Description

Recommendation:
A few years ago I recommended BlackRock as a pair trade (long BlackRock and short IGM Financial).  Today I’m recommending BlackRock as a standalone long.

BlackRock is consistently taking share in the asset management industry, and these share gains are highly likely to continue, making it a long-term compounder.  Despite being a great business, BlackRock is trading at a market multiple (19x LTM EPS).  Of course, the best time to buy BlackRock is during a market correction, but even at today’s price, I believe BlackRock is a good long-term holding.

Company Description:
BlackRock is the world’s largest asset manager with $4.9 billion in AUM.  BlackRock’s AUM is diversified by product, client type, style, and region.  Unlike other publicly-traded peers, BlackRock generates a large and increasing portion of its revenue from passively-managed products.  BlackRock greatly expanded its exposure to passively-managed products with its purchase of Barclays Global Investors and its iShares franchise in 2009.  iShares ETFs and other index products now represent 61% of current AUM, 41% of LTM investment advisory revenue, and, I estimate, over 50% of the Company’s operating profit.

Sources: BlackRock SEC filings

BlackRock is a consistent market share gainer:

Sources: BlackRock SEC filings, BCG annual Global Asset Management Reports (freely available online)

There are two main reasons why BlackRock is (and likely will continue to be) a share gainer:

1) There is a secular trend of increasing allocations to ETFs and other passively-managed products
The sales pitch for passively-managed products is simple: they are lower cost, and as a result, they outperform their average actively-managed counterparts.  While some active managers beat the market, by definition only a minority can do so, and it is difficult for investors to identify those managers ahead of time.  Importantly, the sales pitch for passive management holds true across all market environments.  Explains William Sharpe (of Sharpe Ratio fame): “If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.  These assertions will hold for any time period.  Moreover, they depend only on the laws of addition, subtraction, multiplication and division.”   As a result, ETFs and other passively-managed products have increased their share of global AUM from less than 10% a decade ago to 15% today (BCG annual Global Asset Management Reports).  But at only 15%, there is still plenty of runway for this trend to continue.

2) BlackRock is one of the dominant players in passively-managed products

Source: ETF.com data

With its iShares brand, BlackRock is the number #1 ETF provider with 37% share worldwide; in addition, they have over 20% share of the non-ETF index market.  Whereas scale can often be a hindrance for an active manager, scale is beneficial for a passive manager.  In the ETF space, BlackRock’s ETFs are differentiated by superior liquidity, investor familiarity, and low cost, factors which all protect incumbent market share.

ETF providers that establish the de facto standard ETF for a market segment enjoy a virtuous cycle whereby increased liquidity makes the ETF the most attractive one in its segment, which in turn leads to even greater liquidity.  For example, see the menu below of ETFs available for investing in the German stock market:

EWG (a BlackRock offering) was the first ETF established in the segment, and as a result, it offers the best liquidity, which in turn makes it well suited for larger investors.  As a result, even though it isn’t the cheapest ETF in the space, EWG commands 80% of the AUM in the segment, with HEWG, its currency-hedged companion, garnering another 11% of share.

Evidence of this virtuous cycle dynamic can be seen in the stability of ETF inflow market share for BlackRock.  For predominantly active asset managers, net flows vary considerably from year to year based on the relative performance of the manager’s funds.  But for BlackRock, its share of ETF inflows is consistently positive:

Sources: BlackRock filings, iShares Monthly ETP Landscape publications

Flows to BlackRock’s ETFs have been positive in 25 of the 26 quarters since BlackRock acquired the iShares franchise.

