When it comes to investing in shares, numbers – and particularly the numbers in financial statements – are very important. Although there are investors out there who invest solely on the basis of numbers alone – known as quantitative investors or ‘quants’ for short – I do not believe that successful investing can be boiled down to a painting by numbers exercise.
If you are going to invest in high-quality shares, you need to spend time getting to know a business and try to understand how it produces the numbers it reports to investors. You need to ask yourself whether the numbers stack up and really make sense.
Last week’s shenanigans involvingPatisserie Holdings (AIM:CAKE) will have dented a lot of investors’ trust in published financial statements. I understand this, but believe that it was virtually impossible for a company outsider to spot what looks like a case of fraud.
Where people like me and lots of other commentators and analysts tripped up with Patisserie Holdings is perhaps the failure to ask a very basic question about the business and spend more time trying to answer it: How could a chain of posh cake shops be making such high profit margins? These margins have now been revealed to be a work of fiction.
Quality investors look for very profitable, growing businesses with high profit margins and high returns on capital employed (ROCE) backed by cash flows and low levels of debt. One of the best examples of this type of company in recent years is Hargreaves Lansdown (LSE:HL), the largest do-it-yourself investment platform in the UK.
Hargreaves’ Lansdown’s financial performance in terms of profit margins, ROCE, free cash flow and growth has been sensational in recent years and has helped to make its shares an outstanding investment.
Ask yourself how many businesses out there make profit margins of 65 per cent, ROCE of nearly 80 per cent and turn over half of its revenues into free cash flow? As far as I can see, there is only one other business listed on the London Stock Exchange that does this: Rightmove (LSE:RMV).
On the basis of its numbers alone, Hargreaves Lansdown (HL) looks like a great business. I am going to take a closer look to see why the numbers are so good and what, if anything, can stop them continuing to be as good. In other words, I am going to look at the scale and depth of its economic moat.
HL is really a very simple business. It is the largest direct-to-consumer investment platform in the UK with a market share of just over 39 per cent (based on assets under management) of a £206bn market.
It gives private investors a safe place to manage their own investments and gives fund managers a platform to sell their funds to private investors. If customers invest their savings in funds they pay a platform fee to HL.
HL runs its own investment funds and receives fee income from them. The company also makes money from giving financial advice, organising customers’ pensions when they retire and from commissions on the buying and selling of shares by customers. The breakdown of its revenues is shown in the table below.
HL net revenues (£m)
Net renewal income
HL Fund AMC
less commission payable
Total net revenue
You can see that HL gets the bulk of its money (nearly 60 per cent) from its customers owning funds – particularly open-ended investment funds – in the form of platform fees and annual management charges (AMCs) on its own funds. Other significant sources of revenues are stockbroking commissions and the net interest margin earned on its customers’ cash balances.
Revenues have grown rapidly in recent years as HL has taken on more customers and more money managed on its platform. Growth in assets under management (AUM) have also had a significant boost from rising stock markets.
Net revenue margin
Source: Annual report
The net revenue margin is a measure of the profitability of HL’s platform. It refers to the net revenue income received as a percentage of average assets under management during a year. Different products and services attract different net revenue margins as shown below (Estimated HL profits with a 20% decline in the value of funds).
HL’s net revenue margin has come down from 0.68 per cent in 2013 to 0.42 per cent in 2016 and is currently 0.46 per cent. The company used to make bigger margins from funds (typically 0.75 per cent before customer discounts) until trail commissions from fund managers were phased out from 2014. The replacement of commissions with a platform fee has reduced the margin on distributing funds to customers to 0.41 per cent currently.
HL has also launched its own funds in order to earn the higher net revenue margins typically received by fund managers.
Despite earning lower net revenue margins, the rapid growth of customers and AUM has largely offset this. HL is largely a fixed-cost business (staff, marketing and IT being the most significant costs), which means that growth in scale and revenues sees a large chunk of them flowing through to trading profits via the process of operational gearing.
You can see that HL’s profit margins took a hit after the retail distribution review (RDR) lowered the profit margins from funds after 2013, but are now pretty much back to where they were before then due to the increased size of the business and the benefits of operational gearing.
In many businesses high profit margins attract competition. Competition does exist in the investment platform market, which begs the question as to why HL’s high profit margins have not been competed away?
Hargreaves Lansdown’s sources of competitive advantage
One of the biggest competitive advantages that HL has is its immense scale compared with its competitors. This scale not only allows the business to make lots of money and generate lots of cash, but gives the company money to reinvest in customer service, marketing and information technology (IT).
The capability and integrity of IT is a key barrier to entry. IT has to make the company’s services easy to use, trustworthy and capable of coping with peaks in demand such as the end of the tax year or economic events.
HL has played close attention to these issues, which has enabled it to retain and grow its customer base despite cheaper fees being available elsewhere. HL has been impressive at building a very powerful brand by investing in leading levels of customer service and investor education.
Its Wealth 150 list of funds has performed well – by beating the returns of the stock market in general – which has allowed it to offer itself as a go-to distributor for fund companies, but also allow it to offer fee discounts to its fund customers.
The numbers speak for themselves. HL is taking market share in the investor platform market and has more than doubled its customer base since 2013. Its customer retention rate for the year to June 2018 was 94.3 per cent and has been consistently high. These are the hallmarks of a business with a big moat.
