It’s increasingly obvious that the Federal Reserve Open Market Committee (FOMC) will start to raise short-term interest rates by the end of this year. For banks, insurance companies, and many other financial institutions, higher rates can’t come soon enough, as they will start to generate higher interest income on their vast cash balances.
Yet one financial services company in particular has especially strong leverage to rising rates, making it a timely investment.
Federated Investors (NYSE: FII ) is an asset management firm with a focus on equity, fixed income, and money market accounts.
Money market funds are investment vehicles in which the primary focus is protection of principal. Fund managers invest in only very short-term bonds where the risk of loss is nearly zero. In normal interest rate environments, the firm keeps a sliver of the investment profits for itself.
But these are not normal interest rate times. With short-term yields at nearly zero, Federated Investors has not been able to cover the costs of running the funds. Instead of charging the cost difference to fund investors, Federated Investors has voluntarily issued “fee waivers” to its clients. The waived fees, which would constitute a significant source of revenue for the firm, ensure that customer accounts always maintain positive or zero net yields.
Adding the net fee waivers back into operating income shows the true potential earnings power of this company. In the chart below, I’ve done just that:
As my findings show, under a 35% tax rate, Federated Investors earnings per share would have climbed from $1.42 in 2014 to $2.19, assuming fee waivers weren’t in place.
When interest rates normalize, the fee waivers will disappear and the rest of the market will catch on to Federated Investors’ true earnings power.
Federated Investors’ management hasn’t been waiting for interest rates to rise to improve the business mix. In 2009, money market funds accounted for almost 80% of assets under management and 70% of its revenue. Over the past six years, Federated Investors launched a number of equity and fixed-income funds to diversify its business model.
This diversity of revenue offers some protection to investors should the rate hikes get delayed. The company has grown assets under management in its non-money market business 6% per year since 2010, which has slowly reduced Federated Investors’ reliance on money markets. Money markets now account for only 31% of revenue.
Most investors see rising rates as imminent and most financial services stocks have rallied in anticipation. But shares of Federated Investors shares have lagged. Check out the chart below, which shows that FII is still seven percentage points back from the rest of the financial sector — represented here by Financial Select Sector SPDR Fund (NYSE: XLF ).
The market still isn’t fully accounting for this company’s very fast earnings growth potential when rates rise. Not only will Federated begin collecting fees on its money market accounts, higher rates will also encourage clients to keep money in those accounts when they start earning a positive return, juicing the assets under management and associated fee revenue it can collect.
Risks to Consider: Federated Investors is a play on rising rates. Investor returns will largely depend on factors outside the company’s control. China’s recent move to devalue its currency could encourage the FOMC to wait on rate hikes.
Action to Take –> At $33 per share, the stock trades at a significant discount relative to its true earnings potential. The company’s 3% dividend yield is a nice way to keep shareholders happy until interest rates cooperate.
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