This post originally appeared on gatorcapitalblog.com on March 11, 2011.
As a hedge fund manager who specializes in 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 overlooking 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 risks 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 a 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 issues their cards has the lending risk. Even with the current regulatory scrutiny, 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 a higher risk because of its credit exposure. Plus, American Express has a 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 is 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. Rating 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 rating 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 rating 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.