TROW And Franklin Resources: Obsolete Or Ripe For Rebound?

Introduction

I first covered active asset managers Franklin Resources (NYSE:BEN) and T. Rowe Price (NASDAQ:TROW) in January and March 2022, respectively. In April, I published a detailed comparative analysis examining the performance of these active asset managers over the past 20 years. As 2022 draws to a close, I believe an update of my investment theses is warranted. The bear market not only hurt TROW and BEN stock prices, but understandably also assets under management (AUM). A significant portion of both companies’ assets under management consists of equities in general and U.S. equities in particular. But of course, the bond markets also performed quite poorly in 2022 due to rising interest rates, putting further pressure on BEN and TROW’s asset base.

In this update, I will compare the performance of the two active asset managers since the onset of the COVID-19 pandemic on a quarterly basis and highlight client cash flows and AUM dynamics during these arguably quite difficult times. I will also discuss the strategies that the two companies are pursuing to remain competitive in the long term.

Performance Of TROW And BEN Since The Pandemic And During The 2022 Bear Market

At the end of 2019, T. Rowe Price reported $1.21 trillion in AUM. After briefly declining in the first half of 2020 due to the SARS-CoV-2 pandemic, AUM increased to nearly $1.7 trillion by the end of 2021, primarily due to a booming equity market. Since then, assets under management declined 27% in the first nine months of 2022, but recovered slightly in October and November, reducing the year-to-date decline to 21%.

Franklin Resources reports its full-year results a quarter earlier than TROW and released its fiscal 2022 10-K in November. For comparability, I examined the companies on a like-for-like basis and used calendar quarters in the illustrations below (e.g., 2019-Q4 corresponds to TROW’s fourth quarter of 2019 and BEN’s first quarter of fiscal 2020).

BEN’s AUM nearly doubled in the third quarter of 2020 due to the consolidation of Legg Mason. BEN’s organic growth in 2020 cannot be determined as Legg Mason contributed AUM in most of the company’s reportable segments. However, between the third quarter of 2020 and the fourth quarter of 2022, Franklin Resources’ AUM grew at a CAGR of 9%, which is certainly not bad, but significantly weaker than TROW’s AUM, which grew at a CAGR of 22% over the same period. This is largely due to BEN’s focus on fixed income strategies, especially after the Legg Mason acquisition. At the end of fiscal 2022 (ended September 30, 2022), 38% of BEN’s AUM consisted of fixed income assets and 30% consisted of equities. In stark contrast, 53% of TROW’s AUM in Q3 2022 was in equities and only 13% in fixed income. In more normal market conditions, TROW’s focus on equities is even more pronounced, accounting for about 60% of total AUM. In the first nine months of 2022, BEN’s assets under management fell 18%, or about 900 basis points less than TROW’s, further underscoring the former fund manager’s focus on fixed income. The rebound in AUM in October and especially November reduced the year-to-date decline to 11%.

Figure 1 shows the quarterly change in AUM and highlights BEN’s outperformance, particularly in recent quarters. Interestingly, both fund managers reported similar declines in assets under management in the first quarter of 2020, but TROW saw significantly higher growth in subsequent quarters due to its exposure to equities in general and growth equities in particular. Note that the data include (largely insignificant) client cash flows because the companies do not break them down at an asset-specific level. Figure 2 compares quarterly changes in BEN and TROW equity-based AUM and nicely shows that BEN’s equity portfolio tends to be more value-oriented, while TROW tends to invest more in growth stocks.

In addition to performance comparison, it is very important to monitor client cash flows as they serve as an indicator of customer satisfaction and the companies’ ability to retain funds long-term. Including net distributions not reinvested, TROW experienced net customer cash outflows of $45.4 million in the first nine months of 2022. At BEN, net customer outflows were nearly $52 million in the first nine months of 2022. To such an extent, outflows during bear markets should be considered normal. Figure 3 shows cash flows as a percentage of each quarter’s beginning AUM, confirming that recent outflows are of little concern. BEN suffered significant outflows in 2020, likely due to the firm’s more conservative focus on value stocks and fixed income strategies. Since the Legg Mason acquisition, outflows have been contained and are not currently a concern. Still, T. Rowe Price reports better retention of client funds over the long term (see my previous analysis), in large part because two thirds of the company’s AUM are derived from retirement accounts. Longer term, of course, baby boomer retirements are putting pressure on AUM, and this trend is not expected to abate anytime soon.

