Quality companies often produce exceptional returns for ordinary investors.
Just ask Terry Smith or Nick Train.
These ace fund managers have delivered wonderful gains by investing in first-class businesses such as Diageo, Reckitt Benckiser and London Stock Exchange.
Let’s use SharePad to find a quality company to study for ourselves.
Immense figures imply an incredibly strong competitive advantage
For this search, I screened for companies that exhibited an extended history of high margins and high returns on equity (ROE).
To narrow the field down further, I required my shortlisted companies to possess cash-positive balance sheets.
The exact criteria I used were:
1) An average 10-year EBIT margin of 20% or more;
2) An average 10-year ROE of 20% or more, and;
3) Net borrowing of zero or less (i.e. a net cash position).
(You can run this screen for yourself by using SharePad’s amazing Filter Library. My instructions show you how.)
I was not surprised the 24 matching shares mostly sported premium valuations. After all, a decade of superior accounts is likely to have attracted the attention of many investors.
Among the largest companies within the shortlist, only spread-bet firm IG Group possessed an obviously modest P/E rating.
However, my reviews of fellow spread-bet firms CMC Markets and Plus500 highlighted sector drawbacks that I dare say apply to IG also.
Anyway, I selected Hargreaves Lansdown because this company:
* was the largest on the shortlist;
* offers services used by many private investors, and;
* prompts different opinions from those aforementioned quality investors, Terry Smith and Nick Train.
Let’s double-check HL’s ten-year history of margins and ROE:
Margins have almost always topped 50% while ROE has consistently surpassed 60%. Such immense figures imply HL enjoys an incredibly strong competitive position and is very much a quality company.
The history of Hargreaves Lansdown
Hargreaves Lansdown (HL) was formed during 1981 when Peter Hargreaves and Stephen Lansdown began an investment newsletter called “The Unit Investor”, which published information about unit trusts and tax planning.
(Source: The Times)
A few years later, HL started a discretionary investment service and, a few years after that, a stockbroking operation was created.
A history of savvy direct marketing that took advantage of significant events within the financial-services sector — notably the introduction of PEPs, new pension rules and the launch of various privatisations — helped propel HL to industry prominence.
(Source: Drayton Bird)
Today HL is the country’s largest ‘investment platform’ for private investors.
More than 1 million customers currently use the firm’s ISAs, SIPPs and dealing accounts to buy, hold and sell funds, shares and bonds.
At the last count, HL’s assets under administration totalled £86bn and represented approximately 40% of the £200bn-plus direct retail investments held by UK investment platforms and online stockbrokers.
HL floated during 2007 and the firm’s subsequent revenue and profit history are displayed below:
This chart shows the share-price history:
The shares have ten-bagged since the 160p flotation to currently support a near £8 billion market cap.
I did say quality companies often produce exceptional returns for ordinary investors.
Average assets per client and the effect of the RDR
HL’s progress has been supported by a relentless gathering of extra money from new clients.
The following chart from my own spreadsheet shows assets under administration (AUA) (blue bars, left axis) and client numbers (green bars, right axis) growing consistently:
Assets per client have more than doubled to £84,000 during the same period:
However, revenue and profit per client have not enjoyed a similarly upward trajectory:
Back in 2013, HL earned revenue of £577 and an operating profit of £380 per active client. Last year the respective figures were £410 and £267.
The decline followed the introduction of the Retail Distribution Review (RDR), which changed the way financial products (notably managed funds) could be sold to the public, and the way advisers and brokers such as HL were remunerated from selling such products.
Instead of accepting commissions from fund managers, HL now (post-RDR) charges its clients so-called platform fees — some of which appear rather pricey.
The fees earned from funds, shares and cash
My chart below shows how HL’s assets under administration (AUA) are split between third-party funds, shares, cash and the company’s own managed funds:
My next chart shows the revenue derived from each type of client investment:
During 2018, revenue was split:
* 44% (£198m) — fees for holding funds;
* 20% (£90m) — share-trading fees;
* 9% (£42m) — interest received on cash balances held within investment accounts;
* 15% (£67m) — in-house fund-management fees, and;
* 11% (£51m) — fees for other services such as financial advice, data licensing and annuity sales.
HL’s shareholder presentations reveal the fee levels applied to the different client assets:
(Bps stands for basis points, and 100 basis points equal 1%.)
With funds for example, 40.9 basis points equate to fees of £4.09 from every £1,000 of client money invested. HL’s share-trading division generates fees of £2.72 for every £1,000.
HL’s in-house funds and the interest received from client cash balances appear to be lucrative sources of income:
Collecting interest of £6.68 for every £1,000 of cash sat in an investment account seems a great way of earning decent sums for little effort. Indeed, the rate is close to what HL receives from running its own in-house funds.
I must add that HL pays between 0.1% and 0.35% on cash balances within its ISA, SIPP and dealing accounts, which does not seem too bad compared to other brokers.
