Morningstar digests “surprising” Franklin/Legg deal

Morningstar has put Franklin Templeton and Legg Mason ‘under review’ following the merger announced this week.

Morningstar is digesting what the deal means to the combined firm’s competitive advantage, as expressed by the Morningstar notion of ‘economic moat’.

While in favour of consolidation among US-based asset managers to help them achieve scale and offset fee pressure, Greggory Warren, Morningstar equity analyst, says “a combination of narrow-moat-rated Franklin Resources [which owns Franklin Templeton] with no-moat Legg Mason was not even on our radar”.

In Morningstar’s words (see below), the idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period.

“We believed both firms were likely to be acquirers of smaller asset managers as opposed to either one being an acquisition target,” Warren wrote, acknowledging “surprise” at the deal after believing most US-based asset managers would be buyers rather than sellers.

Once combined, the asset manager will have a heavier focus on fixed income (expected to account for 46% of managed assets) as opposed to equities (33%).

Warren says: “While Franklin looks to be willing to retain Legg Mason’s affiliate structure, which has proved problematic in the past, we think the strength of the deal resides in Western Asset Management, which accounted for 57% of Legg Mason’s $792 billion in AUM at the end of December 2019.

“This will not only expand Franklin’s bond operations, making it far less reliant on the Michael Hasenstab-driven global/ international fixed-income platform, but also benefit from Franklin’s registered investment advisor distribution network.”

Michael Hasenstab is Franklin’s chief investment officer for Templeton Global Macro, the branch of the firm that conducts macro-economic analysis.

With a price tag of $4.5 billion, or $50 per share of Legg Mason common stock, Morningstar said this was more than a 25% premium to its fair value estimate for Legg Mason. However, the firm added it expects to lift the fair value estimate to $50 per share “as we see little that would stand in the way of the deal getting done”.

What is Morningstar’s economic moat?

The firm says: “Economic Moat is a proprietary Morningstar data point.

“The idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it’s this characteristic–think of it as the strength and sustainability of a firm’s competitive advantage–that Morningstar is trying to capture with the economic moat rating.

“At Morningstar, one of the first things we do when we’re thinking about the size of a firm’s economic moat is look at the company’s historical financial performance. Companies that have generated returns on capital higher than their cost of capital for many years running usually have a moat, especially if their returns on capital have been rising or are fairly stable. Of course, the past is a highly imperfect predictor of the future, so we look carefully at the source of a company’s excess economic profits before assigning a moat rating.”


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