But is there anything that can stop the relentless march of HL?
I think there are two main threats: increased regulation and a significant fall in the value of the stock market. These threats are not unique to HL – they would apply to platform businesses in general but maybe not to the same extent.
Is the cost of DIY investing still too high?
According to research company Platforum, 44 per cent of UK private investors now claim to manage their own investments. HL has undoubtedly played a big part in this.
That said, the costs of investing vary significantly depending on the amount of money being invested and the type of investment being used. It costs a lot more to invest in funds than it does in shares, exchange traded funds (ETFs), investment trusts and bonds. For investors running large portfolios, the cost of investing solely in funds can be very high – perhaps too high.
Let’s look at the differences in the money paid by two different customers with a HL self-invested personal pension (Sipp). One invests entirely in shares, ETFs and investment trusts. The other invests entirely in funds.
I want to make it very clear that this different charging structure applies to all investment platforms that charge platform fees, not just HL. The tiering of charges will be slightly different across the market.
HL charges fees on shares that are 0.45% on the value of their account but this is capped at £200 per year. This means that once their account’s value is more than £44,444 they do not pay more than £200 per year in fees.
This is not the case for the Sipp investor who puts all of their money in funds. As the size of their Sipp gets bigger they pay more to HL (see below). Someone with £1m invested in funds will pay annual platform fees of £3,000 compared with £200 for someone with £1m in shares.
Fees paid by HL Sipp customers
It is not difficult to see how this is not a particularly good deal for customers. It’s the main reason why I don’t own funds at all.
I may be missing something, but I don’t see why platform providers should receive more money just because an investor chooses a different type of investment. It’s also difficult for the customer to understand why they should pay more to a platform provider because the value of an investment fund managed by a third-party fund manager has increased. This explains why platform providers such as HL make more money from funds when the stock market in general rises.
I’m sure the argument from platform providers is that there are higher administration costs to look after funds. Maybe this is the case, but I’d be astonished if the cost difference between fund administration and shares administration was as big as implied in the differences in fees customers pay.
The Financial Conduct Authority (FCA) is currently reviewing the platform market. Whether it addresses this issue remains to be seen. I have some sympathy with the view that platform fees do lack transparency in some cases and the differences between the fees on different investments are arguably not explained clearly to customers.
That said, there is no reason why platform providers can’t compete on platform fees and there is plenty of evidence that they do. AJ Bell’s fund charges are significantly cheaper than HL’s. Other platforms such as iWeb are even cheaper. People are free to move to different platforms and save money if they want to – providing the exit fees and process are not too prohibitive.
Amount invested in funds
HL platform fee
AJ Bell platform fee
£250,000 - £1m
£1m - £2m
Source: Company websites
If an investor switched from a £1m fund portfolio with HL to AJ Bell they would pay £1,375 per year rather than £3,000 with HL. Yet, customers continue to move to HL while existing customers tend to stay put. Is this just a case of customer inertia or a sign that many investors are prepared to pay more for a better service?
What is clear is that the materially higher platform fees HL charges on funds is the major source of its very high profitability. A business based on the charging structure of AJ Bell would be considerably less profitable.
For what it’s worth, my view is that platform charges on funds are too high for investors with large portfolios. Whether HL has to reduce these fees through competition or regulation remains to be seen. Given that it earns most of its revenue from fund fees, this is a risk that investors need to be aware of.
A geared play on the stock market
There are good grounds for believing that platform providers such as HL can continue to win more business and money under management without relying on an increase in the value of stock markets. Money can come from other platforms, IFAs and wealth managers. Fund management companies can outsource the administration of their retail customers to HL.
On top of these sources there is the growth in auto-enrolment of company pensions and a growing awareness among people that they need to provide for their own retirement.
Yet these businesses can still see a significant influence on their revenues and profits from changes in the value of stock markets and the effect it has on the value of funds. The high fixed costs and operational gearing of the business can magnify the effect of changing revenues on profits.
Estimated HL profits with a 20% decline in the value of funds
net revenue margin bps
A very rough and ready calculation shows that a 20 per cent fall in the value of assets in funds from June 2018 levels and assuming the same net revenue margins, that revenues from shares is unchanged – a market fall could see more trading activity – and costs are not reduced would have a significant impact on profitability. Operating profits would fall by 17.8 per cent from £288.8m to £237.3m.
Yet the business would still remain extremely profitable and would still be positioned to benefit from the gearing effect of any stock market recovery. This is a business that looks to be very robust.
Are the shares attractively valued?
Despite its charges being more expensive than most of its rivals and the dangers posed to its profits by a fall in stock markets, HL shows all the signs of having a very wide and deep economic moat. At the moment, it’s difficult to see how its high levels of profitability and cash generation are going to disappear.
Looking at current consensus analysts’ forecasts, the outlook for future growth is a bullish one.
This kind of backdrop can be used to justify a very high valuation for the company’s shares. However, even after a 17 per cent fall in its share price over the past month, HL shares still trade on a one-year forecast rolling price/earnings (PE) ratio of just over 30 times, which is quite expensive in most people’s eyes. For now, the shares look as though they have lost the momentum needed to push them higher.