Many people lost faith in banks after witnessing the collapse of Bear Sterns and Lehman Brothers during the Global Financial Crisis. However, not all banks are huge risk takers with volatile revenue streams. State Street Corporation (NYSE:STT), a trust bank which provides various back-end services to support investment managers, boasts of strong recurring fee income.
It derives more than four-fifth of its revenue from asset servicing services and is a proxy for the secular trend of the increased outsourcing of such services. State Street Corporation (NYSE:STT) has the highest ROE of its peer group and is trading at a discount to its peers.
Why invest in trust banks rather than commercial banks?
In the aftermath of the Global Financial Crisis, investors have started paying more attention to credit risk in assessing banks as investment candidates. Trust banks typically do very little or no lending at all, unless it is linked to other ancillary services. For example, trust banks might provide financing associated with the transactions of its wealth management clients, as part of the entire service package. As a result, trust banks are less exposed to credit risk than commercial banks.
The relationships between trust banks and asset managers are more ‘sticky’ than that of their commercial bank counterparts. While it is common for companies to seek cheaper re-financing alternatives, asset managers typically do not switch service providers halfway through the tenure of their funds. Also, fee income provides more stability than net interest income. While companies have to work their socks off to generate free cash flow to pay interest, trust fees are typically deducted periodically from a stable pool of assets under management. In addition, clients value trust banks’ services, as they allow investment managers to save on costs and focus on their core competency — investing.
Why invest in this trust bank?
Strong recurring revenues are often quoted by management as investment merits for their company, but there is no reason to simply take their word as the gospel truth. There are two simple metrics to assess the ‘stickiness’ of any recurring fee income business: length of customer relationships and proportion of new business generated from existing clients. State Street Corporation (NYSE:STT) does well on both counts. According to its full year 2012 earnings conference call, about 80 of State Street’s top 100 clients have done business with them for more than a decade; and existing clients of State Street Corporation (NYSE:STT) contributed more than three-quarters of new business in fiscal 2012.
You could be forgiven for thinking that growth is limited in the asset servicing services industry, given the maturity of the investment management business. The numbers tell a different story. According to a Brown Brothers Harriman report, increased regulatory oversight of alternative investments, such as the registration requirement for advisors with over $150 million in assets under management, is driving demand for outsourced asset servicing services for alternative asset managers.
Only about a quarter (in terms of assets under management) of real estate and private equity fund managers outsource their back office services, based on management estimates. State Street Corporation (NYSE:STT) is well-positioned to capitalize on this trend by virtue of being the global leader in alternative asset servicing in terms of assets under management.
The Bank of New York Mellon Corporation (NYSE:BK) is the most diversified of the three in the peer group, deriving only half of its revenue from asset servicing and the remaining from ADR issuance, treasury services, prime brokerage services, and securities lending. Although diversified banks like The Bank of New York Mellon Corporation (NYSE:BK) typically put forward the argument of having a broad portfolio of services to attract and retain clients, I still prefer focused businesses like State Street. Besides sporting a 2.10% forward dividend yield, The Bank of New York Mellon Corporation (NYSE:BK) is also returning excess capital to shareholders through a $1.35 billion share repurchase program.