1. Equity Research Report on Legg MasonBy: Raution Jaiswal 1. Introduction Over the past two decades, world has experienced an exponential growth in financial assets and debt market. Innovation and competition has fueled the growth and thus the participants in the financial industry have soared. This growth provides a platform for efficient use and distribution of capital and for better risk management. Developments in the financial industry have thus contributed to stronger and more stable economic global growth over the past decades. Technical development has reduced the cost of communication, computation, cost of processing, and storing. This has lead to a transparent system to restore faith in the system. Financial market has expanded and become deeper. The broader involvement has permitted risk to be widely spread across borders. Borrowing has been voluminous and cheap from different parts of the world, to invest in different financial instruments that fit into the needs and cater to different profile of risk and return. Market seems to deliver what people are expecting from the market but when we dig deep into it we will find a different pictures amid recent development and crisis. Evaluation of recent changes in the financial landscape will help us to draw the right picture about the growth in financial sector and related industries. 2. Recent developments in the industry: Developments in the financial services industry is a mix bag as it present new challenges for financial institutions coupled with untapped potential to grow and expand globally. These changes are being driven by economic influence, financial modernization, privacy concerns, industry consolidation, the emergence of new institutions, new trends in borrowing and lending, globalization, and emerging technology. Overall, the future of the industry is bullish. Markets will recover to find directions, and investor confidence will be restored with gradual upturn. There will be a move back from cash and money market instruments into equity-related assets management. Demand for asset management will remain strong as the population becomes older and lives longer and as more individuals rely on defined contribution plans and individual retirement accounts. With social security systems under strain in the United States and many other countries, there may be international opportunities for asset management companies.
2. A. Scale and size of the market: Factors promoting consolidation in the asset management industry is relevant even for the smallest asset managers, namely the need to spread the cost of technological and administrative overhead and the desire to maintain earnings growth. There has been a spate in the mergers and acquisitions in the asset management industry. These mergers and acquisitions is an attempt to capture the benefits of scope through the expansion in international market, developing distribution relationship or alternative business rather than mere scaling asset under management. Instead of seeking to dominate in every segment and territory in which they operate, many institutions will temper their ambitions, looking to expand regionally instead of globally or focusing on particular customer segments. Size will still be important to institutions, not least as a means of deterring potential predators, but there will be an emphasis on simplification, both of processes and platforms inside the organization and of the service offering to the customer. The consequence will be the rise of competency-led enterprises, institutions that develop and excel in particular areas. Economies of scale will help in the reduction of operating cost, use of broader channel for distribution, spreading of the risk, and strategic growth of the organization. Big players are getting considerably bigger: just 5 years ago, an average top-ten player managed about $500 billion in assets; today, their asset under management has doubled and the figure is closer to $1 trillion1. Even though the industry as a whole is performing better, there is a profit and performance gap between the performers and the laggards of the industry, irrespective of their size and the customer segment they serve, this gap continues to widen. Although the rise in the recent volatility in the financial market has resulted in outflows from stock mutual funds and equities in 2007, the asset management industry continues to be strong enough to cope with the turmoil. Overall mutual fund asset under management (AUM) continues to increase and totaled about $11.9 trillion in September compared to $10.6 trillion in February, according to data from trade group Investment Company Institute (ICI). Exchange-traded-funds (ETF) have also been a high growth business for the asset management industry in the past few years. As of September 2007, the combined assets of the nation's exchange-traded funds (ETFs) were $551.10, compared to just $300 billion at the end of 2005 according to ICI. 1 www.mckinsey.com
3. Source: Investment Company Institute (ICI), Note: 2007 data is till September 2007B. Cross-border activity: Expansion in asset management industry has not been confined to United States rather it has been a cross border expansion. This has scaled the operational capabilities and integrated the operations globally. This cross-border activity has contributed to increased competition among international and domestic players, a wider range of options for operators operating internationally and the sharing of expertise across organization. With operations from several geographical markets, the financial system is also less vulnerable to cyclical developments in any one country. Growth stories in emerging markets requires expertise from the matured markets as risk assessment is more demanding. A consequence of cross-border institutions may also be that turbulence in financial markets in one country can more easily spill over to other countries. Moreover, a crisis may be more complicated to resolve in an internationally active institution than in a national institution. This has helped asset management companies to spread risk and gain from emerging markets.C. Tough pricing Environment: Increase in competition and slowdown of economic growth has put downward pressure on the pricing of the financial products. It has been found that there has been a 50% reduction in the
4. total shareholder cost. ICI figures show that in 1980, the buyers of equity funds incurred an average cost which was 2.26% of their initial investment. That cost declined to 1.13% by the end of 2005. These recent price declines of the actively managed products are likely to continue. Asset management industry which has enjoyed a steady asset growth and consistent annual fees increase for most part of the last decade seems to diminish and the implication seems to be profound. Expense ratio has declined due to shift in the focus from load funds to non-load funds due to its low cost structure. It is also experienced that as the funds grow in size and reap the advantages of economies of scale, it reduces the expense ratio due to fees reduction. This has forced organizations to be more creative and look forward to alternative capabilities. Over the past several years a number of traditional managers have developed alternative capabilities in the form of hedge funds, private equity arms, or fund-of-funds vehicles. Alternatives have become an important asset class for revenue generation. For many players these changes required them to revisit their business model. This has forced far more complex organizational structure and processes, design to effectively manage a broader range of products.D. Economic turmoil: The performance of the economy at the national level directly affects the business strategies of individual financial institutions and the industry's overall performance. Changes in the business cycle of sectors such as commercial, real estate, agriculture, interest rates, inflation, energy, and unemployment, influence the lending and funding strategies of insured depository institutions. Adverse economic or financial conditions abroad did spill over and had impacts on the national and regional economies. An economic slowdown has adversely impacted the financial services industry, resulting in slower asset growth, increased loan losses, and diminished profitability. Looking forward to the economic trends and growth indexes, financial services industry can expect leaner time over the medium term. Economic forecaster expects the next few years to be characterized by a gradual slow down of output, demand growth and economy as a whole. Financial industry will be affected as the industry is an important contributor to overall economic activity and employment in the United States. It is a noteworthy contributor to the overall gross domestic product. With the downturn in the economy and the accompanying declines in stock market values, the industry has been hit hard. Growth will still be robust by historic standards but financial institutions will have to overcome a number of challenges to make money over the next
5. few years. This will lead to the search for markets that is under-utilized. But the challenges of successful and sustainable entry into emerging markets, from emergent domestic competition to the regulatory and compliance issues of operating in multiple territories, will encourage most institutions to adopt an incremental approach to geographic expansion.E. Subprime effect: Subprime mortgage defaults continue to make their mark on the economy and financial market since their emergence in late 2006. There are several factors that collectively account for the occurrence of subprime event, such as creative loan practices, loose lending standards by lenders, under-educated borrowers and lack of governmental oversight. All these events have led to a record number of A