factor pushing up the shares of asset managers—particularly those that run actively managed funds. Active manager Franklin Resources, for instance, has rallied 16% since the election, while passive juggernaut BlackRock has risen just 5%.[emphasis added]
Investors Are More Aware of Fees
Assets are not shifting to passive strategies because of a proposed DOL rule. The shift has been ongoing for years. It’s why Vanguard has over $3.5 trillion in assets under management. Investors are more aware of the high costs and poor performance associated with active management. It was even a subject for Last Week Tonight with John Oliver.
And when active managers fail to outperform a passive index and charge more to do so, the assets will flow to index investing. It’s not rocket science.
Ending the DOL fiduciary rule will not end this trend. It is a small reprieve.
This is not to say active management is dead. Active management will have its place. But the long-term trend favors the passive investing firms and President-Elect Trump can’t change that.
Buying a home is about buying a place to raise and protect your family rather than making a short-term profit. A rising property value usually becomes a concern only when it is time to sell the home. Subsequently people own their homes on average for long periods of time, 13 years on average from the latest study. Allowing the value of a home to grow over a long time period (even at a low rate) coupled with paying down a mortgage produces large gains in a home’s equity.
Owning a cash flow positive business is arguably a better investment than owning a home since the business pays you. Like owning a home the more time you give a free cash flow generating business to grow the better off your investment will become. People are not doing this.
In 1940, a 50-year old had a life expectancy of 21.9 years, and the average stock was held for about seven years. By 2010, a 50-year old had a life expectancy of 29.6 years, and the average stock was held for less than a week.
Now compare that to John Hay’s goal of buying two shares of the New York Tribune Newspaper back in the early 1870s.
Hay joked to Bigelow “I shall take my own medicine as soon as I own two or three shares of Tribune stock” – an impossiblity, at least for the foreseeable future, since only one hundred shares existed, each valued at $10,000.
$10,000 back in the early 1870s is about $180,000 today. If you had to save up $180,000 to buy one share in a company how long do you think you would hold onto that share? Also, how selective would you be in determining which company to buy shares of?
Because it is so easy to trade stocks, it is easy to forget what owning stock really means. It is an equity stake in a company. You are an owner of the business and you have a claim on its profits.
Businesses need time. The time to reinvest profits. Time to reduce costs. Time to gain market share. Time to increase cash flows. Time to increase value for its shareholders. Giving a business time is one of the hardest things to do in our fast paced world, but it is the greatest thing you can give an investment. In the long run your portfolio will thank you.
Your Portfolio Management Team
Dividend Stock in Focus
BlackRock, Inc. (BLK): $364.40* *price as of the close December 5, 2014
It began over a disagreement about compensation. One manager, Larry Fink, wanted to share equity with his employees. The other manager, Steve Schwarzman, did not. Unfortunately for Mr. Fink, Steve Schwarzman was/is the Chairman and CEO of the Blackstone Group (BX). Larry Fink and his fixed income investment management unit had to go. In 1995 the unit was sold to PNC Financial for $240 million and during the sale process the money management unit changed its name to BlackRock.
Then in 1998 PNC merged its equity and mutual fund business into BlackRock and in 1999 the company IPO’d at $14 per share with $165 billion in assets under management. The company continued to grow its assets under management and it also bought other companies: State Street Research & Management in 2005; Merrill Lynch Investment Managers in 2006; and then during the financial crisis Barclay’s Global Investors and its large Exchange Traded Fund (ETF) business iShares. Today BlackRock is the world’s largest asset manager with over $4.5 trillion in assets.
BlackRock is so large it is now the single largest shareholder in many of our portfolio holdings including JPMorgan Chase, Exxon Mobil, Apple, and McDonald’s. According to an Economist article from 2013, BlackRock owns a stake in almost every listed company in America and around the world.
What does Steve Scharzman think about that sale of BlackRock back in 1995?
Blackstone Group LP’s Steve Schwarzman said his decision 19 years ago to sell what would become the world’s largest money manager was a “heroic” mistake. – Bloomberg
Over the last 10 years BlackRock has grown its annual dividend at a compound annual rate of 21%. For fiscal year 2014 BlackRock is on track to pay $7.72 per share in dividends a 14.8% increase over fiscal year 2013.
Catalysts for Dividend Growth and Price Appreciation:
Diversified Asset Manager
No matter what happens in the capital markets BlackRock is in a position to succeed. As you can see in the table below BlackRock is diversified between asset classes: 53% Equity, 29.5% Fixed Income, 2.5% Alternatives (Hedge Funds).
BlackRock also has a good mix between retail (11.6%) and institutional (60.1%) assets. According to Morningstar, the average annual redemption rate for retail assets is 30% and institutional assets, which are managed by committee, have an even lower annual redemption rate.
BlackRock’s assets are also blended between active (retail + institutional active at 32%) and passive (iShares + institutional index 60.5%) management strategies.
The large institutional and passive assets are a strong asset base for BlackRock to work off of. However, these assets generate lower fees. Retail assets and active strategies generate higher fees but make up a lower percentage of BlackRock’s assets. The majority of BlackRock’s active fixed income strategies are performing above their benchmarks and outperforming their peers. BlackRock’s active equity strategies are having trouble, only half of their equity funds are beating their peers. Management is dedicated to “fixing” their equity strategies. If management can improve performance asset growth should follow along with higher revenue growth.
