Sunday, December 4, 2011

Economic Commentary: Eurozone crisis and Depression era politics - Ari

First I'll briefly discuss the Eurozone crisis and then delve into the possibility that the US will repeat depression era politics and fiscal policies.

The Eurozone crisis is truly in the endgame. Investors began shunning even German debt in the past two weeks and the EU leaders responded by swiftly negotiating for fiscal union. There is now a consensus that Europe must begin the formation of a fiscal union in the very near future (probably within 4 weeks) or face a self-fulfilling spiral into disintegration The big announcement three days ago of coordinated central bank intervention only prevented the collapse of several European banks this week. It basically provided unlimited overnight funding to avoid liquidity problems. It did not deal with the sovereign debt issue at all. A possible short-term bandaid that's being talked about is an $700 billion+ bailout for Italy that would include IMF funding. This would require a vote by Congress, and it looks like Republicans are unlikely to approve this. The real solution is to turn the eurozone monetary union into a fiscal union, but Germany wants to walk a fine line. They are advocating a fiscal union but say that the issuance of eurozone bonds is completely off the table. They're demanding almost unilateral control over the eurozone budgetary process, which is unacceptable to France. The ECB is currently standing firm against monetizing the debt of the profligate countries, but suggested they will be willing to step in aggressively if there is a credible plan for fiscal union in the future. I'm not an expert on European politics, but I'd guess that there's a 40% chance they'll form a meaningful fiscal union, a 35% chance the eurozone dissolves, and a 25% chance of something in between (e.g. a two-tiered euro or a couple countries leave). I've been short a small number of euros for the past two years and have scalped around the last couple weeks, but am retaining a small short position. We will likely get a major announcement within the next 10 days.

In the Great Depression, the economic consensus was for a policy of fiscal austerity. The wealthy banker Andrew Mellon advised president Herbert Hoover to, "liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people." Today economists understand that in a recession, companies and consumers deleverage, so the government must increase spending or you can get a downward spiral. To take a simple example, consider bank assets. In 2008, many banks were leveraged 40 to 1 or even 150 to 1. That means that if asset prices fell by just 2%, these banks were insolvent. When asset prices fall 1%, banks start selling assets to raise capital; this selling sends prices down further forcing more selling, which sends prices down further and so on. In the classical view of the free market system, smart buyers will step in to buy up these underpriced assets. But what if there's more forced selling than money available to buy? If the majority of investors try to sell at the same time, prices will continue collapsing until some new source of buying power enters the system. Partly because of President Hoover's fiscal austerity measures, the Great Depression became deeper and lasted longer than necessary.

Ben Bernanke learned this lesson and in fact wrote several academic papers on how the central bank should have "dropped money from a helicopter" back in 1930 to prevent the depression. Bush, Obama, Paulson, and Geithner were also determined to avoid repeating history and they launched the most ambitious fiscal stimulus projects since the New Deal. However, the political sentiment today is that we have little to show for the spending and money printing, and the excessive deficit is the biggest problem.

I see two likely political paths that both lead to bearish outcomes. The first is that the market and unemployment continue to improve through election day and Obama is re-elected. By choice or because he simply can't get Congress to pass any spending bills, government spending shrinks. This will happen automatically unless Congress reverses the automatic spending cuts that were part of the debt ceiling legislation this summer. Obama will likely resist republican pressure for even greater spending cuts and will be painted as profligate. Within a couple months of the next term, I would expect markets to be turning downward in anticipation of next recession that these spending cuts will almost inevitably create. Obama gets blamed for the worsening economy, and 4 years later we get a "tea party" style candidate who takes austerity to an extreme and creates deflationary pressure for an additional 4+ years.

The second path is that the government is unable to "juice" the economic data into election day and Obama loses. The republican led government imposes austerity which creates a recession. The negative effects of the austerity are quickly visible and the next candidate reverses course with mild "New Deal" type policies. Either way, it seems like we're going to be getting some form of fiscal austerity in the next few years that will be very bearish for the markets. Historically, the stock market has rallied strongly in the 4th year of a president's first term; the president has the ability and incentive to "juice" the markets in all sorts of ways. I wouldn't be surprised by a repeat heading into the upcoming presidential election and will be looking to buy equity puts if the rally happens.

It's worth repeating a key theme in this commentary of the last two years: company revenues, profit margins, and balance sheets are healthy; but only because of the exceptional fiscal and monetary policies. Back in 2008, the Fed made $7.7 trillion in loans to banks (the exact number was just made public recently), from which the banks profited directly by at least $13 billion. Of course, they profited much more indirectly by being able to avoid costly liquidations and continue funding their core operations. Similarly, the fiscal stimulus has mostly wound up in the coffers of large corporations. As soon as the US deficit shrinks, we'll see profit margins fall immediately, and revenue growth will likely decline after a small lag.

Friday, December 2, 2011

Blackrock (BLK) is a decent buy with high beta to equity markets - Alpha


BlackRock, Inc. (BLK) is an independent investment management firm with $3.345 trillion of assets under management (“AUM”) at September 30, 2011. BLK focuses exclusively on investment management and risk management, with no proprietary trading or other activities (like banking). BLK invests capital throughout the world and its clients include taxable, tax-exempt, and official institutions, plus retail investors and high net worth individuals. After combining with BGI in 2009, Blackrock has a platform of active (funds and managed accounts) and passive (ETF/index) products. Big competitors are Allianz (DB:ALV), State Street (STT), Franklin (BEN), Invesco (IVZ), Legg Mason (LM), and Fidelity (private).

