Franklin Resources (BEN): A Cheap Dividend Aristocrat or Value Trap?

When it comes to low-risk dividend investing, it’s usually hard to go wrong with dividend aristocrats, those 51 S&P 500 companies that have managed to grow their payouts for at least 25 consecutive years.

 

After all, such consistent growth generally requires that a company operate in a stable, growing, and wide moat business.

 

As importantly, management needs to be conservative and take a long-term disciplined approach to growth, while continuously evolving the business in case the industry undergoes large and or rapid changes.

 

However, as the saying goes, “past performance is no guarantee of future results.” From time to time, secular technological or social shifts can occur that can make even mighty dividend aristocrats not worth owning.

 

Franklin Resources (BEN), also known as Franklin Templeton Investments, has delivered not only 34 straight years of increasing dividends, but blisteringly fast payout growth as well as well.

 

In fact, Franklin Resources’ dividend has grown at an annual rate of 18.2% over the past 30 years. That has helped the stock generate 11% annual total returns over the past two decades, beating the S&P 500 by about 2.3% a year.

 

However, as impressive as this track record is, there are numerous challenges facing the company going forward that will likely challenge Franklin to recreate its past success.

 

Let’s take a closer look at this struggling dividend aristocrat to see what its future likely holds and if it could be worth consideration today as a value stock in a diversified dividend portfolio.

 

Business Overview

Founded in 1947 in New York City, Franklin Resources is the 23rd largest asset manager in the world. Its 9,000 employees (including 650 investment professionals) manage $742.8 billion in assets for a client base located in more than 180 nations around the globe.

 

Franklin Resources is almost a pure play active management firm, with about two thirds of its business coming from the U.S. and a primary focus on providing equity funds (42% of assets under management):

 

 

 

 

The vast majority of its business is with retail investors, specifically through their 401Ks and IRAs.

 

Only 27% of Franklin’s clients are institutional (pensions, insurance companies, endowments, sovereign wealth funds) or high-net worth individuals who are utilizing its alternative asset management (hedge fund) services.

 

 

 

Business Analysis

The asset management business is theoretically ideal for generating secure and fast-growing dividends for the long-term.

 

After all, it’s a capital light industry that is highly scalable; relatively small fixed overhead costs can be amortized over vast asset bases, resulting in some very fat margins and returns on shareholder capital as an asset manager’s business expands.

 

Best of all, since the stock market generally rises over time (9.1% annually since 1871), asset managers should theoretically have the wind at their backs when it comes to steady, strong, and highly profitable growth in sales, earnings, and cash flow.

 

And indeed, thanks to a highly disciplined and cost cutting-focused management team, Franklin Resources enjoys higher-than-average profitability, including an impressive free cash flow margin that has allowed it to shower investors with buybacks and dividends to the tune of $13 billion over the last decade.

 

Franklin Resources Trailing-12 Month Profitability

 

 

 

The company’s capital returns have been slowing in recent years because Franklin faces a secular trend that threatens not only its ability to continue growing in the coming years, but possibly its very existence over the long-term.

 

You can see that the company’s sales, earnings, and free cash flow per share have faced challenges in recent years.

 

 

As you can see, the bull market of the 1990’s was a golden age for active asset managers. Thanks to the soaring stock market they were able to continue to attract new investor funds despite having much higher fees than passively managed counterparts, such as index ETFs.

 

However, starting around 2005 this changed and has become a stampede of investors who have finally realized that low costs are the best way to maximize long-term returns.

 

 

 

Given these much higher costs, combined with the fact that over the past 15 years 92% of large cap fund managers have failed to outperform their benchmarks (95% for small cap managers), as well as the S&P 500 in general, it’s not hard to see why passive index pioneers such as Vanguard and BlackRock (BLK) have done so well, with assets under management exploding to $4.4 trillion and $5.7 trillion, respectively.

 

 

In fact, even the greatest investor in history, Warren Buffett, who over the last 50 years has generated 20% annual returns at Berkshire Hathaway (BRK.B), has said that his advice to those seeking to save for retirement is to “consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time.”

 

And thanks to some rather poor performance by its funds (only 35% of its equity & multi-asset / balanced funds are beating half of their peers over the past three years), Franklin has been consistently losing market share, resulting in significant asset outflows in recent years.

 

 

Keep in mind that even though Franklin’s bond funds did slightly better than its peers during this time, the “top two quartiles” is a low bar to clear because it just means that Franklin’s funds were beaten by no more than half its actively managed competition. And given how poorly active managers have done over time, this achievement deserves little more than faint praise.

