Research

If you can’t beat ‘em, join ‘em

When Kevin Durant looked across the court on May 30th, 2016, it’s likely the sense of defeat truly rolled over him. He hadn’t just lost Game 7 of the Western Conference Finals to the Warriors, he was looking at a juggernaut that was set up to keep on winning. He couldn’t see a way his Thunder could beat them.

His solution? To join the Warriors the next year, creating a world eating line-up that dominated the NBA for several seasons.

Many active managers are likely starting to feel the same way about passive investing strategies. Every time investors look up, passive investing has taken more AUM from active investors. Relative to many active managers, passive has also offered better performance.

Portfolio managers and analysts don’t have it as easy as Kevin Durant did. Most of them can’t just walk over to BlackRock and join the team.

And recently, trying to follow along with BlackRock by buying the stock has not been any more beneficial than fighting against them. The stock has fallen from above $500 in early 2018 to below $450 today.

BlackRock has seen equity AUM declines. Also, as-reported ROA for BlackRock is incredibly low, at below 2%. Perhaps BlackRock is starting to lose its step. Perhaps the move back to active managers has begun?

In reality, our Uniform Accounting shows that not to be the case. While the market has beaten the company up recently for those short-term issues, at the current stock price the market misunderstands how profitable BlackRock is. And it looks like they are starting to see fundamental momentum shift in a real way that might make the market start to see the error in its ways.

I’m in Chicago this Friday

This Friday, I’m presenting at the Driehaus College of Business at DePaul in Chicago. The free event is at 9am, at the campus in the Loop

I’ll be presenting my popular presentation “Give My Regrets To Wall Street” at 9am.

I’ll be highlighting my thoughts on why Wall Street’s fixation on as-reported earnings and forecast of earnings has led to the dark side of financial statements analysis.

If you are interested in joining us on 10/18, from 9am-10:30am CT, please RSVP.

Seating is limited, so let us know if you’re interested, and we’ll be sure to save you a seat. You can reply to this email, or email Andy Aronson (andrew.aronson@valens-research.com).

I look forward to seeing you there.

Market expectations are for Uniform ROA compression, but management is confident about their alternatives franchise and bond ETFs

BLK currently trades near recent averages relative to UAFRS-based (Uniform) Earnings, with a 15.9x Uniform P/E. At these levels, the market is pricing in expectations for Uniform ROA to compress from 32% in 2018 to 20% by 2023, accompanied by 7% Uniform Asset growth going forward.

Meanwhile, analysts have less bearish expectations, projecting Uniform ROA to only decline to 30% in 2020, accompanied by 1% Uniform Asset shrinkage.

Historically, BLK has generated robust, somewhat cyclical profitability. After improving from 21% in 2003 to 33% in 2006, Uniform ROA compressed to 18% in 2007, before expanding to a high of 41% in 2010, as the firm took advantage of a weak competitive landscape during the Great Recession. Thereafter, Uniform ROA gradually compressed to 29% in 2014, before expanding to 34% in 2015 as the firm took advantage of shifts toward passive management, and most recently fading to 32% in 2018. Meanwhile, the firm has seen relatively consistent Uniform Asset growth, positive in 12 of 16 years, and ranging from -16% to 43%, excluding outlier 228% growth in 2006 when the firm merged with Merrill Lynch’s asset management segment.

Performance Drivers – Sales, Margins, and Turns

Trends in Uniform ROA have been driven by improvements in Uniform Earnings Margin and cyclicality in Uniform Asset Turns. After expanding from 25% in 2003 to 30% in 2004, Uniform Margin compressed to 16% in 2005, before improving to and stabilizing at 31%-35% levels from 2008 to 2018. Meanwhile, Uniform Turns expanded from 0.8x-0.9x levels in 2003-2004 to peak 2.0x levels in 2005, before compressing to 0.6x in 2008. Thereafter, Uniform Turns increased to 1.3x in 2010, before compressing to 0.9x in 2014, rebounding to 1.1x in 2016, and fading to 0.9x in 2018. At current valuations, markets are pricing in expectations for continued compression in Uniform Turns, coupled with a reversal of recent Uniform Margin expansion.

Earnings Call Forensics

Valens’ qualitative analysis of the firm’s Q2 2019 earnings call highlights that management is confident they had a lower diluted share count in the current quarter and that they have continued momentum in their alternatives franchise. Furthermore, they are confident their minority investments are part of their capital management strategy, and they are confident about the future growth opportunities they see for their bond ETFs.

However, management is also confident total expenses increased due to acquisition-related expenses, and they may be concerned about investors rebalancing out of equities into fixed income. Furthermore, they may lack confidence in their ability to capture clients’ asset class preferences, and they may be concerned about their global positioning. Additionally, they may be concerned about further declines in their operating income, and they may lack confidence in their ability to continue their share repurchase program. Finally, they may be concerned about the impact of their recent iShares ESG Fund launch.

UAFRS VS As-Reported

Uniform Accounting metrics also highlight a significantly different fundamental picture for BLK than as-reported metrics reflect. As-reported metrics can lead investors to view a company to be dramatically stronger or weaker than real operating fundamentals highlight. Understanding where these distortions occur can help explain why market expectations for the company may be divergent.

Uniform Accounting metrics also highlight a significantly different fundamental picture for BLK than as-reported metrics reflect. As-reported metrics can lead investors to view a company to be dramatically stronger or weaker than real operating fundamentals highlight. Understanding where these distortions occur can help explain why market expectations for the company may be divergent.

As-reported metrics significantly understate BLK’s asset efficiency, a key driver of profitability. For example, as-reported asset turnover for BLK was 0.1x in 2018, materially lower than the Uniform Turns of 0.9x, making BLK appear to be a much weaker business than real economic metrics highlight. Moreover, as-reported asset turnover has remained at 0.0x-0.1x levels since 2009, while Uniform Turns have ranged from 0.9x-1.3x in this timeframe, distorting the market’s perception of the firm’s historical asset efficiency trends.

Today’s Tearsheet

Today’s tearsheet is for Alibaba. Alibaba trades at well above market average valuations, but even at these levels, the market is undervaluing the company’s growth opportunities. The company has grown and is forecast to continue to grow earnings significantly faster than the market is pricing in. Alibaba also has well above corporate average returns.

Regards,

Joel Litman
Chief Investment Strategist