BLACKROCK INC BLK
December 11, 2013 - 8:46am EST by
Par03
2013 2014
Price: 299.40 EPS $16.02 $17.88
Shares Out. (in M): 169 P/E 18.7x 16.7x
Market Cap (in $M): 50,722 P/FCF 0.0x 0.0x
Net Debt (in $M): 1,056 EBIT 0 0
TEV ($): 51,778 TEV/EBIT 0.0x 0.0x

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  • Asset Management
  • Special Situation
 

Description

Recommendation:
Although this will show up as a recommendation to buy shares of BlackRock, more specifically I am recommending a pair trade of going long BlackRock and short IGM Financial.  As such, this writeup should be read in conjunction with Carbone959’s excellent writeup (from November 14, 2013) recommending a short position in IGM.

The rationale is simple.  IGM Financial is a crappy asset management firm.  BlackRock is a very good asset management firm.  Moreover, I believe there is a long term secular trend of low-cost, passively managed funds/ETFs taking share from high-cost, actively managed mutual funds.  This secular trend will continue to serve as a tailwind for BlackRock while serving as a headwind for IGM Financial.  Despite all this, BlackRock trades at almost the same P/E multiple as IGM Financial (19.2x for BLK vs 18.1x for IGM).

While I think BlackRock should trade at a much higher premium to IGM Financial, multiple compression/expansion isn’t necessary for this trade to be a winner.  For reasons I elaborate below, BlackRock is likely to grow earnings at a faster clip than IGM Financial, making this trade profitable even if the relative multiples stay constant.

I’ll also point out that the short interest in IGM Financial is very low, and I easily found a borrow at a negligible rate.

 

Company Description:
BlackRock is the world’s largest publicly-traded asset management firm with $4.1 trillion of AUM as of 9/30/13.  Being as big as they are, BlackRock’s product offering runs the gamut, including equities (52% of AUM), fixed income (30% of AUM), multi-asset (8% of AUM), alternatives (3% of AUM), and money market funds (6% of AUM).

What really differentiates BlackRock from other publicly-traded asset managers, however, is its exposure to passively managed strategies.  Through its purchase of Barclays Global Investors in December 2009 for $15.2 billion, BlackRock added the iShares line of ETFs to its product offerings.  Now, BlackRock’s passively managed products, including both iShares ETFs and institutional index products, account for 60% of total firm-wide AUM and 37% of revenue (through the first 9 months of 2009).

IGM Financial is Canada’s 2nd largest mutual fund manager, with CAD$126 billion of AUM as of 9/30/13.  IGM focuses on retail investors reached through financial planners.  IGM has two main brand names: Investors Group  (~50% of AUM) and Mackenzie Investments (~50% of AUM).  Investors Group mutual funds are distributed through a network of ~4500 Investors Group “consultants” who are IGM employees and are paid entirely on commission.  Mackenzie funds are distributed mostly through third party financial planners.

Carbone959 does a much better job than I will in explaining why IGM is a crappy asset manager.  To summarize however, IGM’s products are typically characterized by:

  • Poor performance:
    • As of 9/30/13, 39% of Investors Group mutual funds had a Morningstar rating of 3 stars or better (compared to 65% for the Morningstar universe) and 11% had a Morningstar rating of 4 or 5 stars (compared to 27% for the Morningstar universe)
  • Extremely high fees:
    • Investor Group fee revenue for the LTM period totaled 2.4% of AUM, while Mackenzie fee revenue totaled 1.2% of AUM (by contrast, BlackRock’s actively managed strategies generated fee revenue of only 34 bps of AUM in the LTM period).
  • Frequently deceptive marketing practices:
    • Again, I refer to Carbone959’s writeup, but Investors Group funds usually have Deferred Sales Charges (DSCs), which are fees to redeem one’s investment (typically 5.5% within the first two years of purchase, stepping down to 0% after 7 years).  If you google “Investors Group”, you can find anecdotes of clients being sold Investors Group funds without being informed of the DSCs.