 

In fact, in fiscal 2016 organic assets under management fell by 12% and are expected to decline by another 6% to 9% in fiscal 2017.

 

 

 

Even the second longest and strongest bull market in U.S. history hasn’t been able to save Franklin from declining revenue, in what should theoretically be another golden age for asset managers.

 

 

If anything, five straight quarters of strong market gains have only just offset five consecutive quarters of continued outflows. Now the good news is that the rate of outflows has slowed, and management is working hard to diversify its business model towards low-cost passive investing on one side and a high-cost high net worth hedge fund business on the other.

 

For example, the company’s K2 subsidiary offers feeder hedge funds, meaning that it creates portfolios of other hedge funds for high-net worth individuals to invest in. At the end of 2016, this business had gained $2.2 billion in AUM.

 

Meanwhile, Franklin wisely decided to avoid competing for passive investor business via commoditized index funds, such as those that track the S&P 500 or Russell 2,000, because it simply lacks the scale to be able to profitably offer expense ratios as low at 0.03%.

 

So instead Franklin has launched a series of smart beta indexes and actively managed ETFs under the Franklin Libertyshares brand.

 

A smart beta ETF is one that, unlike traditional index ETFs, doesn’t weight by market cap, which can result in overexposure to the most popular (i.e. most overvalued) stocks, but rather weights by quality and value factors, such as volatility, valuation, and returns on equity and assets.

 

It’s not hard to see why Franklin is hanging its future growth on smart beta ETFs. After all, it’s the fastest growing asset class, with BlackRock estimating that total AUM will grow 37% annually from $282 billion in 2016 to about $1 trillion by 2020.

 

Franklin has created its own quality-based indexes, such as the LibertyQ U.S. Large Cap Equity Index, which is composed of 246 U.S. mid and large cap companies that have favorable exposure to four investment style factors – quality, value, momentum, and low volatility.

 

Each of these factors has been shown by decades of historical research to result in market-beating performance. Franklin is betting that combining all four will create proprietary indexes that its ETFs can track to beat the overall market, attracting strong AUM inflows and allowing it to charge slightly above average expense ratios (e.g. 0.25% for the LibertyQ US Equity ETF).

 

Meanwhile, active ETFs are essentially the same as actively traded funds, except with all the benefits of ETFs, including: greater tax efficiency (i.e. lower turnover), lower cost, and greater liquidity because they are traded like stocks throughout the day. These funds are designed to beat their indexes, rather than merely track them.

 

Key Risks

“The cosy old world of asset management seems already seems like a different era. One day, CEOs will probably tell their grandchildren about the bygone days of fat margins, soft dollars and dubious intermediary arrangements. Business school students will be shocked by case studies of high-fee, low-added-value active management.”

-Liam Kennedy, editor Investments & Pensions Europe

 

There are three main risks to investing in Franklin Resources.

 

First, as you can see below, there are many larger asset management rivals for it to compete with for market share and investor dollars.

 

 

While it’s true that in the coming decades the economic growth of emerging markets will likely result in much greater demand for asset management, it’s far from certain that Franklin will be able to attract those investment dollars.

 

In fact, should current trends continue, then BlackRock (which operates the very successful iShares ETFs) and Vanguard could continue to become ever more dominant.

 

 

That’s because with such vast AUM, these mega-money managers can afford to cut expense ratios to the bone. In fact, Vanguard recently unveiled a new share class for the Vanguard Total Stock Market Index and Total Bond Market Index funds that boasts the lowest expense ratio yet seen, just 0.01%.

 

That’s just $500,000 in fees to manage $5 billion for pension and sovereign wealth funds to gain access to the entire U.S. stock market, including 3,613 small, mid, large, and mega-cap companies.

 

But shouldn’t Franklin’s smart beta and actively-managed ETFs be able to turn things around? Perhaps, but keep in mind that Franklin is far from the first to try this approach.

 

Specifically, a smart beta ETF is where an asset manager makes up their own index to track against. So naturally this creates a defense against “underperforming your index” because by definition the portfolio is the index.

 

Of course that kind of loophole, combined with asset managers desperation to stem the tide of outflows has resulted in an explosion of new indexes.

 

 

 

In fact, today there are more indexes than individual stocks because everybody and their mother is launching their own smart beta ETFs.

 

Even specialized asset managers such as WisdomTree (WETF), which is a pure play smart beta ETF sponsor with 11 years of experience and that pioneered the concept of alternative factor weighting (e.g. weighting positions by dividends instead of market cap), are struggling to maintain assets in the face of such well-capitalized competition.

