10 Best Business Models in Financial Services
Mar/111
As a hedge fund manager who specializes on the financial services sector, I often run into investors who say, “I would never invest in a financial company because it is impossible to analyze them.” While there are many banks and insurance companies with opaque balance sheets, these investors are over looking many good business models within the financial services sector. These businesses have transparent revenue models, are not capital intensive and have strong competitive moats. Plus, several of these businesses operate in markets with significant growth prospects.
I developed the following list of my 10 favorite business models in financial services. You won’t see commercial banks or traditional insurance companies on this list. These are companies with business models that use their balance sheets sparingly. (Please note – I wouldn’t necessarily buy the stocks mentioned in this discussion, but I would add them to a watch list.)
10. Multi-level marketing insurance sales – That was a mouthful, but I am referring to Aflac and Primerica. These companies use captive salesforces of independent contractors to sell their insurance. The models depend on hire many, many people who sell insurance. Of course, not all of the new hires are successful, but they unsuccessful ones quickly weed themselves out. Both of these companies sell insurance that is low volatility and low severity because the risk are predictable and spread out across huge a population of policy-holders. Some analysts would argue they sell overpriced insurance policies.
9. Traditional Asset Management – Traditional asset management is a great business. Assets are sticky, so the revenue is recurring. No capital is at risk on the asset manager’s balance sheet. Business grows without capital investment. All cash can be paid out to shareholders. The risks are non-diversified asset managers can suffer from performance related outflows (like Janus in 2001-02 and Artio Investors currently). Look at the compounded returns of some asset managers for the last 15 years (not including dividends): Eaton Vance 20%, T. Rowe Price 16%, and Franklin Resources 13%, which compares favorably to the S&P 500 at just under 5%.
8. Retail Stock Brokerage – This entry may surprise some investors, but retail stock brokerage is very good business model. The business does not require much capital. The income generated by the business can be paid out to the shareholders or used for acquisitions. Customers have high switching costs because of their relationships with their brokers. Revenues grow as clients add money to their investment accounts or when the stock market rises. The problems with the business are the ongoing regulatory scrutiny, the cyclicality due to the stock market cycle and the potential for legal losses when customers lose money in the market and blame their advisors. Examples of how good the returns from these businesses can be are Stifel Financial which has compound its stock price at 27% annually for the last 10 years and Raymond James which has compounded at 19% annually since it came public in 1986.
7. Credit Card Network – The credit card networks are great businesses, specifically Visa and Mastercard. The business is an oligopoly where competitors can’t drive volume by cutting price. Visa and Mastercard don’t have capital at risk from lending. Instead, the bank that issue their cards have the lending risk. Even with the current regulatory scrunity, Visa and Mastercard don’t have a ton at stake with declining interchange because they capture such a low percentage of the interchange fee with the rest going to the issuing bank. The businesses grow minimal capital spending. Almost all cashflow can be paid to shareholders. On one hand American Express might be an even better business because it has reinvestment opportunities through credit card lending, but it also has higher risk because of its credit exposure. Plus, American Express has higher risk to interchange legislation.
6. Insurance Reciprocal – Insurance reciprocals are unique corporate structures that very few investors know about. An insurance reciprocal is like a mutual insurance company because it is owned by its policyholders. However, the insurance reciprocal has a management company that manages the business of the reciprocal for a fee. The management company is a great business because it earns a fee from a captive customer. All of the management company’s earnings are free cash flow because it doesn’t require capital to grow. The management company does not have any capital at risk. The only publicly-traded manager of a reciprocal is Erie Indemnity (ERIE). USAA and Farmers are well-known companies that are reciprocals, but their management companies are either private or are small divisions of much large insurers. Marsh McLennan’s private equity division has funded a start-up reciprocal, Privilege Underwriters Reciprocal Exchange. Without knowing the details of their financials, I’ve been hoping this company would have an IPO sometime soon.
5. Pawn Shops – Pawn Shops are a terrific business. The stores take in collateral for loans, charge high rates, and still make money if the loan defaults. The stores are able to make strong margins with almost no leverage compared to 12 times leverage at a commercial bank.
4. Alternative Asset Management – Alternative asset managers are great businesses. They are a step up from traditional asset managers because they earn an incentive fee, which makes them more profitable as a percentage of assets under management. Within the alternative asset management space, there are three tiers of attractiveness based on the stickiness of the assets under management. The lowest of the tiers are straight hedge funds. Hedge funds assets are the least sticky and the most vulnerable to performance driven outflows. Example of publicly traded hedge fund managers are Och-Ziff and Mann Group. On the next higher tier are funds with defined lies such as private equity or venture capital. Assets in this tier are sticky because they have a 5-year investment period and a 10-year harvesting period. The best tier are vehicles managing permanent capital, such as external managers of publicly traded companies. Some of these external managers are also publicly traded, such as Brookfield Asset Management, Fortress Investment, NuStar Holdings, Targa Resources Corp, Alliance Holdings GP, Kinder Morgan, and Energy Transfer Equity.
