Federated Hermes, Inc.

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

Federated Hermes is a leading global investment manager, providing a wide range of investment solutions and related services to institutional clients, financial intermediaries, and individual investors.

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The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Federated Hermes, a leading global investment manager, operates with a diverse range of capabilities, offering solutions in equity, fixed income, and alternative investments. Despite its established position and some scale advantages, the firm faces intense competitive pressures and has only a narrow and limited moat.

Business Overview

Federated Hermes, Inc. is an investment management company that offers a range of services and products to a diverse client base that includes institutions, financial intermediaries, and individuals. Here’s a breakdown of their business:

  • Revenue Distribution: The company generates revenue through investment advisory and administrative services, with investment advisory services being the major contributor.

    • Investment advisory fees are earned from managing various investment portfolios, which encompass equity, fixed income, money market, and alternative strategies.

    • Administrative fees are typically earned on the assets under management.

  • Trends in the Industry: The asset management industry is characterized by several significant trends:

    • Shifting Landscape: Increasing competition from both traditional and alternative investment providers.

    • Fee Pressures: Intensified competition is further leading to pressure on fees, squeezing margins for managers who cannot demonstrate value beyond that of their peers.

    • Focus on Performance and Value: There’s a strong movement toward performance-based fees and an increased investor focus on value creation, pushing managers to justify their returns.

    • Regulatory Changes: Stringent financial regulations impact the business strategy for all players, including the way that managers approach their business and capital strategies.

    • Market Volatility: A highly volatile market is characterized by high interest rates and inflation as well as geopolitical turmoil.

  • Margins: Federated Hermes’ operating margins have shown fluctuations in recent years. The operating margins are influenced by fee rates, expense control, and market-related changes in the value of assets under management (AUM). In particular, market declines decrease AUM as a result decreasing fees and squeezing profits. In order to provide some context on profitabilty, for example, the adjusted net income margins for the first six months of 2023 was 12.9% whereas in the same period of 2022, the margin was 19.6%, showing a large decline.

  • One of the most effective methods for value creation is revenue growth, but in this industry this is highly linked to AUM, which is affected by factors outside the control of management, including market performance.

  • Moreover, a large portion of the operating expenses goes to personnel costs, which can also be very difficult to mitigate.
  • Competitive Landscape:
    • The market is intensely competitive, with numerous firms that compete in all categories. Large companies such as BlackRock, Fidelity, and Vanguard, offer similar investment solutions. The market is incredibly crowded and is often very difficult to separate from other competitors who might have the same products and brand, and who are offering similar strategies and performance.
  • Alternative investment firms can also be viewed as competitors, since they are also a threat. * Smaller or specialized managers often focus on niche strategies, such as emerging markets, high-yield bonds, or socially responsible investing.

  • What Makes FHI Different: While many competitors focus on market share, and AUM growth, Federated Hermes is focusing on long term performance and also has a reputation for being a high-quality player. The company emphasizes a consistent investment approach with a focus on maintaining positive returns through all market cycles.

  • In addition, the company also tries to engage with their shareholders in a more direct and transparent manner, as seen by their open communications and detailed earnings reports.
  • They are focusing on becoming a partner to their customers, rather than just a service provider.

Moat Analysis

Based on the definition that a moat is a sustainable advantage that protects the company from competitors for the long term, FHI’s moat is rated a 2 / 5, indicating that it has some, but limited, ability to prevent competitors from replicating its business model.

Here’s why the rating is as such:

  • Intangible Assets: FHI’s brand recognition, while established, is not particularly strong enough to give it a considerable advantage that would allow it to extract pricing power or high customer captivity.

    • While clients and partners might have some familiarity with the name, they might not prefer this over other managers.
    • Most clients choose their managers for performance and returns, and very few will favor this because of their brand name.
  • Switching Costs: For traditional clients with long and complex investment plans, there is some difficulty in moving out of this service and into another. This provides a small switching cost to their clients.
    • It should be remembered though that most clients will move to different managers very quickly if they are not generating the required levels of returns, no matter what switching costs are present. Therefore, their profitability is not as protected as, for instance, a software company with high switching costs.
  • Network Effects: Network effects are almost nonexistent in this industry, clients do not favor or choose a specific manager because other clients are using them. The value of FHI’s service to a customer is mostly independent of the size of their customer base.