 

Trailing 12-Month WisdomTree US AUM 

 

This can be a problem for new entrants into the market like Franklin because while smart beta ETFs are pretty hands off, rules-based autopilot style investment vehicles this don’t mean that they cost nothing to run.

 

In fact, the total operating costs for most ETFs is between $250,000 and $500,000 a year. And according to Morningstar the average smart beta expense ratio is 0.485%, meaning that, on average, a smart Beta ETF requires $50 to $100 million in AUM just to break even.

 

In the case of Franklin’s lowest cost smart beta ETF, the 0.25% expense ratio means that it needs $100 million to $200 million in AUM to be sustainable. Unfortunately for Franklin, just one of its smart beta ETFs has managed to attract this kind of investor interest.

 

 

While Franklin’s smart beta ETFs are still too new to pass final judgement on their ultimate success, there are a few troubling trends.

 

In particular, after launching its first series of smart beta ETFs one year ago, only the emerging markets fund has proven a hit with investors.

 

Similarly, the newest ETF offerings, focused on U.S. equities, indicate that only the broadest fund is likely to prove profitable in the long-term, rather than more specialized, esoteric, and higher expense ratio (i.e. more profitable) offerings.

 

And as for active ETFs? Exchange maintenance fees (the cost of being listed) are actually $35,000 a year greater for active funds than passive ones, as are listing fees.

 

However, don’t forget that these funds require a full-time manager (some of Franklin’s active ETFs have two) that have to be paid, which means that active ETFs can easily cost at least $1 million per year to operate.

 

Worst off all, when it comes to active ETFs, Franklin has thus far failed to find any footing.

 

 

In fact, not a single one of its active ETF is likely large enough to be profitable for Franklin, much less stem the outflow tide or the margin compression that the industry’s race to the bottom on fees is causing.

 

For example, the short duration U.S. Treasury bond fund is nearly four years old and has yet to gain anywhere close to enough assets to remain viable in the long-term.

 

Meanwhile, the U.S. Low Volatility ETF, of which there are are numerous lower cost smart beta alternatives, has for all intents and purposes failed to attract any net investor capital (Franklin provided seed funding of about $5.5 million to launch its active ETFs last year).

 

In other words, Franklin’s attempts to protect its fees with active ETFs has, at least thus far, been an unmitigated failure.

 

That’s not surprising given that high fees were just one part of the reason that investors began flocking to passive ETFs in the first.

 

The other was that the far majority active managers have essentially proven to be about worthless, thus making the entire concept of active ETFs not that much different than the traditional active mutual funds that are now in decline across the industry.

 

Which ultimately means that, although Franklin Resources’ continues to be a highly profitable, free cash flow machine, its weak competitive position in the new industry paradigm (in which it has zero previous experience) is likely to force it to continue cutting expense ratios on its core active mutual funds while it hopes to find a mix of smart beta ETFs that can finally restore its sales, earnings, and FCF to growth.

 

 

 

However, as bad as things look for Franklin right now, they could also get worse. That’s because the company has been struggling with flat or declining sales and earnings during the second strongest, longest, and least volatile bull market in history.

 

While all asset managers will see AUMs, sales, and profits collapse during bear markets, Franklin is especially at risk because 73% of its business is retail, rather than institutional or high-net worth clients.

 

In other words, if we are near the end of the current market cycle, things are likely to get a lot worse for Franklin before they get better.

 

That’s because the people investing in its mutual funds are the most likely to panic and stampede for the exits once the economy enters another recession and the bull market turns into a bear.

 

 

 

Finally, be aware that the Department of Labor’s Fiduciary Rule, in which financial advisors must do what is in the best interest of their clients (instead of peddling high fee funds that give them kickbacks) remains in effect despite some industry insiders expecting the new administration to rollback this newest of financial regulations. However, that is far from a certainty.

 

For example, Skip Schweiss, director of advisor advocacy for TD Ameritrade Institutional, recently said:

 

“What people are missing about this rule is that it is final – this is not a work in progress. The house has been built, it’s just waiting for us all to move into it. To undo the rule would be to say that we all need to tear down the house, to reverse and somehow undo a final rule. That would take an entirely new rulemaking process.”

 

In other words, with the administration currently struggling with numerous other important policy goals, the Fiduciary Rule (which could negatively impact Franklin’s future AUM flow via its broker/dealer and advisor channels) could well survive and result in even further growth challenges.

 

Franklin Resources’ Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Franklin Resources has a Dividend Safety Score of 95, indicating that the company has one of the most secure dividends in the market, which is what one would usually expect from a dividend aristocrat that has been raising its payout every year since 1982.