Youinvest, which is owned by AJ Bell, pays between 0% and 0.25%, while Selfrade, owned by Equiniti, pays only 0.1% on anything above £250,000.
Elsewhere, Halifax, owned by Lloyds Banking, and interactive investor, a privately held business, pay no interest whatsoever.
The net return on client cash at these other brokers must therefore be even higher than that at HL.
HL’s fees compared to Youinvest, Selftrade, ii and Halifax
The interest received (if any) on your cash is one of the many points to consider when calculating the overall cost of using a particular investment platform or broker.
As I noted earlier, 44% of HL’s revenue last year came from fund-related fees… and the firm’s charging structure reveals why:
HL applies a tiered percentage fee based on the value of your funds.
Once your funds reach a value of £2 million(!), HL’s annual fee is effectively capped at £4,000.
However, HL’s annual fee for owning shares is limited to just £200 for a SIPP, £45 for an ISA and zero for a standard dealing account.
No, I am not sure why there is such a huge fee difference between holding funds and shares either.
However, HL’s charges — at least for funds — do seem excessive compared to the rest of the sector.
For some perspective, I have calculated the annual platform or custody fees charged by HL, Youinvest, Selftrade, interactive investor and Halifax within an ISA for a fund-only client.
You can see how HL’s percentage-based structure becomes more expensive once your funds are worth £30,000 or more:
Interactive investor charges £90 a year while Halifax charges £12.50 a year to hold your funds in an ISA — regardless of the value of your funds.
As your fund portfolio grows, so do your HL fees… up to £4,000 a year:
Selftrade’s annual fund fees are limited to £1,000 while Youinvest’s fund charges eventually plateau at £1,875.
I dare say charging clients up to £4,000 a year is one reason why HL’s margins have been so amazingly high.
Let me stress that the charts above are for illustrative purposes only and are based on the headline fees published on the relevant company websites.
I am aware that:
* many investors hold both funds and shares, not just funds;
* dealing commissions, fund discounts and other costs/benefits will affect the client’s overall charge, and;
* costs are not everything because clients also value customer service, website functionality, and so on;
On that final point, HL does pride itself on tip-top customer service. For instance, the group’s latest presentation highlighted 57% of telephone calls being answered immediately:
Whether HL’s excellent telephone support — and all the other services and website features — are worth up to £4,000 a year is something I will leave you to decide.
All I will say is 94% of HL’s customers stick with the firm each year, so the company must be doing something right.
HL’s in-house ‘funds of funds’ struggle to outperform
HL’s in-house funds appear to be useful money-spinners.
Clients who own these funds pay HL:
* the aforementioned standard platform fee for funds (of up to £4,000 a year) and;
* the fund’s annual management fee (approximately 0.75% of the fund’s value)
By the way, HL’s own funds invest in third-party funds — the running costs of which are absorbed by the client, too.
HL has sold its own funds for a few years now and the associated client assets under administration have advanced significantly:
However, the investment performance of HL’s own funds does not seem obviously fantastic.
The group offers eight ‘funds of funds’, the largest of which is the £3 billion HL Income & Growth Trust portfolio:
Using HL’s own charting facility, the performance of this fund (the red line) has matched the performance of the FTSE 100 index (the blue line):
SharePad’s comprehensive database contains details of all of HL’s in-house funds. HL’s Income & Growth Trust is shown below:
The total return (TR) performance against the sector benchmark is not truly convincing.
SharePad shows the fund’s top holdings — a mix of other funds and a trio of high-yield shares:
SharePad can compare all of HL’s in-house funds to the FTSE 100 index.
For this comparison, I selected the accumulation versions of HL’s own funds (that is, the funds with dividends reinvested) and a popular FTSE 100 exchange-traded fund (ETF). I also included the official FTSE 100 total return index:
The table above is sorted on the three-year percentage change, with the best performers at the top.
Only HL’s Asia/Emerging Markets, Special Situations and European portfolios have outrun the FTSE 100 over three years.
True, some of HL’s laggard funds are invested in bonds and the comparison with an equity index is therefore not strictly like for like.
In addition, the two ‘HL Select’ funds — which pick individual shares — appear to have done well in their first two years of existence.
Overall though, the general attractions of HL’s in-house funds are not abundantly clear to me…
…especially when you could have enjoyed a similar return from a bog-standard index-tracker ETF…
…and paid HL no annual fee (using a HL standard dealing account) for the privilege.
Forecasts suggest at least 10% per annum growth
HL’s SharePad Summary tab shows a good spread of green numbers:
The forecasts on the second row are encouraging. Useful double-digit growth is expected during the next few years:
Half-year results published last month showed revenue up 7% and profit up 4% — despite assets under administration dropping 6% due to weaker markets.
During the six months, 45,000 new clients opened accounts and brought with them investments worth £2.5 billion.