 

Of course, IGM Financial’s products have exhibited these characteristics for a long time, so it’s not as if the company is going away anytime soon.  That said, these characteristics mean that IGM Financial struggles to grow AUM at the same rate as competitors like BlackRock.  Since the end of 2009 (immediately after BlackRock acquired Barclays Global Investors), BlackRock has grown AUM by 22.4%:

 

Over the same time period, IGM has grown AUM by just 4.5%:

 

With subpar AUM growth, IGM grows earnings at a much slower pace.  In 2010 (first full year of BlackRock ownership of BGI), BlackRock generated adjusted EPS of $10.94.  That figure has since grown over 40% to $15.62 over the LTM period:

 

In contrast, IGM Financial generated CAD$2.89 in adjusted EPS in 2010.  LTM EPS of CAD$2.97 has only grown 3% from the 2010 level:

Clearly, BlackRock’s business has performed better than IGM’s over the last few years.  For the reasons I outline below, I think this trend is likely to persist:


BlackRock is a better asset gatherer than IGM Financial:
Below is a graph showing net subscription/redemption rate* for IGM Financial and BlackRock from 2010 through the most recent quarter.  BlackRock’s net subscription rate has exceeded IGM’s in each of the last 6 quarters and in 11 of the last 15 quarters.

*As I’ve defined it here, net subscription/withdrawal rate is net client subscriptions or withdrawals in a quarter divided by the beginning AUM in the quarter.

 

The source of BlackRock’s asset gathering edge is sustainable:
If we break down BlackRock’s net subscription/redemption rates for its actively managed products versus its passively managed products (both institutional index funds and iShares ETFs), we see that passively managed offerings are driving BlackRock’s relative strength in asset gathering:

*For the chart above, I’ve excluded BlackRock’s advisory portfolio liquidation AUM (which is small anyway)

Because BlackRock’s asset gathering advantage is driven by its passively managed products, we don’t have to worry about a star manager leaving the firm, and we don’t have to worry about the firm’s portfolio managers going on a cold streak.  I believe the trend of low-cost passively managed offerings taking share is secular one that should continue to consistently benefit BlackRock going forward.

Of course, the other takeaway from this chart is that BlackRock’s actively managed funds haven’t exactly been tearing the cover off the ball in terms of asset gathering.  That said, BlackRock’s actively managed funds alone still have done better than IGM Financial’s in terms of net subscription/redemption rate over the last few years.

 

BlackRock is also likely to beat IGM Financial in fund performance:
If you go back and look at the two charts from earlier in this writeup that show total AUM growth for BlackRock and IGM over the last few years, you’ll see that market appreciation drove a 24% gain in BlackRock AUM since 12/31/09, whereas market appreciation only drove a 14% gain in IGM AUM over the same time period.  In other words, recent history shows BlackRock’s funds outperforming IGM’s funds.  But about going forward?

Because of BlackRock’s size and exposure to passively managed products, BlackRock’s fund performance, in aggregate, is likely to be pretty close to the market.  As a smaller manager with actively managed products, IGM Financial’s fund performance is more likely to differ from the broader market.  While they could conceivably go on a hot streak and start beating the market, I think it is more likely that their cold streak continues, based on the simple fact that their fee structure creates a high bar to jump over to simply keep pace with the market.

 

IGM’s fees have nowhere to go but down; BlackRock’s fees are already super low:
I referenced this earlier in the write-up, but to reiterate:

*Fees based on LTM period ending 9/30/13 and avg AUM over the period.  Numerator includes distribution fees.

Amazingly, IGM’s fees over the LTM period are actually slightly lower than they used to be.  In May of 2012, IGM announced changes to their pricing; management fees were lowered (by a total of between 5 and 40 bps) on two thirds of their mutual funds.  This suggests that IGM is increasingly seeing pushback on its fees.  Given that they still remain extremely high, I don’t think this pushback is going away.

 

Why do this as a pair trade?
I was very intrigued when I read Carbone959’s writeup of IGM, and I agree with him/her that there is a very compelling short case.  After doing my own diligence however, I had two concerns about shorting IGM.  My first concern is the lack of a specific catalyst.  Carbone959 argues for a potential Canadian bear market as a catalyst, but I’m agnostic about the Canadian market going forward.  My second concern is that while IGM’s P/E multiple (currently 18.1x) strikes me as too high, it’s not out of line with other asset managers and what IGM has traded at for much of the last decade.

By pairing the IGM short with a BlackRock long, I think these two concerns are largely mitigated.  A decrease in IGM’s P/E multiple would certainly help the trade, but the trade is still likely to be profitable even without multiple compression, simply because BlackRock is likely to continue to grow earnings at a faster clip.

