The Shift From Active To Passive Funds Put Asset Managers On Sale, But Be Selective And Patient

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Includes: BEN, BLK, LAZ, LM, TROW, WDR
by: Dividend Power
Summary

BlackRock, T. Rowe Price, and Lazard are trading at discounts relative to their 10-year P/E ratios and the S&P 500's average P/E ratio.

These three asset managers have competitive advantages that permit them to organically grow assets under management.

All three companies have consistently grown their dividend over the past 10 years.

BlackRock and T. Rowe Price reported strong earnings growth for Q1 2019.

Overview and Thesis

Asset managers have, in general, been beaten down since their peaks in early 2018 and some are trading at decade lows. This is due to poor broader market performance leading to asset outflows. In turn, this has caused assets under management and fees to decrease over time pressuring revenue and earnings. I have written previously about the challenges faced by Waddell & Reed (WDR). But others such as Legg Mason (LM) and Franklin Resources (BEN) have similar challenges. Although they are priced at low price-to-earnings multiples and have good dividend yields, they are not able to consistently generate net inflows and, in turn, increase AUM.

Although many asset managers are on sale, one should be selective and patient. Saying that there are several asset managers with structural advantages that can offer small investors dividend growth with decent total returns. In this article, I summarize the industry shift from active to passive funds. I then discuss three publicly-traded asset managers that continue to increase AUM through net inflows and market returns. These three firms are BlackRock, Inc. (BLK), T. Rowe Price (TROW), and Lazard Ltd. (LAZ). They all pay a growing dividend and may provide small investors decent total return.

Asset Managers

Source: grahamcapitaladvisors.com

Shift from Active to Passive Funds

The main issue for many asset managers is competition provided by passive funds, both index mutual funds and exchange-traded funds. Passive funds have increased market share in the past 25 years. The gain has accelerated in the past 10 years due to the emergence of passive ETFs.

Total Assets Under Management in Active and Passive Funds

AUM in Active and Passive Funds

Source: "The Shift from Active to Passive Investing: Potential Risks to Financial Stability?" by Federal Reserve Bank of Boston

This persistent shift has occurred across all asset classes. In 1995, less than 3% of total AUM was invested in passive funds. This increased to 14% in 2005. By end of 2018, there was almost equal AUM between active and passive equity funds. In bond funds, the shift has been much less pronounced. But at the same time, passive funds have gained market share and in the total bond fund category, they now have over 25% of AUM.

Active and Passive Equity Funds AUM

Active and Passive Equity Funds AUM

Source: bloomberg.com

There is no sign that this trend will abate soon due to the low cost and turnover of passive funds and historical data indicating that passive funds outperform active funds over time. The cost of passive funds continues to drop. In fact, Fidelity Investments recently began offering two index mutual funds for free and also reduced the fees on other index mutual funds by 35%. Furthermore, most active equity fund managers have a difficult time beating their benchmark while passive funds essentially track the benchmark. In bond funds, active managers are more successful versus the benchmarks mostly due to taking more credit risk, which has been rewarded in the past 10 years.

Percentage of Active Funds Beating Their Benchmark

Category

2018

2017

Large Cap Blend

36.2%

48.8%

Small Cap Blend

23.1%

31.5%

Foreign Large Cap Blend

30.1%

53.8%

Intermediate-Term Bond

70.9%

85.1%

Corporate Bond

48.1%

76%

Source: bloomberg.com

The primary beneficiary of this trend has, of course, been Vanguard Group, which pioneered the index mutual fund under John Bogle. Vanguard is also the second largest provider of ETFs. However, Vanguard Group is not publicly traded. But there are three publicly-traded firms that are successfully navigating this shift, generating net inflows and organically increasing AUM. At the right price, I view these stocks as buys.

BlackRock, Inc.

The second main beneficiary of the aforesaid trend is BlackRock, which is the largest provider of ETFs and also the largest asset manager in the world. The iShares ETF brand has about 30% of BlackRock's total AUM with institutional index funds at 37% of total AUM. Notably, BlackRock is also a large player in active fund management with 26% of total AUM. Total AUM at end of Q1 2019 was $6.515T, which grew 3.1% on a year-over-year basis and 9.0% in sequential quarters. Net asset inflows totaled $59.0B of which $14.0B were to active funds, $14.4B were to index funds and $30.6B were to iShares ETFs. Notably, this led to BlackRock beating both on revenue and also earnings by $0.48 for GAAP EPS in Q1 2019. The important point here is that BlackRock has shown the ability to increase net inflows and fees even in the recent market downturn. The iShares brand continues to give BlackRock a competitive advantage due to the breadth of offering and low costs.

BlackRock's Net Inflows (Orange) and Fee Growth (Pink)

BlackRock Net Inflows and Fee Growth Rate

Source: BlackRock Q1 2019 Earnings Results

BlackRock has consistently grown the dividend since 2003 and I expect this to continue in the future. In fact, BlackRock will likely become a Dividend Aristocrat. Over the past 10 years, the dividend growth rate has been almost ~15%. The current dividend yield is ~2.8%, which is slightly above the 4-year average and also greater than the S&P 500's average of ~1.9%. BlackRock's dividend yield has periodically risen above 3% in the past five years, which may be a good entry point for small investors once the yield exceeds this value again.