  • Cost Advantages: Federated Hermes has cost advantages due to its scale, which enables some standardization and lower costs in several areas of operations.

  • However, smaller and more flexible firms are able to compete due to low requirements of their resources. Also, the cost structure within asset management is usually not very large. Therefore, smaller companies can also achieve similar levels of margins.

Risks to the Moat and Business Resilience

Although FHI has shown that it is able to generate good profits consistently over time, this is not completely immune to risks. Some of the key risks that could harm both its moat and its business resilience are:

  • Market Volatility: A sharp downturn in financial markets can significantly impact FHI’s AUM, which directly affects its revenue and profitability.

    • During times of market turbulence, investors could reduce their holdings in the stock market, as well as decrease their appetite for new investments, thereby reducing revenue for asset management firms.
  • Fee Compression: Increasing competition may intensify the downward pressure on fees. It’s quite unlikely that FHI will be able to command a higher price than its competitors over the long run. As a result, margins could be compressed even further.
  • Performance Risk: Investment performance may vary and poor performance may result in lower retention of current customers and make acquiring new clients even more difficult.
  • The firm’s long term performance might not materialize as expected due to the high volatility in markets, causing their clients to leave.
  • Key Personnel Risk: A large amount of key people leaving the company or being less productive would have a severe adverse impact on the company.
  • Regulatory Risk: The company is subject to various financial regulations and changes to these regulations can materially impact their business operations and cost structure.
  • Disruptive Technologies: Technology advancements may disrupt the traditional investment management practices that FHI relies upon. If there is a new way of managing clients through the help of technology, FHI may not be able to keep up with the new landscape of the industry.

Given these risks, FHI exhibits modest resilience. While it can rely on a certain degree of stability given its AUM base, fluctuations in both AUM and revenue are likely, as is evident in the past few years.

Financial Analysis

FHI has shown a history of generating profits that have been sufficient to be a sustainable business. However, in times of market volatility and crises, these profits have suffered, implying it is not immune from market fluctuations.

  • Revenue: FHI’s revenue is primarily dependent on investment advisory and administration fees. As of YTD in September of 2023, revenue has decreased to $1,345,318, compared to $1,446,621 in the same period of 2022, as a result of lower AUM and a shift in business mix.
    • The company makes money by charging their clients a fee based on the amount of assets that they manage, leading to fluctuations based on market performance.
  • Expenses: Compensation and related expenses remain the largest component of operating expenses, which are mainly related to the employees of the firm. This can pose a problem when management is trying to minimize costs, in order to achieve more profits.
    • Operating expenses are relatively stable and predictable in other components.
  • Profitability: Due to the reasons mentioned before, profits tend to fluctuate significantly over the years. Net income margins in the past few years have ranged from 10% to almost 20%, showing how their profits can move due to market conditions.

  • Balance Sheet Health: Federated Hermes has shown a strong balance sheet, with a manageable debt load, and sufficient levels of cash to meet its obligations and to continue to invest in its business.

    • Total debt of the company is $591.4 million, and the total assets are $3,344 million, showing the company is quite capable of sustaining any downturns.

  • Current Controversies/Problems: There were concerns about Federated Hermes’ performance in the 1Q2023 results due to market declines affecting revenues. Despite the problems in the market environment, management has expressed optimism about the company’s long term goals and ability to drive shareholder value. They also stated that despite their strong focus on the long-term, the company also looks forward to the opportunities that arise in the short-term, implying that they are flexible and will adapt to changing market circumstances.

  • The most recent 3Q2024 results showed that the revenue was up by 18% compared to the same period of 2023, as well as a net income per share of $0.78 compared to a net loss of 0.32 in the same period of 2023, giving reason to be more optimistic than in the past.

Understandability

The investment management industry and the specific operations of Federated Hermes are moderately complex to understand. Here’s why the understandability rating is 3 / 5:

  • While the general concept of investment management may be simple to understand, analyzing the various investment strategies, the nuances of different market conditions, and the specifics of the financial performance of FHI requires a certain degree of financial acumen.

  • Furthermore, it can be difficult to predict the future performance for asset managers, as this depends on different factors, many of them out of their control.

  • Moreover, analyzing and understanding financial statements of such a company requires an understanding of accounting as well as finance, which further increases the difficulty in predicting its future performance.