BLK generates most of its revenues from fixed fees as a percentage of AUM; performance fees on a small asset base are much more volatile and adding or reducing revenues by 1% (so while most of this benefit flows to margins, it is variable and seen as a boost and not as core). The two largest topline drivers of BLK’s business, then, are total AUM overseen and the level of fixed fees, which varies by segment (it is higher for alternatives, lower for fixed income). Active equity, iShares, and active fixed income are the three largest product lines, accounting for 53% of total revenue. For expenses, employee compensation is by far the largest (36%), with G&A being almost half that.


Diversified investment product platform not-reliant on any asset class, fund, or region. As of December 2010, 67% or revenues are from the Americas and the rest from Europe and Asia-Pacific. The AUM base is split between equity (48%), fixed income (32%), multi-asset class (5%), alternatives (3%), and cash management (8%). The AUM mix is also split between active (38%), institutional index (43%), and ETF/iShares (19%). BLK’s strategy is to offer every type of product to clients, though its historical strength has been in fixed-income and ETFs (via BGI). As the CEO Fink noted on his recent earnings call, clients are reaching for yield and income products in the current uncertain environment, and BLK can promote existing products that meet this need.

Strong FCF generation and smart allocation of capital (though weak cash). As the chart to the left shows, BLK generates about $2.5bn of OCF with only $200-300mn of capex required. It pays a solid 4% dividend yield. One problem: currently if you add BLK’s excess cash balance of $2.92bn, its $1.40bn of investments, and deduct $4.79bn of total debt, BLK has -$0.47bn of net cash and investments. The lack of capital was driven by the recent capital drain from the BAC ownership repurchase. However, BLK is increasing its cash balance by natural cash flow generation.

BLK's Cash Flows and Dividends are Attractive

Superior management team and board. The management team headed by CEO Larry Fink is one of the best in the investment management business. No other publically traded investment management firm has anything like it. The company also has a strong board of financial experts (John Varley, Bob Diamond, Tom Montag, Deryck Maugham, Bill Demchak, etc.), unlike many other financial companies with general corporate or non-profit execs on their boards.

Valuation. Consensus forecasts for 2012 and 2013 suggest BLK will earn $12.5 and $14.4 per share in 2012 and 2013 for a 13.5x and 11.7x forward P/E. Compare BLK to peer multiples which trade in the 11x to 13x range. The FCF yield on the current price is about 4.4% based on 2010 FCF figures (OCF-capex), which is attractive when the 10-yr UST yields ~1.9% and the Barclays Aggregate yields ~2.4%. A DCF valuation suggests that BLK common stock is worth between $197 to $255 (key assumptions are revenue growth rates from 4.4%-7.0% with constant margins and equity discount rates of 9.1%-10.4% per the CAPM). The free cash flow yields on BLK are strong but its ROE at 6.4% is weak.


Active products could see outflows if they underperform peers, plus securities lending is a risk. Revenues in the active equity products can be quite volatile as AUM fluctuates. While the ETF and fixed income products are stable, the reputation risk of a real estate fund or niche equity fund blowing up could adversely affect other active products. Securities lending is akin to picking up dimes in front of a bulldozer. While BLK claims to only do this for clients and not take principal risk, investors should worry about risk controls in such a business.

Competitive fee pressures, low barriers to entry, and clients internalizing asset mandates could hurt pricing and revenues. Fees in BLK’s business range from 20bps to 2/20% deals for alternative funds. In general, the barriers to entry in the investment business are low as two people in an office with a computer terminal can compete. Also, as CEO Fink mentioned in his latest conference call, a worrisome trend is that some large plan sponsors may be internalizing investment operations to bring down costs; losing $10-$50bn mandates at a time is a risk.

Merrill Lynch or Barclays may fail in their distribution and backstop roles. First, Merrill Lynch provides distribution, portfolio administration, and servicing for certain BLK products and services through its various distribution channels. Loss of market share within Merrill Lynch’s Global Wealth & Investment Management (GWIM) business could harm BLK’s operating results (distribution concentration risk). Second, Barclays has certain capital support agreements in favor of a number of cash management funds acquired in the BGI Transaction; this lasts till December 2013. Failure to meet these could cause a cash squeeze at BLK.

Concentrated control of BLK stock by the board. Approximately 28% of the BLK’s common stock is held by Barclays and PNC. Both entities have given proxy control of their ownership to the board, which now has strong corporate governance control but significantly different economic upside vectors. This could lead to agency problems and the latest proxy statement suggests executive compensation is high (the top 3 execs earned about $20 million each in 2010).


• Possible Catalysts: No clear catalyst other than strong continued revenue and earnings growth. Weak global equity market performance could be a downside catalyst.
• Market Misperception: BLK, like most asset managers, trades at a P/E discount to other firms with similar cash flows due to the perceived volatility from their AUM and revenue sources. To the extent that BLK is diversified and has many passive products, its revenue volatility could be much lower (justifying a higher premium).
• Price Movement: The stock has moved within the $140-$240 price range in the last few years after bottoming at $92 in the 2009 trough.
• Buy, Sell, and Stop-loss Points: Target = $220.0, Current price = $169.02, Undervaluation = ~23%
• Recommendation: BLK is a fair BUY because it is a large-cap stock that is misunderstood by many sell-side analysts and large buy-side institutions. The current valuation gap is barely enough to make this underappreciated “blue-chip” stock a buy - it is roughly priced below the market with a potential for 3% to 5% of alpha over the next few years. BLK is a decent security to hold in a moderately concentrated pool of 15-20 securities for the financials bucket of the portfolio, instead of highly levered broker-dealer or commercial banks. Alternatives like V or MA should also be considered.