From a valuation perspective, BlackRock's 10-year average P/E ratio is approximately 19.2. The current P/E ratio (FWD) is ~16.7 suggesting that the company is slightly undervalued. Furthermore, the company is trading at ~$480 after closing on April 24, 2019, which is still ~20% lower than BlackRock's all-time high of ~$590. The price is also lower than the fair valuation of ~$530 based on the 10-year P/E ratio and expected 2019 earnings of ~$27.90. But due to margin compression, industry-wide pressure on fees and recovery in stock price I am currently neutral on BlackRock. If the stock price drops below $440 or the yield rises above 3% then I would consider taking a position.

T. Rowe Price

T. Rowe Price is another asset manager that I have favorable views on. I wrote an article in early November 2018 stating that T. Rowe Price should be on small investors' watch list. In fact, the price was about $97 at that time and dropped to ~$85 by end of 2018. The company's stock price recently traded at $109.76 after closing on April 24, 2019. Despite not having significant strength in passive funds, T. Rowe Price has demonstrated ability to organically grow AUM. In fact, in Q1 2019, AUM grew 12% sequentially to $1.082T with $5.4B coming from net inflows. The company reported earnings on April 24, 2019, that beat estimates on revenue and earnings-per-share. In fact, GAAP EPS was $0.26 higher than estimates indicating that their business is gaining in parallel with the stock market gains.

T. Rowe Price has several competitive advantages permitting it to organically grow AUM. The company's active funds have relatively low expense ratios. Although they are not as low as passive funds the cost penalty is much smaller relative to other active fund managers. T. Rowe Price has very popular target-date funds focused on retirement accounts. A target-date fund is one that seeks to grow assets over a specified period of time to a targeted year in the future. The asset allocation of stocks, bonds, and cash in a target-date fund is a function of the specified time period and in general, the fund becomes more conservative as it nears the target date. This autopilot feature has made them popular with retirement accounts. Lastly, T. Rowe Price's active mutual funds have performed well compared to the Morningstar median. Furthermore, 85.5% of the company's active funds have a 4-star or 5-star rating from Morningstar.

T. Rowe Price's Active Fund Performance

T. Rowe Price Active Fund Performance

Source: T. Rowe Price Q1 2019 Results

T. Rowe Price has grown the dividend for 33 straight years making the company a Dividend Aristocrat. I expect the dividend to continue growing. Over the past 10 years, the dividend growth rate has been almost ~12%. The current dividend yield is ~2.8%, which is near the 4-year average and also greater than the S&P 500's average of ~1.9%. The company's stock price has recently been volatile. The dividend yield has periodically been over 3%, which has proven to be a good entry point for small investors.

From a valuation perspective, T. Rowe Price's 10-year average P/E ratio is approximately 17.8. The current P/E ratio (FWD) is ~15.4 suggesting that the company is slightly undervalued. Furthermore, the stock is trading below its all-time high of ~$126. The price is also lower than the fair valuation of ~$120 based on expected 2019 earnings of ~$6.95. I am long T. Rowe Price and view the stock as a long-term hold due to its long history of growing EPS and dividends. Although I am currently neutral on T. Rowe Price, I would be a buyer if the price drops below $100 or the yield goes above 3%.

Lazard Ltd.

Lazard is the third asset manager that I view favorably. I recently wrote an article on the bullish case for Lazard due to its growing EPS and low stock price. The stock is trading $37.59 after close on April 24, 2019. This is well below its recent and all-time high of ~$59. Unlike many other companies, Lazard's stock price has not rallied since the broader market low. In fact, it has been trading in a range between ~$34 and ~$41 since late 2018. Lazard reports earnings on April 25, 2019. It is possible that Lazard's asset management business will have good results based on the performance of other asset managers in Q1 2019. Lazard also previously reported that AUM increased in January, February and March. Saying that global M&A activity is down but the deals are larger. This may negatively impact Lazard's advisory business.

Lazard is not a pure asset manager since it also has significant business providing financial advice. Lazard's competitive advantage is not structural but rather it focuses on relationships and reputation. In this context, Lazard's has a global reputation for excellence. In addition, Lazard focuses on institutional clients rather than retail clients. This may lead to stickier assets. Lazard also has products with investment strategies that leverage its global presence and likely differentiate it from other asset managers. For instance, the company has strategies emerging market debt, developing markets equity and international strategic equity among others. Notably, Lazard has been able to organically grow AUM at a roughly 6% rate in the past 5-years.

Lazard Is Able To Grow AUM Through Net Inflows

Lazard Net Inflows

Source: Lazard Q4 2018 Investor Presentation

Lazard has grown its dividend for 11 straight years. The company announced a 6.8% increase to $0.47 per share on April 24, 2019. I expect the dividend to continue growing. The current dividend yield is roughly 5%, which is much greater than the S&P 500's average yield of 1.9%. Notably, Lazard usually pays an annual special dividend increasing the dividend yield to over 6%. The total yield is now the highest in the past 11 years.

From a valuation perspective, Lazard's average 10-year P/E ratio is about 15.7. The current P/E ratio is below 10.0 suggesting that the stock is very undervalued relative to historical valuations and also compared to the S&P 500. The S&P 500's average P/E ratio is 22.1. A fair valuation is ~$57 based on a P/E ratio of 15.0 and expected 2019 EPS of $3.80. I am long Lazard. I currently view Lazard as a buy due to its high dividend yield, low P/E ratio and increasing AUM.

Disclosure: I am/we are long TROW, LAZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.