Stockwatch: Valuation issue for this share

Can £5.3 billion, FTSE 100-listed financial services group Hargreaves Lansdown justify its valuation? It is interesting to compare with the much smaller Liontrust Asset Management I referred to last week, also wealth manager Brewin Dolphin in the Mid 250 index.

While Hargreaves Lansdown has a dominant profile and brand, at 1,100p it trades on a 12-month forward price/earnings (P/E) multiple of about 27 times compared with 12 times for Liontrust and 14 for Brewin Dolphin. P/E's can be affected by stock availability (i.e. low for less-liquid stocks), but fundamentally they should reflect earnings growth prospects. Hargreaves enjoys a substantial premium that attracts momentum traders in a bull market, but is exposed and unstable when sentiment turns risk-averse - as now. By way of dividend yield, Hargreaves offers 3.3% versus 4.25% for Brewin and 2.9% for Liontrust.

Rising macro risks are wiping away froth

In the wake of a Conservative majority government being elected - a positive for savings and investments - Hargreaves hit a 2015 high of 1,293p, but the stock has topped out as attention shifted to international events. A highly-rated financial share like this is liable to move with macro sentiment. Indeed, it soared from 412p in 2012 to 1,549p by early 2014 as loose monetary policy boosted asset values hence trading activity (Hargreaves would benefit as a stockbroker/asset manager). The chart then shows it plunging to 852p with profit-taking among stocks typically more sensitive than the wider market.

Markets have overall been remarkably sanguine towards the impasse over Greece. Indeed, the European banking system is stronger than in 2012, and Greek debts have largely been shifted to EU taxpayers, but there is a genuine crisis for the eurozone which coincides with stresses in China as Beijing struggles to prop up over-leveraged stocks. If investor sentiment continues to break down then Hargreaves is likely to drop further - an implied dividend yield of 4% at about 900p might attract support, although there isn't much earnings cover. This business doesn't need to conserve cash, it is well-positioned to return it to shareholders, but quite a lot depends on 2015/16 forecasts.

Flattened earnings reflect margins at risk

Hargreaves' £5.3 billion valuation compares with annual pre-tax profit expected to rise from £210 million to £247 million by June 2016. That's the hope, although the table shows the profits/earnings growth trend levelling somewhat from 2013, which begs a question about strong competition in financial services putting margins at risk. In fairness, Hargreaves is market leader in UK execution-only stockbroking, with an end-May update citing its share up from 23.6% to 24.2% in the last year or so, but competition and higher costs of regulation are also mentioned. These are typical late-cycle characteristics, as is a fundamentally cyclical business being rated like a highly-prized growth stock. Financial services stocks tend to start the business cycle on low P/E's, then enjoy a re-rating as trading activity and market sentiment improves. Typically, the market proceeds to lose perspective with animal spirits dominating.

Senior manager exercises options and sells stock

The only recent significant trade was on 23 June by a senior IT manager in the group who exercised a total 250,000 share options and sold all the shares.

This was presented in terms of meeting taxation arising on the options exercise and partly to fund a property purchase, but effectively was a choice to switch a financial asset into bricks-and-mortar. The manager's ongoing holding is 19,044 shares. The chief executive continues to own 333,000 shares and, indeed, Peter Hargreaves (not on the board) retains 32.2%. However, there have not been any meaningful cash purchases recently. All this coincides with the sense Hargreaves is a sound long-term business, if currently over-priced.

2015 rebound has appeared curious

Showing sensitivity to trends, Hargreaves plunged from 1,594p to 852p throughout 2014. The February 2014 interims cited a 43% jump in assets under administration, net business inflows up 70%, revenue up 13%, pre-tax profit and the interim dividend both up 11%. There was a first-half bias however, as September's prelims then showed revenue up 8% to £291.9 million, diluted earnings per share up 9% to 34.2p and the total dividend up 8% to 32p. So the 2014 market appeared to logically de-rate the stock in anticipation - then ironically in 2015, push it back up to a P/E rating in the mid-thirties.

Revenue only marginally ahead in 2015

Several key variables in a 20 May update were very respectable - assets under administration are up 22% year-on-year, total active clients up 13%, and net inflows of £2.75 billion against £2.55 billion. But net revenue was only marginally ahead at £241.0 million as new assets/funds have been offset by factors such as lower interest rate margins and lower charges especially for clients holding fund assets.

Management complains about a significant increase in its levy to the Financial Services Compensation Scheme, estimated at £4.6 million amid an upward revision of amounts being raised under the scheme. But headwinds relating to competition, changes in markets and regulation are part of the financial services industry cycle and should be reflected in stock ratings. It reflects relatively low freedom to price.

A growth stock rating appears over-generous

One argument for a growth rating is new pension freedoms from 6 April 2015, transforming people's approach to investment. Hargreaves is one of the largest UK pensions/drawdown firms, having invested heavily in support and planning tools; and management says its preparations have paid off in terms of new business and inward transfers, also lower-than-expected withdrawals as people use the freedoms sensibly. Mind that some are now waking up to being hit with 45% tax, even for withdrawing as little as £20,000, leading to cynicism the "reforms" were really about bringing forward tax revenues. These pension changes have provided a boost but superior long-term growth remains to be seen.

Lastly, the lessons of financial history - e.g. Polaroid in the 1960s, Rentokil in the 1990s - show even the best businesses moderate progress and their stocks de-rate. Hargreaves has a sound future, but may come to be seen as a prime example of how the stockmarket became over-energised in 2013 and the first half of 2015.

For more information see hl.co.uk.