Of course, asset managers’ largely fee-based revenues decline in line with assets under management during a bear market. It is therefore not surprising that both TROW’s and BEN’s operating margins (Figure 4) have trended downward in recent quarters. However, TROW remains in a much stronger position, in part due to its better economies of scale and more efficient organization. At the same time, this allows TROW to generally charge somewhat lower fees, while BEN has had to improve its offerings over the years to remain competitive (see my previous analysis). Still, it seems worth noting that TROW runs a much more profitable business at a very similar – and sometimes even lower – average expense ratio than BEN (Figure 5), which should help TROW remain relatively more competitive with lower-cost passive fund offerings. TROW’s better profitability is also reflected in its significantly higher free cash flow margin (average Q4 2019 to Q3 2022 of 35% vs. 18% for BEN).

Does The Bear Market Spell Danger For The Dividends?

Since the asset management business is extremely asset light and the balance sheets of both TROW and BEN are very solid, I do not think the dividend payouts are at risk. In addition, the managements of both companies have been very generous with dividends in the past and increased their payouts to shareholders even during the Great Financial Crisis. However, it is important to remember that times have changed and active asset managers face stiff competition from cheaper passive offerings. However, I do not view the active asset management business as a “type writer business” of tomorrow and will discuss BEN and TROW strategies to avoid obsolescence in the last part of this article.

Franklin Resources recently announced a 3% dividend increase, marking its 40^th consecutive increase. Long-term dividend growth has been quite spectacular, averaging 13% since fiscal 1999 (standard deviation of 8.2%). The highest increase was in fiscal 2008 (33%), but since fiscal 2020, BEN’s dividend increases have been more muted at 3% to 4% per year (Figure 6). It should be noted that occasional special dividends are not included in the illustration. To some extent, the recent rather weak dividend growth is due to the company’s focus on conserving cash for debt reduction (BEN acquired Legg Mason for $4.7 billion in cash and assumed an additional $2 billion in debt), but certainly also due to weaker profitability and the ongoing integration of Legg Mason and recently acquired BNY Alcentra Group Holdings, Inc. Still, the dividend payout ratio is anything but worrisome at around 40%.

Investors in TROW can expect another dividend increase in early February, as the company reports its annual results in late January. Last year’s increase was a very solid 11% due to extremely strong earnings and represented the 36^th consecutive increase. Since 1999, T. Rowe Price has raised its dividend an average of 15% per year, with a standard deviation of 7.5%. As with BEN, this does not include occasional special dividends. The weakest increase was in 2009 (4%) and the highest in 2008 (28%) (Figure 6). TROW generally grows organically and currently has no debt on its balance sheet. Hence, and taking into account its superior profitability and lower operating leverage, investors in TROW can expect to beat also higher rates of inflation through generous dividend increases.

Finally, the fact that TROW continues to operate from a position of strength is underscored by the company’s share buybacks. Management does not typically waste cash on buybacks at high valuations (with the exception of Q4 2021), but opportunistically repurchases shares, for example in Q1 2020 and Q3 2022 (Figure 7). Since Q4 2019, TROW has repurchased 11.1 million shares (net of newly issued shares due to exercised stock options), representing 4.7% of the weighted average diluted shares outstanding during the quarter, and notably fully funded by free cash flow. The repurchases at BEN are rather insignificant, but nonetheless more than offset dilution due to exercise of stock options. Over the same period, the number of shares outstanding decreased by 1.4%.

Strategies For Avoiding Obsolescence And Remaining Competitive With Passive Offerings

Passive investing has been adopted a long-time ago, and active fund managers face stiff competition due to lower fees and the general (and to some extent true) perception that active managers often lag the market. Therefore, the investment case for active managers, even though they represent wonderful, asset-lean business models with high excess returns on invested capital, is not an easy one. Management needs to have a plan in place to make sure to avoid obsolescence and remain competitive with passive offerings.

T. Rowe Price is a particularly positive example in this regard, as management maintains a very strong, single corporate culture focused on retaining client funds long-term (i.e., a focus is on retirement products) and delivering consistent results. As I have pointed out in my previous article, long-term performance at TROW has been much more consistent than at BEN, and I believe this is appreciated not only by shareholders but also by customers. TROW is very transparent about its results and reports quarterly on the performance of its funds (e.g., p. 25 f. 2022 10-Q3), similar to BEN (e.g., p. 31, 2022 10-FQ3) but with an added comparison to the Morningstar median. Unlike TROW, BEN’s management leaves fund management teams largely independent, resulting in a more fragmented corporate culture.