Because of its exposure to passively managed strategies and its reasonable valuation (especially compared to the asset manager universe), BlackRock is my favorite relative value in the sector and could be a good long in its own right.  But without a corresponding short, I’m hesitant to buy an asset manager at a high teens P/E after a period that, due to outsized market appreciation, has been so favorable for asset manager earnings.


Risks:

  • IGM could be an acquisition target
    • We can’t rule this one out.  Because of the benefits of scale for large asset managers, IGM’s AUM could be attractive to a strategic acquirer (perhaps one of the Big Five banks in Canada).  Note that IGM is already ~60% owned by Power Financial corporation (TSX: PWF).
  • Currency risk
    • IGM is traded in Canadian dollars, and its financials are quoted in Canadian dollars.  BLK is traded in US dollars, and its financials are quotes in US dollars.  I’m agnostic about the direction of the currencies, but if you’re concerned about the Canadian dollar strengthening relative to the US dollar and negatively impacting the pair trade, you should be able to hedge out much of that risk.
  • Canadian stock market outperformance
    • The risk here is twofold.  First, if the Canadian stock market outperforms, then IGM’s share price is likely to benefit since it’s a Canadian stock. Second, Canadian stock market outperformance will disproportionately benefit IGM’s AUM, which in turn will increase IGM’s earnings power.  I’m okay accepting this risk however, because, the directional correlation of each firm’s fund performance is surprisingly high:

*Net market appreciation rate defined as growth in AUM attributable to market appreciation (or depreciation) divided by AUM at the beginning of the period.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Catalysts:

  • Increased regulation and/or fee disclosure in Canadian mutual fund market
    • In my diligence on IGM, one contact I spoke with (who works in the mutual fund industry in Canada) noted that there are murmurs of increased regulation of mutual fund fees and fee disclosure in Canada over the next few years.  The only definitive regulatory change I can point to is that, starting in June of 2014, Canadian mutual funds will have to deliver a “Fund Facts” sheet (which shows simplified fee disclosure, including deferred sales charges) to investors within 2 days of purchasing a mutual fund.  And at some point further in the future, Canadian mutual funds will be required to provide these “Fund Facts” sheets at the time of sale (although the date for this requirement has yet to be set).  This is a minor change, but it will likely impact IGM disproportionately relative to other asset managers, and it may be a harbinger of further changes.
  • Differential EPS growth over time
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    Description

    Recommendation:
    Although this will show up as a recommendation to buy shares of BlackRock, more specifically I am recommending a pair trade of going long BlackRock and short IGM Financial.  As such, this writeup should be read in conjunction with Carbone959’s excellent writeup (from November 14, 2013) recommending a short position in IGM.

    The rationale is simple.  IGM Financial is a crappy asset management firm.  BlackRock is a very good asset management firm.  Moreover, I believe there is a long term secular trend of low-cost, passively managed funds/ETFs taking share from high-cost, actively managed mutual funds.  This secular trend will continue to serve as a tailwind for BlackRock while serving as a headwind for IGM Financial.  Despite all this, BlackRock trades at almost the same P/E multiple as IGM Financial (19.2x for BLK vs 18.1x for IGM).

    While I think BlackRock should trade at a much higher premium to IGM Financial, multiple compression/expansion isn’t necessary for this trade to be a winner.  For reasons I elaborate below, BlackRock is likely to grow earnings at a faster clip than IGM Financial, making this trade profitable even if the relative multiples stay constant.

    I’ll also point out that the short interest in IGM Financial is very low, and I easily found a borrow at a negligible rate.

     

    Company Description:
    BlackRock is the world’s largest publicly-traded asset management firm with $4.1 trillion of AUM as of 9/30/13.  Being as big as they are, BlackRock’s product offering runs the gamut, including equities (52% of AUM), fixed income (30% of AUM), multi-asset (8% of AUM), alternatives (3% of AUM), and money market funds (6% of AUM).

    What really differentiates BlackRock from other publicly-traded asset managers, however, is its exposure to passively managed strategies.  Through its purchase of Barclays Global Investors in December 2009 for $15.2 billion, BlackRock added the iShares line of ETFs to its product offerings.  Now, BlackRock’s passively managed products, including both iShares ETFs and institutional index products, account for 60% of total firm-wide AUM and 37% of revenue (through the first 9 months of 2009).