3. Ratings Agency – This will be the most unpopular entry on the list. The only companies more hated than Standard & Poor’s and Moody’s are Fannie and Freddie. The ratings agencies still have a strong competitive position. They receive fees for issuing opinions. The customers are often forced to get ratings. The volume of ratings increases with the growth of the capital markets. Most of the ratings agencies earnings are free cash flow and available to make acquisitions or return to shareholders. There are some lingering legal issues, but any legislative or regulatory changes look benign. These companies will continue to gush cash.
2. Discount Stock Brokers – The discount brokers are similar to retail brokers with the added benefits of faster growth and less legal issues in bear markets. Customers do not switch brokers often. There is an oligopoly among Schwab, Fidelity and Ameritrade. The industry is better positioned today than eight years ago because the pricing umbrella provided by Schwab is gone. Discount stock brokers are better businesses than traditional asset managers because they do not have performance risk and they own the customer relationship.
1. Futures Exchange – Operating a futures exchange is a great business because of the liquidity effect creates a competitive moat that blocks competitive threats from other exchanges. Buyers and sellers want to trade where there is the most liquidity, and their arrival at the most liquid markets creates more liquidity. Another important factor in the competitive barriers around futures exchanges is a futures contract be continuously margined through a clearinghouse, so to close a position, the contract must be sold on the same exchange it was bought. This is an important difference from a stock exchange where shares of a stock can be bought on one exchange and sold on another exchange. Futures exchanges have fixed costs and historically have had rising volumes. Futures exchanges, such as the CME Group, have demonstrated pricing power. The stock exchanges are still good businesses, but their competitive barriers are not as strong as the futures exchanges.
This list is an attempt to get you thinking about different business models within financial services. Financial services is not a homogenous sector where all companies respond to the macro environment identically.
Franklin Resources: Massive Fund Flows
Dec/100
Franklin Resources (NYSE: BEN) is a mispriced stock right now. BEN is benefitting from massive fund flows into its mutual fund complex. For the overall company through the first 9 months of the year, net fund flows are 11% of previous year-end assets under management (AUM). This is best among its peers, yet BEN is trading at a below average valuation even though its peers have less robust or even negative flows.
Here a comparison table showing publicly traded asset managers with market capitalizations above $2 billion. The table shows market cap, assets under management, net debt outstanding, EV/EBITDA, and 3rd Quarter fund flows and YTD fund flows expressed in terms of beginning assets. Companies are ranked by EV/EBITDA valuation. We can see from the table that BEN has best-in-class fund flows expressed as a percentage of existing AUM. However, it is the third cheapest stock in terms of enterprise value to EBITDA. 
Source – company reports
Asset Managers Have High Quality Businesses
Taking a step back to discuss the characteristics of the asset managerment industry, the asset management business model is one of the highest quality business models in existence. Asset managers have recurring revenue. They get paid on time in cash. They grow with market appreciation. With net positive fund flows, they can grow their revenues faster than the market. They have no balance sheet risk. They have minimal capital expenditure requirements. They can use their free cash flow to make acquisitions, buyback stock or pay dividends. Assets managers are one of the few segments of the Financials sector where generalist portfolio managers feel comfortable investing. Many PM’s hate the Financials sector because of the opaque balance sheets found at banks and insurance companies. But, asset managers are one of the few niches in Financials with low or no balance sheet risk. The others niches are the securities exchanges, the discount brokers, the financial transaction processors, and the insurance brokers.
Massive Fund Flows
BEN’s mutual fund flows are simply massive. Through the first 9 months of 2010, investors added $60 billion to BEN’s mutual funds. $60 billion is a huge amount of fund flows for one company. This is the equivalent of the entire company of Waddell & Reed being added to the BEN’s funds. These flows are easily the best among its peers. The table below ranks the asset managers (mkt cap >$2B) by their year-to-date fund flows expressed as a percentage of beginning of the year assets under management. 
Note – FII flows are for equity and fixed income assets only. Money market assets are excluded.
Diversified Asset Mix
Unlike smaller asset managers, BEN has a diversified asset mix. This adds stability to the franchise and reduces risk.
Source – company reports
Importantly, BEN has very little in money market funds. The money market business is at a cyclical low given low rates require fee waivers and given rate competition from banks. The longer-term issue with money market funds is the potential regulatory changes as a result of the need to bailout the money market industry after First Reserve broke the buck in September 2008. If there is a regulatory change that hurts the money market fund industry, it won’t be material to BEN.
