- BlackRock operates a fee-based business that does not depend on propriety trading or corporate issuance as is the case for other financial services firms.
- BlackRock has a well diversified business mix which reduces earnings volatility.
- BlackRock's current valuation is reasonable.
- BlackRock management is top quality.
Financial services companies are among the most difficult to analyze because of their complexity and leverage. For this reason, I have limited my discussion of financial services firms to a few special situations. However, as I will discuss in this piece, I believe BlackRock (NYSE:BLK) is the exception and is a good long-term investment.
Why Investing In Financial Services Companies Is Difficult
One of the basic problems with investing in banks and quasi-banking companies is that they earn small to medium sized profits for a number of years before reporting large losses in a single bad year that can sometimes wipe out the gains from all the previous years. Recent examples of this include the likes of Citigroup (NYSE:C), AIG, and Lehman Brothers in 2008. More historic examples of banking failures include the S&L Crisis and the Great Depression. Comparably, during bad years cyclical non-financial companies such as U.S. Steel (NYSE:X) or Caterpillar (NYSE:CAT) will lose money but not multiples of what they earn during the good years. That is not to say that non-financial companies can't blow up, they can. Recent examples include General Motors (NYSE:GM) and American Airlines (NASDAQ:AAL). A driving factor behind why both companies were forced to file bankruptcy was too much leverage. Financial services firms tend to be the most leveraged firms around due to the nature of the business. For example, Bank of America (NYSE:BAC) has about $2.1 trillion in assets and $1.8 trillion in liabilities and a market capitalization of just $159 billion. Other large financial firms such as Citigroup and Goldman Sachs (NYSE:GS) are also highly leveraged. Due to this, I have tended to avoid discussions about the long-term prospects for financial firms.
How BlackRock Is Different
With over $4.4 trillion of assets under management, BLK is the largest asset management company in the world. In addition to being the largest asset management company in the world, BLK is also the, largest, most pure play on asset management. Other important players in the asset management business include UBS, Goldman Sachs, and JPMorgan Chase (NYSE:JPM). However, these companies are engaged in many other businesses and are not a pure play on asset management. In particular, investment banks such as UBS, Goldman, and J.P. Morgan tend to derive a significant portion of their earnings from proprietary trading and issuance underwriting. I believe the fee-based asset management business is a better business than proprietary trading or underwriting because the revenues are more stable. While fee revenue will fall during downturn because of shrinking AUM figures, the revenue generated from fees will remain relatively stable compared to the decreases seen in the trading and underwriting businesses. Since BLK is not in the business of trading its own account, shareholders need not worry about waking up to news such as the London Whale at JPMorgan.
Diversified Business Mix
Of course, BLK is not the only pure play asset management company. Other pure play asset management companies that come to mind are Federated Investors (NYSE:FII), T. Rowe Price Group Inc (NASDAQ:TROW), and Franklin Resources (NYSE:BEN). BLK is different than these companies because it is more diverse. The other asset management companies mentioned here focus mostly on the mutual fund business: BLK is different because it also owns iShares, the world's largest ETF provider with roughly $700 billion in AUM. One of the arguments that is often used to suggest that traditional asset management companies are not a good bet is the move away from active managers to more passive ETF products. While this is certainly true, traditional asset management companies have continued to do well. Both T. Rowe Price and Franklin Resources are trading at all-time high prices. BLK is positioned well to continue profiting from the legacy mutual fund business as well as profit from the growing ETF business. Another source of revenue for BLK is BlackRock solutions, a risk analytics business that generated $154 million of revenue in the first quarter out of a total companies revenue of $2.7 billion.
As shown by the chart below, BLK appears to be reasonably valued compared to its asset management peers. However, it should be noted that at 16.85 times forward earnings and nearly 2 times book value BLK is not cheap relative to other financial stocks such as Bank of America which trades at 10 times forward earnings and 0.73 times book value. Goldman Sachs trades at 10 times forward earnings and 1.05 times book value. I believe BLK deserves its premium valuation because it is a better business. Famed investor Warren Buffett has often said:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
BLK is a wonderful company trading at a fair price.
BLK continues to be led by its co-founder Larry Fink. Fink has managed to grow BLK into the world's largest asset management firm in just 26 years, a remarkable feat. Fink has executed a number of strategic transactions that have worked out very well for BLK shareholders. In particular, Fink's moves to acquire Merrill Lynch Investment Management in 2007 and iShares in 2009 have proved extremely timely. More recently, Fink has put more emphasis on returning capital to shareholders in the form of stock buybacks and dividend increases. To put it simply, Larry Fink, and BLK's management team more broadly, is a major positive for long-term investors. BLK has proved not only capable of managing and growing its legacy business but also opportunistic when it comes to making aggressive moves.
Despite the challenging nature of investing in financial services companies, prudent investors must have an allocation to the space because of the large market cap of the sector. While I believe investors can rotate into and out of a number of financial stocks for short-term trades, there are very few financial stocks I believe investors can own for the long term. In my opinion, BLK is the financial stock to own for the long term. BLK's high quality fee-based business structure, diversified business mix, reasonable valuation, and strong management team are all reasons why I believe BLK is a solid long-term investment.