    IGM Financial is Canada’s 2nd largest mutual fund manager, with CAD$126 billion of AUM as of 9/30/13.  IGM focuses on retail investors reached through financial planners.  IGM has two main brand names: Investors Group  (~50% of AUM) and Mackenzie Investments (~50% of AUM).  Investors Group mutual funds are distributed through a network of ~4500 Investors Group “consultants” who are IGM employees and are paid entirely on commission.  Mackenzie funds are distributed mostly through third party financial planners.

    Carbone959 does a much better job than I will in explaining why IGM is a crappy asset manager.  To summarize however, IGM’s products are typically characterized by:

    • Poor performance:
      • As of 9/30/13, 39% of Investors Group mutual funds had a Morningstar rating of 3 stars or better (compared to 65% for the Morningstar universe) and 11% had a Morningstar rating of 4 or 5 stars (compared to 27% for the Morningstar universe)
    • Extremely high fees:
      • Investor Group fee revenue for the LTM period totaled 2.4% of AUM, while Mackenzie fee revenue totaled 1.2% of AUM (by contrast, BlackRock’s actively managed strategies generated fee revenue of only 34 bps of AUM in the LTM period).
    • Frequently deceptive marketing practices:
      • Again, I refer to Carbone959’s writeup, but Investors Group funds usually have Deferred Sales Charges (DSCs), which are fees to redeem one’s investment (typically 5.5% within the first two years of purchase, stepping down to 0% after 7 years).  If you google “Investors Group”, you can find anecdotes of clients being sold Investors Group funds without being informed of the DSCs.

     

    Of course, IGM Financial’s products have exhibited these characteristics for a long time, so it’s not as if the company is going away anytime soon.  That said, these characteristics mean that IGM Financial struggles to grow AUM at the same rate as competitors like BlackRock.  Since the end of 2009 (immediately after BlackRock acquired Barclays Global Investors), BlackRock has grown AUM by 22.4%:

     

    Over the same time period, IGM has grown AUM by just 4.5%:

     

    With subpar AUM growth, IGM grows earnings at a much slower pace.  In 2010 (first full year of BlackRock ownership of BGI), BlackRock generated adjusted EPS of $10.94.  That figure has since grown over 40% to $15.62 over the LTM period:

     

    In contrast, IGM Financial generated CAD$2.89 in adjusted EPS in 2010.  LTM EPS of CAD$2.97 has only grown 3% from the 2010 level:

    Clearly, BlackRock’s business has performed better than IGM’s over the last few years.  For the reasons I outline below, I think this trend is likely to persist:


    BlackRock is a better asset gatherer than IGM Financial:
    Below is a graph showing net subscription/redemption rate* for IGM Financial and BlackRock from 2010 through the most recent quarter.  BlackRock’s net subscription rate has exceeded IGM’s in each of the last 6 quarters and in 11 of the last 15 quarters.

    *As I’ve defined it here, net subscription/withdrawal rate is net client subscriptions or withdrawals in a quarter divided by the beginning AUM in the quarter.

     

    The source of BlackRock’s asset gathering edge is sustainable:
    If we break down BlackRock’s net subscription/redemption rates for its actively managed products versus its passively managed products (both institutional index funds and iShares ETFs), we see that passively managed offerings are driving BlackRock’s relative strength in asset gathering:

    *For the chart above, I’ve excluded BlackRock’s advisory portfolio liquidation AUM (which is small anyway)

    Because BlackRock’s asset gathering advantage is driven by its passively managed products, we don’t have to worry about a star manager leaving the firm, and we don’t have to worry about the firm’s portfolio managers going on a cold streak.  I believe the trend of low-cost passively managed offerings taking share is secular one that should continue to consistently benefit BlackRock going forward.

    Of course, the other takeaway from this chart is that BlackRock’s actively managed funds haven’t exactly been tearing the cover off the ball in terms of asset gathering.  That said, BlackRock’s actively managed funds alone still have done better than IGM Financial’s in terms of net subscription/redemption rate over the last few years.

     

    BlackRock is also likely to beat IGM Financial in fund performance:
    If you go back and look at the two charts from earlier in this writeup that show total AUM growth for BlackRock and IGM over the last few years, you’ll see that market appreciation drove a 24% gain in BlackRock AUM since 12/31/09, whereas market appreciation only drove a 14% gain in IGM AUM over the same time period.  In other words, recent history shows BlackRock’s funds outperforming IGM’s funds.  But about going forward?