The current-year forecasts shown on SharePad imply the second half might deliver H2 revenue up 12% and H2 profit up 15%.
Longer term, HL hopes to attract part of the £800 billion of personal investments held through private banks, financial advisors and wealth managers. (I dare say the fund fees applied by some of those parties could make HL’s maximum £4,000 charge seem very reasonable).
HL is also embracing the £1 trillion cash-savings market through an affiliate-type set-up with certain ‘challenger’ banks. HL will charge these banks a fee equivalent to up to 0.25% of your cash savings.
Lastly, HL is signing deals with investment trust groups, such as Legg Mason, Jupiter and most recently Witan, to administer their saving schemes and pick up new clients that way.
HL’s cash conversion, special dividends and lack of debt
A few clicks around SharePad do not reveal anything worrying within HL’s accounts.
Earnings have converted well into free cash:
Much of the cash has then been distributed through a rising dividend and numerous special payouts:
The firm has consistently kept a notable cash balance and has never borrowed money:
And relatively little has been spent on intangibles while nothing has been spent on acquisitions:
One chart that does not look great is staff productivity — as measured by turnover per employee — which has fallen away following the RDR and the recruitment of additional IT workers:
Nonetheless, producing fees of £300,000 or so per employee remains impressive.
Regulatory study reveals low knowledge of platform fees
Any business that has delivered ten years of consistent 50%-plus operating margins and 60%-plus ROEs deserves special consideration…
…if only to set a quality benchmark for other shares within your portfolio.
HL’s accounts and track record are no market secrets. Investors today are being asked to pay more than 30 times trailing earnings and approximately 24 times the earnings projected for 2021:
The present valuation suggests HL’s majestic financials will be sustained for some years to come.
But could anything go wrong?
Well, the Financial Conduct Authority (FCA) is currently undertaking a review of the investment-platform market.
Regulatory concerns include:
“The FCA found fees were hard to understand and compare.”
and
“Customers with large cash balances who may not be aware they are missing out on investment returns or on the interest they forego by holding cash this way.”
The FCA’s preliminary investigation has provided many startling statistics.
In particular, only 26% of investment-platform clients can apparently estimate their annual charges.
A further 47% know they pay something, but have no idea how much they pay.
And a disturbing 27% believe they do not pay — or do not know whether or not they pay — any charges.
The lack of awareness about charges — and potential follow-up FCA action — could mean HL’s relatively high fees may eventually face greater customer scrutiny.
I also wonder whether the FCA will introduce measures to prevent HL (and other brokers) from retaining so much interest on uninvested client cash.
(The full FCA documentation is essential reading for anyone wishing to learn more about the investment-platform sector).
Terry Smith vs Nick Train on HL
A nagging risk to HL’s success is debatable marketing — at least according to Terry Smith.
Last month Mr Smith questioned the independence of HL’s flagship Wealth 50 publication.
Mr Smith told the Times newspaper:
“Hargreaves Lansdown’s recommended funds continue to be chosen mainly for fund managers’ willingness to comply with a charging structure which enables Hargreaves Lansdown to maximise its own profitability, and not because they perform well for investors.”
Among global funds, HL preferred Nick Train and his Lindsell Train Global Equity fund over Mr Smith’s Fundsmith Equity portfolio.
According to HL’s website:
“Terry Smith’s track record is much shorter than other fund managers in the global sector. We also think the fund is expensive. We prefer to back managers with longer records of exceptional performance that can be bought at a more attractive price.”
Fundsmith charges 0.95% a year and does not offer HL customers any discount. In contrast, HL clients pay 0.52% for Lindsell Train using a special 0.2% HL discount.
I am not a fund expert, but the absence of Mr Smith’s Fundsmith Equity from HL’s Wealth 50 guide does surprise me.
The performances of Fundsmith Equity and Lindsell Train Global Equity are very similar:
Unlike Mr Smith, Mr Train is a major fan of HL — his funds recently doubled their collective stake and now own 10% of the business.
Mr Train explained:
“In short, Hargreaves has and continues to invest heavily in its client service.
When confidence and volumes recover, we’d expect HL to deliver explosive growth.”
Mr Train has clearly recognised HL’s quality financials and industry muscle — no doubt underlined by him giving HL the aforementioned 0.2% fund discount — and has invested accordingly.
On the other hand, Mr Smith won’t give HL a discount, disputes the impartiality of HL’s Wealth 50 guide, and presumably will not buy HL shares.
Perhaps Mr Smith is also concerned that 15% of HL’s revenue is derived from in-house funds that, overall, have not really performed that well.
Although Mr Smith and Mr Train both buy quality companies for the long run…
…they do not share the same view on whether HL’s high margins and ROE indicate a truly outstanding business.
I can only conclude one of these two master investors has missed something.
Until next time, I wish you happy and profitable investing with SharePad.
Maynard Paton
Disclosure: Maynard does not own shares in Hargreaves Lansdown.
