3 Bargains as Fiduciary Rule Set to Take Effect
Our financial sector valuations and moat ratings already account for the new standard, and these three firms look undervalued today.
Financial sector firms will have to gear up for implementation of the U.S. Department of Labor’s conflict of interest rule, as it’s been affirmed that major portions of the fiduciary rule will become applicable June 9.
On that day, those providing advice on retirement assets will be considered fiduciaries and will have to comply with the impartial conduct standards of the rule to receive particular forms of compensation, such as commissions. Some of the more operationally intensive aspects of the rule, such as entering into a best-interest contract with clients and certain disclosures, aren’t scheduled to be implemented until Jan. 1, 2018.
We are maintaining our fair value estimates and moat ratings for the financial sector firms we cover, as we have long held that the United States would eventually adopt more fiduciary-like standards, and the continuation of financial sector trends, such as increased use of passive investment products and fee-based accounts, is already firmly established.
While some might view the Department of Labor’s field assistance bulletin with its emphasis on “assisting (rather than citing violations and imposing penalties)” during the transition period, we would note that other parts of the bulletin and the frequently asked questions section seem to indicate that the Department of Labor wants to see real changes at firms even during the interim period. The bulletin states, “The department will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the fiduciary duty rule and exemptions.” The assistance, instead of penalties, from the department is conditioned on good-faith efforts from the financial firms. Additionally, while many disclosure requirements don’t come into effect until Jan. 1, 2018, the FAQs regarding recommendations with conflicts of interest state, “The adviser should be candid about the compensation and the limits on investments.”
The impartial conduct standards are a core part of the fiduciary rule package that goes into effect June 9 and is based on three tenets. (1) Advice should be in the best interest of the retirement investor. This means that the advisor adheres to a professional standard of care and puts the interests of the client before its own financial interest. (2) The advisor charges no more than reasonable compensation. (3) The advisor doesn’t make misleading statements.
We agree with the Department of Labor that even with these minimum principles in place for financial advisors and wealth management firms during the interim period, retirement investors will begin to accrue the benefits that the DOL quantified in its regulatory impact analysis.
BlackRock is at its core a passive investor. Through its iShares exchange-traded fund platform and institutional index fund offerings, the wide-moat firm sources close to two thirds of its managed assets (and nearly half of its revenue) from passive products. In an environment where we expect investors and the advisors that serve them to seek out providers of passive products, as well as active asset managers that have greater scale, established brands, solid long-term performance, and reasonable fees, we like how BlackRock is positioned. The biggest differentiators for the firm are its scale, ability to offer both passive and active products, greater focus on institutional investors, strong brands, and reasonable fees. We believe BlackRock’s iShares ETF franchise, augmented by a technology platform that offers risk management and product/portfolio construction tools directly to end users, making them stickier in the long run, should allow the firm to generate higher and more stable levels of organic growth than its publicly traded peers the next five years.
We continue to be impressed by BlackRock’s ability to generate solid organic growth, especially considering the size of its operations. With $5.420 trillion in total assets under management at the end of March, it is the largest asset manager in the world. Unlike many of its peers, BlackRock is generating organic growth with its operations, with its iShares platform, which is the leading domestic and global provider of ETFs, riding a secular trend toward passively managed products that began more than two decades ago. This has helped the firm to maintain average annual organic growth of 3%-5% in the past several years despite the increasing size and scale of its operations. With BlackRock producing better and less volatile assets under management, revenue, and profitability growth, as well as having less execution risk than its peers, it should continue to garner the premium valuation it has enjoyed relative to the group. We expect the firm to generate high-single-digit to double-digit earnings per share growth the next five years.
Greggory Warren, CFA
T. Rowe Price (TROW)
T. Rowe Price has produced impressive growth in assets under management and revenue during the past decade thanks to its strong brand, solid fund performance, and mostly favorable market conditions. Although its record of strong organic growth has been challenged of late, with the company reporting only its second period of negative organic growth during the past 10 years during 2016, it has done much better than peers with similarly equity-heavy lineups. Total outflows of $3.4 billion last year were driven primarily by outflows from equity/balanced mutual fund products, with the $9.9 billion that flowed out of these funds reflective of a negative 2.6% rate of organic growth. This was better than the industry overall, which posted a blended organic growth rate of negative 6.8% during 2016, driven by a record $264 billion in outflows from active U.S. equity funds. With 82%, 79%, and 85% of T. Rowe Price’s mutual funds beating their peers on a 3-, 5-, and 10-year basis, respectively, at the end of the first quarter of 2017, we expect the firm to continue generating better organic growth than the industry.
T. Rowe Price has had a far stickier set of assets than its peers, with just over two thirds of its assets under management held in retirement accounts and variable-annuity investment portfolios. We continue to believe the bulk of T. Rowe Price’s long-term organic growth will come from its target-date retirement fund platform, which features predominantly in defined-contribution plans and has over the past 10 years grown from around $21 billion in total assets under management to $203 billion at the end of the first quarter of 2017. Organic growth for these funds, which offer investors a way to invest for retirement based on their expected retirement date, has averaged around 2.0% on a quarterly basis the past few years and should average 1%-3% quarterly as we move forward. While there was concern raised when the firm reported $1.9 billion in outflows from its target-date platform during the fourth quarter of 2016, it has since revised that to $63 million in outflows. We expect total inflows from target-date portfolios this year to be below last year’s $8.1 billion total.
Greggory Warren, CFA
Wells Fargo (WFC)
Wells Fargo is the top deposit gatherer in the United States. Its strategy rests on deep customer relationships, sound risk management, and operational excellence. Successful execution of this strategy over decades has resulted in a wide economic moat, clearly evidenced in the company’s financials. Wells Fargo funded its balance sheet 40% more cheaply than North American peers with more than $50 billion in assets over the past five years, paying an average of only 30 basis points in interest expense on total assets. It was also able to generate 30% more revenue per dollar of assets than the same peer group. We attribute this low-cost funding to a loyal base of longtime customers.
Wells Fargo’s leading position in the mortgage market--and its high-quality mix of home loan customers--also contributes to its competitive advantage. The firm benefits from economies of scale in both origination and servicing and targets prime customers for government-sponsored enterprise-eligible and prime loans. We believe the ability to build on durable deposit and mortgage lending relationships is a solid foundation for the bank’s strategy.
Unlike its major competitors, Wells is not a top player in the capital markets. Its business model is more akin to a regional bank than to a money center institution. According to the Financial Times, Wells Fargo generated less than half the investment banking fees in 2016 than companies like JPMorgan Chase (JPM), Goldman Sachs (GS), and Bank of America (BAC). Trading gains made up only 2% of noninterest income. Instead, Wells Fargo relies on the more stable revenue generated by its brokerage, advisory, and asset management businesses.
Wells Fargo’s sales culture did overheat in recent years. Rather than attempting to improve its customers’ financial lives, management chose to increase revenue at all costs, introducing ill-conceived incentive programs for front-line employees. This decision led to widespread fraud and risked relationships and reputation built over decades. However, the company’s monthly disclosures show that the worst of the effects has passed--retail loyalty metrics have already returned to prescandal levels.
Michael Wong does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.