    Because of BlackRock’s size and exposure to passively managed products, BlackRock’s fund performance, in aggregate, is likely to be pretty close to the market.  As a smaller manager with actively managed products, IGM Financial’s fund performance is more likely to differ from the broader market.  While they could conceivably go on a hot streak and start beating the market, I think it is more likely that their cold streak continues, based on the simple fact that their fee structure creates a high bar to jump over to simply keep pace with the market.

     

    IGM’s fees have nowhere to go but down; BlackRock’s fees are already super low:
    I referenced this earlier in the write-up, but to reiterate:

    *Fees based on LTM period ending 9/30/13 and avg AUM over the period.  Numerator includes distribution fees.

    Amazingly, IGM’s fees over the LTM period are actually slightly lower than they used to be.  In May of 2012, IGM announced changes to their pricing; management fees were lowered (by a total of between 5 and 40 bps) on two thirds of their mutual funds.  This suggests that IGM is increasingly seeing pushback on its fees.  Given that they still remain extremely high, I don’t think this pushback is going away.

     

    Why do this as a pair trade?
    I was very intrigued when I read Carbone959’s writeup of IGM, and I agree with him/her that there is a very compelling short case.  After doing my own diligence however, I had two concerns about shorting IGM.  My first concern is the lack of a specific catalyst.  Carbone959 argues for a potential Canadian bear market as a catalyst, but I’m agnostic about the Canadian market going forward.  My second concern is that while IGM’s P/E multiple (currently 18.1x) strikes me as too high, it’s not out of line with other asset managers and what IGM has traded at for much of the last decade.

    By pairing the IGM short with a BlackRock long, I think these two concerns are largely mitigated.  A decrease in IGM’s P/E multiple would certainly help the trade, but the trade is still likely to be profitable even without multiple compression, simply because BlackRock is likely to continue to grow earnings at a faster clip.

    Because of its exposure to passively managed strategies and its reasonable valuation (especially compared to the asset manager universe), BlackRock is my favorite relative value in the sector and could be a good long in its own right.  But without a corresponding short, I’m hesitant to buy an asset manager at a high teens P/E after a period that, due to outsized market appreciation, has been so favorable for asset manager earnings.


    Risks:

    • IGM could be an acquisition target
      • We can’t rule this one out.  Because of the benefits of scale for large asset managers, IGM’s AUM could be attractive to a strategic acquirer (perhaps one of the Big Five banks in Canada).  Note that IGM is already ~60% owned by Power Financial corporation (TSX: PWF).
    • Currency risk
      • IGM is traded in Canadian dollars, and its financials are quoted in Canadian dollars.  BLK is traded in US dollars, and its financials are quotes in US dollars.  I’m agnostic about the direction of the currencies, but if you’re concerned about the Canadian dollar strengthening relative to the US dollar and negatively impacting the pair trade, you should be able to hedge out much of that risk.
    • Canadian stock market outperformance
      • The risk here is twofold.  First, if the Canadian stock market outperforms, then IGM’s share price is likely to benefit since it’s a Canadian stock. Second, Canadian stock market outperformance will disproportionately benefit IGM’s AUM, which in turn will increase IGM’s earnings power.  I’m okay accepting this risk however, because, the directional correlation of each firm’s fund performance is surprisingly high:

    *Net market appreciation rate defined as growth in AUM attributable to market appreciation (or depreciation) divided by AUM at the beginning of the period.

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Catalysts:

    • Increased regulation and/or fee disclosure in Canadian mutual fund market
      • In my diligence on IGM, one contact I spoke with (who works in the mutual fund industry in Canada) noted that there are murmurs of increased regulation of mutual fund fees and fee disclosure in Canada over the next few years.  The only definitive regulatory change I can point to is that, starting in June of 2014, Canadian mutual funds will have to deliver a “Fund Facts” sheet (which shows simplified fee disclosure, including deferred sales charges) to investors within 2 days of purchasing a mutual fund.  And at some point further in the future, Canadian mutual funds will be required to provide these “Fund Facts” sheets at the time of sale (although the date for this requirement has yet to be set).  This is a minor change, but it will likely impact IGM disproportionately relative to other asset managers, and it may be a harbinger of further changes.
    • Differential EPS growth over time

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