Both companies must maintain a reasonable fee structure and management needs to be very cost-conscious. In this regard, TROW has an advantage due in part to its corporate culture and emphasis on organic growth. Since most of the expenses relate to fund manager compensation, it is not surprising that stock-based compensation represents a significant portion of total compensation. This appropriately incentivizes fund managers as their compensation is closely tied to their own performance in particular and the performance of the company in general. Since Q4 2019, stock-based compensation has been 9% of pre-compensation operating cash flow. Staff turnover rates among fund managers and senior management at TROW are very low, confirming an intact corporate culture. Stock-based compensation is slightly higher at 10% for BEN, but it should be remembered that the company’s free cash flow margin is significantly weaker than TROW’s. On a net basis, and considering that TROW and BEN are similar in size in terms of AUM, it looks like employee compensation at TROW is better tied to fund and company performance.

In addition to these factors, diversification into asset classes with lock-in periods or longer expected holding periods is another important strategy to remain competitive and retain client funds. Prior to the Legg Mason acquisition, the Alternatives category accounted for approximately 20% of BEN’s AUM. Legg Mason focused exclusively on equity, fixed income, multi-asset and cash management strategies, so after consolidating its AUM, the percentage dropped below 10%. However, acquisitions such as that of BNY Alcentra Group Holdings, Inc. in November 2022 have increased the percentage of alternative investments. BEN’s AUM allocation as of September 2022 is shown in Figure 8 (right panel). T. Rowe Price, which typically grows organically, acquired Oak Hill Advisors in late 2021 to diversify into alternative investments. As a result, 3% of the firm’s AUM as of September 2022 is in this category (Figure 8, left panel).

Given TROW’s better balance sheet optionality than BEN’s, I would imagine that the current environment (e.g., significant redemptions at Blackstone’s BREIT) is quite promising in the context of growing through acquisitions, with smaller alternative asset managers being available for increasingly compelling valuations.

Overall, I believe T. Rowe Price is in a better position due to its higher profitability, higher-quality brands, more consistent fund performance, and better corporate culture. The company’s balance sheet optionality with respect to potential acquisitions of smaller alternative asset managers should also help it remain competitive. That said, I believe BEN’s long-term future is also far from bleak, as the company is still well-positioned and near-term results, following the Legg Mason acquisition, are reassuring. Also, the fact that about 40% of the shares are owned by the Johnson family and that a family member has been running the company since the late 1940s should be seen as a positive factor.

Key Takeaways

Conventional asset managers focused on equities and fixed income understandably face tough competition from passive and alternative asset managers. Due to the ongoing bear market, TROW and BEN are confronted with significant declines in assets under management. The larger decline at TROW is due to the firm’s focus on equity-based strategies in general and growth strategies in particular.

Withdrawal of funds by customers during bear markets is to be expected, but the magnitude of outflows is not a concern for either company. Since late 2019, outflows have been more pronounced at BEN, but the Legg Mason acquisition is at least partially responsible for improved retention of client funds.

However, even though the bear market has led to significant declines in assets under management and revenues as well as earnings have declined proportionately, income-oriented investors should not despair. Both companies’ balance sheets are solid and dividend payouts are still very manageable. The long-term history confirms that both companies are very shareholder-friendly, even in difficult times. However, TROW is the better dividend growth investment due to its much higher profitability and debt-free balance sheet. BEN is still working on integrating Legg Mason and Alcentra and suffers from much weaker cash flow productivity.

Both companies have a good strategy in place to remain competitive. BEN is more focused on alternative investments than TROW, which typically involve longer holding periods. TROW maintains a single corporate culture with a focus on reliable returns and cost-efficient operations. The focus is on retirement products, which typically translates into high stickiness of funds, but of course also means that AUM is vulnerable to baby boomer retirements. However, given its debt-free balance sheet and superior profitability, TROW can be expected to increasingly diversify into alternative investments, as the company has already demonstrated with its acquisition of Oak Hill Advisors in 2021.

Overall, I believe TROW is better positioned for the future, and that is why I hold the stock in my portfolio. The current very solid dividend yield of 4.3% is well above the five-year average of 2.7%, and the stock also appears undervalued from an earnings perspective (Figure 9). As a result, I have recently added to my position. Franklin Resources is significantly cheaper than T. Rowe Price (Figure 10), but due to the ongoing integration of Legg Mason and Alcentra, below-average profitability, spotty earnings and fragmented corporate culture, I am not really interested in building a position.

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