Rock Solid Balance Sheet
BEN’s management keeps the balance sheet strong by holding a large amount of cash. As of September 30th, BEN had $5.8 billion of cash and only $1.0 billion of debt on its balance sheet. This amount of cash provides downside protection in the case of severe declines in the capital markets. Recently, management commented that the strong balance sheet helped them win new business for the first time as clients were attracted to the stability the balance sheet provided the organization.
Capital Stewardship
In addition to a strong balance sheet, management has been a good steward of shareholder capital. The company has not made transformative acquisition since acquiring the Mutual Series fund complex in 1998. Instead, growth has come organically. Management has used excess cash to steadily repurchase shares. They have managed the company’s capital to create more shareholder value.
Source – company reports
The table shows how BEN’s management has reduced shares outstanding overtime. While not perfect every year, it appears that the management only repurchases shares when the stock’s valuation is at the lower end of the range.
Low Valuation compared to Peers
BEN trades at just 7.7x EV/EBITDA, which is one of the lowest valuations of its peer group. I like to look at EV/EBITDA ratios to account for differences cash and debt outstanding across the asset managers. On this basis, only Federated Investors and Janus Capital have lower valuations than BEN. Both of these franchises have near term business issues than BEN does not have, so they deserve to trade at a discount to BEN. Federated has had serious outflows from its money market funds. Plus, as discussed above, it continues to grant fee waivers and faces a strong regulatory threat. Janus has had performance issues in some of its larger fund offerings in 2010, so their prospective fund flows are at risk.
At the other end of the spectrum, BEN is trading at a material discount to both T. Rowe Price and Blackrock. T. Rowe is a loved stock on the buy-side and commands a premium valuation. Reasons given for the premium valuation are the company’s strong retirement franchise and its high percentage of equity funds. I’d argue that based on fund flows Franklin has at least a comparable distribution franchise to T. Rowe, if not better. BEN should not trade at 3.5 EBITDA multiples cheaper than T. Rowe.
BEN’s discount to Blackrock makes no sense to me. I believe that the iShares acquisition made by Blackrock will prove to be a bad acquisition. The iShares acquisition was made at a high price and the business is going to suffer from coming price competition in ETFs. I would point to Vanguard’s refocus on the ETF business since 2008. Also, the 2011 entry of Russell Investments into the ETF business is problematic for Blackrock as the iShares ETFs based on the Russell indices are among the highest revenue generators in the iShares ETF line-up. Ultimately, the ETF business will become a commodity business with only the index providers extracting economic profits from the business. Blackrock has also missed the huge industry flows into actively managed fixed income funds (its original core franchise) due to portfolio manager turnover. Blackrock should trade at a discount to BEN. We’ve already seen the market recognize this as Blackrock’s shares have underperformed BEN’s shares in 2010: -25% to +10%.
Low Valuation Compared to Its Own History
BEN has a low current valuation compared to its own history. At 7.7x EBITDA, BEN is 2-3 EBITDA multiples below is average valuation over the past 7 years. This is at the same time its new business flows are the best they’ve been. If BEN traded up to its average of 10.5x EBITDA, the stock would trade at $154 or a close to 30% increase from today’s price. Of course, given its strong fund flows, it is easy to make the case that BEN should trade at the high end of its valuation range.
Risks to BEN
1. Concentrated Flows – BEN’s fund flows are concentrated into the Templeton Global Bond Fund. This fund has a great long-term record and has been uncorrelated with flows into U.S. domestic fixed income funds.
2. Industry-wide Flows into Fixed Income are heavy – Investors have been piling into fixed income funds aggressively over the past two years. If this were to change, BEN could see its fund flows change.
3. Margins are already high – BEN has less potential operating leverage than its peers because it already operates at high margins. This could be a reason why BEN trades at a valuation at the low end of its peer group.
4. BEN’s strong balance sheet reduces upside potential – A downside to holding cash on its balance sheet is it is tougher to get an attractive high return as a common shareholder.
5. Asset managers are leveraged to the capital markets – All asset managers are leveraged to the capital markets. If asset values fell across the capital markets, asset managers would see their income decline faster than the market.
6. Asset managers are exposure to personnel changes – All asset managers are at risk to turnover of fund managers. A fund manager departure can lead to negative fund flows.