 

 

There are two keys to this consistency. First, management has remained highly disciplined about maintaining very low EPS and FCF per share payout ratios.

 

As seen below, the company’s payout ratio has been in the teens most years it did not pay a special dividend.

 

 

This creates a very large safety cushion that ensures that even through EPS and FCF are highly cyclical, rising and falling with the market, the dividend is always well covered by both earnings and cash flow.

 

The second major protective factor is the company’s fortress-like balance, specifically one marked by an enormous net cash position (enough to fund the dividend for 18 years), and one of the highest current ratios (short-term assets/short-term liabilities) in the industry, indicating the company has no problems servicing its debt or liabilities.

 

 

When we take a look at Franklin’s debt levels relative to its peers, we see further proof of the company’s extremely healthy balance sheet.

 

 

With a leverage ratio that’s about 10 times less than the industry average and a very high interest coverage ratio, it’s no surprise that Franklin enjoys such as strong investment-grade credit rating.

 

That in turn allows it to borrow very cheaply (average interest rate 3.6%), which, along with its massive cash position, allows it to not only continue growing the dividend, but also invest in future growth by acquiring new asset managers in other countries and industries (such as K2 Securities to get into hedge funds).

 

Franklin Resources Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Franklin Resources has a Dividend Growth Score of 71, indicating that dividend investors can expect continued stronger than average payout growth, at least for the time being.

 

That’s about what one would expect given Franklin’s impressive dividend growth rate over the past decades.

 

 

 

However, while Franklin’s current payout is rock solid and likely to continue growing, if only due to the very low payout ratios and massive net cash position, in the long-term a company’s dividend can only grow as fast as its bottom line.

 

With investors continuing to pull money out of its funds, Franklin is going to face some very challenging times, no matter what the market does, if only because the industry’s race to the bottom on fees will mean ongoing margin compression.

 

Combined with the potential for a market downturn in the next few years, Franklin’s sales, earnings, and cash flow seem likely remain flat or even shrink.

 

Thus, barring some seemingly unlikely turnaround in worldwide investor sentiment (active funds becoming more popular than passive), dividend investors must expect future payout increases to slow far below their historical double-digit rates, perhaps to 7% to 8% in the short-term (1-3 years) and 4% to 5% over the next decade.

 

Valuation

Over the past two and a half years (when AUM started falling quickly), Franklin shares have underperformed the S&P 500 by about 50%.

 

But since the election of Donald Trump, and hope for a repeal of the Fiduciary rule, as well as tax cuts and a repatriation holiday (that would allow Franklin to bring back $4 billion in overseas cash), shares have gained more than 20%.

 

However, thanks to many years of underperforming not only the broader market but also other asset managers, today could be an interesting time for contrarian value investors to take a closer look at Franklin Resources, assuming you have faith that management can somehow right the ship eventually.

 

 

That’s because BEN’s forward P/E is now 15.0, far below the S&P 500’s multiple of 17.4. Meanwhile the yield of 1.9%, while not enough to make this stock suitable for living off dividends during retirement, is more than twice as high as its average yield of 0.8% over the past 22 years.

 

In fact, in the past two decades Franklin’s yield was only higher 10% of the time. If you believe the company will be able to somehow return to growth, Franklin’s stock looks interesting.

 

That being said, even at today’s historically attractive valuation multiples, investors should likely only expect to earn a potential total annual return of about 5.9% to 6.9% (1.9% yield plus 4% to 5% annual earnings growth) over the next decade, far below the company’s historical return rate and the returns offered by most other dividend aristocrats.

 

Conclusion

Franklin Resources has one of the most impressive dividend track records on Wall Street. Combined with the high margin, cash-rich nature of its business, a bank vault-like balance sheet, and a disciplined and shareholder-friendly management team, income investors need not worry about the safety of the payout for a long time.

 

However, be aware that Franklin’s 70-year history has been as an expert in actively managed mutual funds, in which it has built a strong brand that has allowed it to grow steadily until the last few years.

 

But with subpar performance across its actively managed funds, very little expertise in smart beta ETFs, a failing active ETF business, and no chance at breaking into the regular index ETF market (that BlackRock and Vanguard dominate), future growth prospects look very grim for Franklin Resources.

 

Even though the current dividend yield is among the highest it’s been in decades, anyone considering this legendary dividend aristocrat needs to keep in mind that thus far management has shown no ability to halt the secular decline in its core business.

 

There are plenty of other investments to consider in the market that provide much higher yield (review some of the best high dividend stocks here) or much faster long-term growth prospects than Franklin Resources. While their valuations may not look as attractive, many times you get what you pay for.