Asset Management: Not Tapped Out Yet

Despite the flagging momentum of stocks in the sector, S&P likes the industry's fundamentals. One favorite: Franklin Resources

What do some investors do when companies in an industry that has outpaced the market over the past few years report blow-out earnings? Take profits, of course!

Stocks in the S&P 1500 Asset Management & Custody Banks subindustry index—Bank of New York (BK; recent price, $40), Franklin Resources (BEN; $118), and State Street (STT; $70), just to name three of the 15 component issues—have posted better-than-expected December quarter results. What's more, the group has returned superior price performances vs. the S&P 1500 index in each of the past three years. Year to date through Jan. 26, this group has again outperformed the overall market on a year-to-date and 13-week basis.

So why get skeptical all of a sudden? Take a look at the accompanying relative performance chart, which shows a group that has experienced eroding momentum since the second quarter of 2006. That's why.

Higher Margin Shift

As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's 17-year mean relative strength.

Matthew Albrecht and Frank Braden cover the asset management and custody banks subindustry for S&P Equity Research Services, but they think the group has more room to run and have a positive fundamental outlook for it. S&P expects strong earnings growth for many companies in the group for 2006 and 2007, driven by anticipated stock-market appreciation, continued net client inflows, prudent expense growth, and increased performance fees on alternative investments under management.

The analysts see a continuing mix shift toward higher-margin equity and global products aiding profitability, partly offset by a reduction or elimination of so-called "soft dollar" reimbursements by many firms, in an effort to avoid conflicts of interest.

Retirement Boost

Equity markets performed well in the fourth quarter of 2006, following mid-summer lows, and S&P expects the companies within this subindustry to benefit through net asset inflows. International expansion—not only exposing funds to global economies but also wooing potential investors—has been a top priority for many asset managers.

Albrecht and Braden view this as a long-term catalyst in the industry. They also believe that new accounting rules for corporate pension accounts may result in opportunities for new institutional accounts. The analysts note that net asset inflows were strongest to institutional accounts during the third quarter, with wrap (fee-based) accounts and target-date retirement funds also finding favor with investors.

S&P believes an aging population attempting to make up for lost retirement savings will support fund growth. It also thinks efforts to reform Social Security could provide an additional stimulus for industry participants, but doesn't see a quick resolution. However, Albrecht and Braden think industry growth could be partly offset by reduced asset-management fees, due to increased competition, notably from index and exchange traded funds.

Fundamentally Solid

For 2006, the S&P Asset Management & Custody Banks index rose 16.9%, vs. a 13.3% increase for the S&P 1500. Despite the strong results, the analysts note that price-earnings multiples in this subindustry haven't expanded as they would expect, leaving room, in most cases, for appreciation, in their opinion. They expect larger companies with strong relative fund performance, broad product offerings, and diverse distribution channels to outperform the group, while companies tainted by regulatory issues should underperform.

Furthermore, S&P sees greater upside for equity-oriented companies based on its belief that global equity markets will experience multi-year gains, and that appreciation in bond prices over the last several years is unsustainable, given rising interest rates.

So there you have it. Even though it appears as if the subindustry's longer-term momentum leadership is waning, S&P believes the group's fundamentals appear to be intact. Of the stocks mentioned in this report, S&P has a 5 STARS (strong buy) recommendation on Franklin Resources, and 3 STARS (hold) rankings on Bank of New York and State Street.

Industry Momentum List Update For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Industry Company S&P STARS Rank Price (1/26/07)
Apparel, Accessories & Luxury Goods Coach (COH) 5 $44
Broadcasting & Cable TV Comcast (CMCSA) 4 $43
Department Stores Federated Dept. Stores (FD) 4 $40
Diversified Metals & Mining Freeport-McMoRan (FCX) 4 $58
Fertilizers & Agr. Chems. Monsanto (MON) 3 $56
Integrated Telecom. Svcs. CenturyTel (CTL) 3 $44
Investment Banking & Brokerage Merrill Lynch (MER) 5 $95
IT Consulting & Other Services SRA Intl. (SRX) 5 $25
Metal & Glass Containers Ball Corp. (BLL) 4 $46
Motorcycle Manufacturers Harley-Davidson (HOG) 2 $71
Movies & Entertainment Walt Disney (DIS) 5 $35
Steel Carpenter Technology (CRS) 4 $112
Tires & Rubber Goodyear Tire & Rubber (GT) 3 $25
Before it's here, it's on the Bloomberg Terminal.