Conclusion
I believe Franklin Resources is mispriced stock right now. Given its best in class fund flows and margins, it should trade at an EV-to-EBITDA valuation at the higher end of its peer group. The organic growth provided by its fund flows are very valuable to its shareholders. I own the stock outright in the Gator Blue Chip Portfolio and own the stock while shorting Blackrock for my long/short Financials-focused strategy. Please do your own research on BEN before buying it. I suggest you read the company’s securities filings at http://www.sec.gov/, read the last few years of earnings press releases, and listen to the last few years of quarterly conference calls. Disclosures: Long BEN, Short AB, BLK & JNS
Gator Capital’s Small Cap Portfolio Listed on kaChing.com Platform
Aug/100
FOR IMMEDIATE RELEASE
TAMPA, FL [8/27/10] — Gator Capital’s Small Cap Portfolio has been selected by kaChing to be a featured portfolio on the kaChing.com platform. kaChing.com is the nation’s leading online destination that connects independent investment managers with individual investors. The Gator Small Cap Portfolio earned an Investing IQ of 154 based on the risk-adjusted returns, quality of investment rationale and adherence to the stated management style.
Gator Capital Management, a private investment management firm, manages concentrated portfolios of stocks of high-quality businesses. High-quality businesses have durable competitive advantages, business models with attractive economics and management teams dedicated to creating shareholder value. Historically, Gator Capital’s portfolios have had low turnover, which has allowed management teams time to create shareholder value and has reduced taxes for our clients.
kaChing evaluates investment managers based on Investing IQ, a proprietary data-driven metric that separates the lucky from the good. Investing IQ is based on some of the same factors used by Ivy League endowments to select investment managers: risk-adjusted returns, quality of investment rationale, and how closely a manager sticks to their stated investment style. An Investing IQ of at least 140 is required to be listed on the kaChing platform, and Gator Capital is one of a select group of investment managers from across the country that has achieved this status.
“We are extremely pleased and excited to be included on kaChing’s platform of leading investment managers,” commented Gator Capital’s Portfolio Manager Derek Pilecki. “kaChing has made an important innovation in the financial advisory business to give investors the tools and transparency to hire independent investment managers directly. Their scalable technology creates efficiencies for both the investor and the investment manager.”
“Many investment managers have difficulty providing low-cost investment management services for smaller clients. At Gator Capital, we have received requests for investment management from many individuals with smaller amounts to invest,” explained Pilecki. “By working with kaChing, we are now in a position to offer our Small Cap Portfolio to people with as little as $10,000 and open a channel for investors to invest in our portfolios directly online.”
For more information or to open an account, please visit http://www.gatorcapital.com/ or http://www.kaching.com/gator-capital
About Gator Capital Management
Gator Capital Management is a boutique investment management firm dedicated to the professional management of focused, high‐quality growth investment portfolios for high‐net worth individuals and institutions. Gator’s Investment Philosophy is to build portfolios of stocks by viewing each stock purchase as an investment in the underlying business, by investing in high‐quality growth businesses, and by focusing its portfolios on its best ideas.
This press release does not constitute and is not intended to constitute an offer or solicitation for an investment in any Gator Capital’s investment portfolio, including the portfolios mentioned herein.
Contact:
Gator Capital Management
Derek Pilecki
Managing Member
+1 813 282 7870
derek.pilecki@gatorcapital.com
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Gator Small Cap Portfolio Starts the Year Off Strong
Mar/102
The Gator Small Cap Portfolio has had strong performance in the first 10 weeks of 2010. Through March 15th, the Gator Small Cap was up 9.3% after fees compared to 7.8% for the Russell 2000® Index. This continues the portfolio’s strong performance from 2009 when it was up 81.6% compared to 25.2% for the Russell 2000® Index.
We had several strong stocks in the portfolio to start the year. Tivo is up 63% year-to-date on the back of a favorable court ruling awarding the company monetary damages for continued infringement of its patents by a competitor. Brink’s Home Security is up 29% after a larger competitor agreed to acquire the company. Also, DineEquity, the franchisor for IHOP and Applebee’s, is up 46% so far in 2010 after reporting stronger earnings and a better than expected outlook for the rest of 2010.
The Gator Small Cap Portfolio holds a concentrated portfolio of 30 stocks of companies with market capitalizations under $3 billion at the time of purchase. We attempt to own smaller companies with strong franchises and business models with favorable economics. We want to hold onto the shares for multiple years to allow the management teams time to compound the strong economics of their businesses. During 2009, we had 30% turnover portfolio holdings.
We believe the Gator Small Cap Portfolio is a unique offering because it is a small cap portfolio offered in separately managed account form. In addition, the portfolio is concentrated which is unusual for a small cap portfolio. Lastly, our account minimum is $100,000, which makes the portfolio available to individuals with modest assets. Our clients may choose any broker or custodian to hold their account. If the client does not have an existing relationship, most of our clients take advantage of our relationship with Fidelity Investments.
Due to the Gator Small Cap Portfolio’s investments in small company stocks and the portfolio’s concentration of holdings, we expect the portfolio to have a much higher degree of volatility than the overall stock market. Please only invest money which you will not need for five or more years. Past performance is not indicative of future results.
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