April 6, 2011

2011 Q1 Earnings Preview: Asset Manager Outlook Overshadows Big Banks

Neuberger Berman, KBW bullish on asset managers, but big banks still face write-down risks

As first-quarter 2011 earnings season begins, portfolio managers and stock analysts expect good news from the finance sector, but sentiment about the sector’s outlook for the rest of the year favors asset management firms over banks.

While big banks including Bank of America (BAC), Citigroup (C), Wells Fargo (WFC) and even JPMorgan Chase (JPM) still face risks of more write-offs, asset managers such as BlackRock (BLK) have a strong business model, said Neuberger Berman managing director Rich Levine in an interview on Wednesday.

Financial-services investment bank Keefe, Bruyette & Woods, meanwhile, favors asset managers Invesco (IVZ), Legg Mason (LM) and Affiliated Managers Group (AMG) as its top picks.

“We’re less interested in the big banks right now partly because our fund is meant to be conservative and defensive, and I’m afraid there’s still bad news. I’m not sure they’re done taking write-offs,” said Levine (left), a co-portfolio manager of the Neuberger Berman Equity Income Fund, which has a five-star Morningstar rating.

“There’s still risk out there for BofA, Citi, Wells and even JPMorgan. Our sense is that things may be getting better for those four, but they’re not finished taking write-offs for bad loans on their books, and they don’t pay much in dividends,” Levine said.

Good Outlook for Asset Managers

In comparison, asset managers have a good outlook due to their business model, Levine said. Money went into bonds rather than stocks in 2008 and 2009, but with the recent stock rally those firms will see assets under management (AUM) grow as the stock market continues to head upward.

“These companies charge less for managing bonds than stocks, so for the two years prior to the last couple of months, whatever growth they had was on the

fixed-income side, where margins are thin,” Levine said. “But in the last couple of months money is going into stocks, so the mix shift is going in their favor.”

Of the asset management firms, the Neuberger Berman Equity Income Fund holds stock in BlackRock. Levine also likes Franklin Resources (BEN), Invesco and Legg Mason.

In a first-quarter preview of asset managers released Thursday, Keefe, Bruyette & Woods modestly raised estimates and price targets for most asset managers as the firm marked-to-market its AUM forecasts to reflect higher equity values.

“We think flows for many managers remained positive as equity flows modestly improved and fixed income inflows remained positive. We believe valuations generally remain reasonable for many asset management stocks and our top picks include IVZ, LM and AMG,” KBW analysts Robert Lee and Larry Hedden wrote in their preview.

KBW lowered its rating on Waddell & Reed (WDR) to Market Perform on valuation. With only 10% total potential return to our new $44 price target, KBW analysts think the risk/reward in the stock has become less compelling despite what they expect will be continued positive new business trends.

Asset management stock price performance in the first quarter was “a mixed bag and highly company specific,” the KBW analysts said. “We believe investors should focus on good franchises with reasonable valuations and our top pick in this category is Invesco. Also, companies that can add to earnings power without the help of the market and which we think offer value include both Affiliated Managers Group through incremental acquisitions and Legg Mason as a result of its cost savings initiatives.”

Equity Flows Rebound; Companies Are Cash Rich

Overall, first quarter was seasonally stronger with a rebound in equity flows and fixed income inflows, according to both Neuberger Berman’s Levine and the KBW analysts.

“The markets performed surprisingly well in the first quarter of 2011,” Levine said. “Investors are showing optimism that the U.S. economy is back on track and the world economy is growing.”

But, he added, the quarter also produced plenty of reasons for investors to worry. The earthquake, tsunami and nuclear disaster in Japan could not have been predicted, and nor could the political unrest in the Middle East and

Africa. These events add to ongoing concerns about the Europeans’ debt crisis and the United States’ own budget deficit and unemployment, Levine said.

“The market continues to move higher in the face of that. For us, the most worrisome is the impact on oil and gas that might take place in the Middle East and Africa. If it spreads to Saudi Arabia it could have a huge impact on the U.S. and world economies,” he said. “We see the U.S. economy getting better, but we don’t see it getting terrific any time soon.”

M&A Shows Surprising Weakness

Still, companies have a lot of cash on their balance sheets, which may mean more dividends, stock buybacks and mergers and acquisitions in 2011, according to Levine.

In a sign that the U.S. economy may hit another rough patch, however, industry tracker Dow Jones VentureSource reported on April 1 that corporate acquirers in Q1 bought just 91 companies for $8.9 billion, a 22% drop in M&A activity from the same period last year when 116 acquisitions netted $7.4 billion. M&A activity was only slightly higher than the first quarter of 2009 when 83 acquisitions raised $3.3 billion.

“It's eye-opening for venture-backed M&A activity to be closer to levels seen in the first quarter of 2009, shortly after the collapse of the global financial markets, than in 2010, a year associated with recovery," said Jessica Canning, director of global research for Dow Jones VentureSource, in a statement. "Corporations have cash on hand and are willing to invest, but the deals aren't happening. Acquirers may feel that rising valuations have companies on the wrong side of the fine line between good deal and risky investment."

Levine’s advice to investors? Take advantage of interesting growth opportunities elsewhere. “In our fund,” he said, “about one-third is invested outside of the U.S. right now, and a meaningful part of that is in Asia.”

Read another preview of first-quarter 2011 by Ben Warwick of Aspen Partners at AdvisorOne.com.

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