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.
Make Fannie’s Deal No Worse Than TARP
Aug/090
Given Freddie Mac’s recently report profitable 2nd quarter earnings report, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.
Reasons to Change Fannie and Freddie’s Deal with the Treasury
1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut 4 weeks before TARP.
2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson.
6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock. It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios.
9. GSE preferred stock is still primarily owned by small banks. When dividends are restored, the value of the preferred stock will increase by 10x. This will add approximately $30 billion in restored capital to the commercial banking industry. If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.
Terms to Change
1. Lower Preferred Stock Coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point. We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.
The GSEs deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.
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