The passive ETF business is a lower revenue business as ETFs generally charge significantly lower management fees than their active counterparts. The misperception about the ETF business is that it is a low margin business too.
When Blackrock bought Barclays Global Investors in 2008 the iShares ETF business had $385 billion in assets under management. iShares’ AUM is now just shy of $1 trillion and is by far-and-away the global ETF leader.
iShares accounts for 23% of BlackRock’s assets under management and provides 35% of BlackRock’s base fees. What has happened to BlackRock’s margins?
Succeeding in the ETF business is all about scale. The overwhelming majority of ETFs are managed to a passive index. Running an ETF and maintaining its index are not as costly as running an active strategy with its higher labor costs. However, ETFs still have costs which are mostly fixed. The more assets in an ETF, the less costs to operate the ETF as a percentage of AUM. So even if the ETF charges less in management fees its lower cost structure can still produce high margins if its asset base grows.
Even at $1 trillion in ETF assets, BlackRock still has room to grow. Most ETFs are focused on equities and even more so on U.S. equities. The daily liquidity of stocks and the ability to sort them by different metrics, i.e. market capitalization, made them the first and easy targets of ETFs. Now the opportunity is in fixed income ETFs. According to management, fixed income ETFs make up 0.4% of the total market compared to the 3% for equity ETFs.
Room to Grow
At $4.5 trillion in assets you would think there isn’t that much further to grow. However, according to Blackrock total global financial assets are $225 trillion with $62 trillion of it being managed. BlackRock is making the push to grab an even larger share of global assets.
The Fall of the King
Bill Gross founded Pacific Investment Management Company (PIMCO) in 1971 based on the idea of actively managed bond funds. Due to Bill Gross’ investment skill the firm grew into a $1.87 trillion AUM behemoth and Mr. Gross was dubbed the “Bond king”. If the history of real life kings provides any guide, you don’t stay at the top for very long. This year Bill Gross left the company he built before being forced out over recent poor performance of his flagship mutual fund, his brash managerial style, a public feud with former CEO Mohamed El-Erian, and a developing internal coup.
Bill Gross’ departure has cost PIMCO $100 billion in AUM and the withdrawals are still building. PIMCO’s loss is every other fixed income managers’ gain. Billions have been flowing into Vanguard, TCW, DoubleLine, and BlackRock. If you do a search for Bill Gross on Google the very first thing you see is an Ad for BlackRock. PIMCO’s blood is in the water and the sharks are circling, looking to bite off a another chunk of their large fixed income asset base.
Pre-Mortem (Potential Risks to our Thesis):
ETF Price War
BlackRock is the ETF leader and a target for other ETF companies to gain market share from. Vanguard, the pioneer of index investing and low cost funds, offers some of the lowest cost ETFs and has gained market share at BlackRock’s expense. In 2009 BlackRock’s ETF market share was at 48% now it is down to around 39%. In an effort to fend off Vanguard, BlackRock lowered the management fees on 12 ETFs and has introduced a new line of low-cost “buy-and-hold” ETFs. Most of the management fee cuts were in ETFs that compete directly against Vanguard like the iShares S&P Total Stock Market ETF and iShares Total U.S. Bond Market ETF. So far the cuts have not and should not affect near-term profitability. A prolonged price war with cuts across more ETFs will have an affect on revenue growth and profitability.
Can’t Fix Active Strategies
Actively managed strategies account for 1/3 of BlackRock’s asset under management but generate almost half of BlackRock’s base fees. Actively managed fixed income strategies are doing well but BlackRock needs to improve its actively managed equity business. The potential for asset growth and revenue growth in actively managed equity strategies is extremely attractive. Revenue growth and profitability will be harmed if management can’t turn the performance around in its actively managed equity strategies.
Equity Market Risk
Fixed income and money market funds charge much lower fees than active equity strategies. When equity markets are in turmoil BlackRock will face increased redemptions in its equity strategies. Some of those redemptions will find their way into BlackRock’s fixed income funds but more than likely the redemptions will sit in cash. BlackRock’s assets under management will decline because of the general decline in asset prices but also because of the redemptions. BlackRock’s profitability and cash flow will come under pressure as a result. However, as long as BlackRock remains a well managed company any market turmoil and excessive decline in BlackRock’s stock price should be viewed as an opportunity to add to our position.
We sold our position in Navient (NAVI) and SLM Corp (SLM) to take advantage of BlackRock’s price decline in October and start a new position in the company. We’ve owned BlackRock before and like Steve Schwarzman we regret selling our original position. We continued to follow the company and kept reevaluating our estimate of its fair value. In October we finally had a chance to buy BlackRock again at a price below our $352 per share estimate of fair value. While we would’ve liked to have held onto both Navient and SLM Corp., we saw a chance to buy a great company with what we view as much better long-term prospects for dividend growth and capital appreciation. Now we just have to give BlackRock the time to execute its strategy.
The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.