Share gains + operating leverage = double-digit EPS compounder
Led by its ETF business, BlackRock as a whole is outpacing the industry in generating inflows:

Asset Manager Basket includes BEN, IVZ, TROW, LM, AMG, AB, EV, JNS, WDR, APAM, FII, WETF, VRTS, CNS, GBL, MN.  Data from company filings

Passively-managed products (61% of BLK’s AUM, 41% of investment advisory revenue and >50% of operating profit) have inherently greater operating leverage than actively-managed products, since increases in revenue don’t tend to be paid out in higher compensation for portfolio managers.  As a result, BlackRock’s inflows have led to margin improvement; BlackRock’s LTM operating margin of 42.8% is up 350 bps from the first full year of iShares ownership:

Note that margins have come down slightly since the 2Q15 peak.   The recent decline is due primarily to a mix shift towards fixed income (32% of average AUM in the current LTM period vs 30% in the LTM period ending 6/30/15), which tends to generate lower fees than equity products - but I believe the long-term margin improvement thesis remains intact.

The combination of continued share gains and operating leverage has resulted in BlackRock growing EPS at a 10% CAGR since 12/31/10 (first full year of iShares ownership):

Going forward, earnings growth will vary from year-to-year as markets go up and down and as AUM mix fluctuates between fixed income and equity products.  But over the long-term, I believe BlackRock’s moat in its ETF and index products businesses will allow it to continue to take share in the asset management industry, continue to generate operating leverage, and continue to generate double digit EPS growth on average.  These characteristics, combined with the stock priced at a market multiple, make BlackRock a good bet to outperform the market over the long-term.

Risks:

1) Bear market for stocks and bonds:
A bear market is a risk for every stock, but doubly so for an asset manager, as revenue and earnings are driven by AUM, which rises and falls with the market.  Obviously, the best time to buy BlackRock (or any stock for that matter) is after a market correction, but I am unable to predict when the next major downturn will happen, so I’m content to own BlackRock now even though it feels like we’re in the later innings of a bull market.  Even if you do buy BlackRock at the peak of the market, I still think you’re likely to outperform the market in the long term.

Had you bought BlackRock at the peak of the market on October 9, 2007, there wouldn’t have been a single day where your BlackRock holding, measured from its October 9^th purchase date, would have cumulatively underperformed the S&P 500.

Had you bought BlackRock at the April 2010 market peak, you would have underperformed for a while; it would have taken nearly 3 years before your BLK investment surpassed the total return of major stock market indices.  Had you bought BlackRock at either the April 2011 or April 2012 market peaks however, it would have been less than nine months from purchase before your investments in BlackRock turned into an outperformer.

2) Poor performance in BlackRock’s actively-managed products drives outflows that more than offset the inflows generated by its passively-managed products:
Mitigants to this very real risk include 1) BlackRock’s actively-managed business is so large and diversified that it’s hard for BlackRock’s many actively-managed products to screw up performance-wise at the same time, and 2) actively-managed products are becoming less important to the story every year.

3) Pricing pressure in ETFs:
Price cuts in the ETF industry have been occurring for several years.  BlackRock has still managed to grow margins however because 1) incumbent ETFs benefitting from first-mover advantage and established liquidity tend to maintain market share against lower-cost competition (see above discussion of German stock market ETFs) and 2) BlackRock has a higher mix of less fungible ETFs than peers like State Street and Vanguard.

In October of 2012, BlackRock reacted to pricing pressure in the ETF industry by launching its “Core” brand of ETFs.  BlackRocks’ “Core” ETFs are similar to existing BlackRock ETFs, just with lower fees.  For instance, if you want to invest in a BlackRock emerging markets ETF, you can choose either the iShares MSCI Emerging Markets ETF (ticker EEM), or the iShares Core MSCI Emerging Markets ETF (ticker IEMG).  If you prioritize lower costs, then IEMG is the better solution with its 0.16% expense ratio (vs. 0.69% for EEM).  If you prioritize liquidity, then EEM is the better solution with average daily trading volume of $2.3 billion (vs $244 million for IEMG) and a lengthy list of trade-able options strikes.  The fact that the relatively high-cost EEM continues to maintain higher AUM ($27 billion) than low-cost substitute IEMG ($14 billion) offers further evidence that volume in the ETF space does not necessarily migrate to the lowest cost.

Catalyst

Continued share gains