10 Core Stocks for Your Portfolio: MSCI

This week and next, we're presenting 10 core stock ideas -- stocks our writers believe can serve as the foundation for a long-term-focused portfolio.

If you're reading this article, chances are you follow your portfolio more closely than the average investor, and I expect you track your returns against those of a stock market index such as the S&P 500. For professional investors, there are no two ways about it -- they live and die by their performance relative to their benchmark index. MSCI (NYSE: MSCI  ) is one of the heavyweights when it comes to providing these investors with a full range of indices; the firm calculates values for some 120,000 equity indices daily!

Company name and ticker

MSCI (NYSE: MSCI  )

One sentence statement of operations

Provides index data and equity risk management solutions to professional investors.

Recent price

$33.98

Market Cap

$4.0 billion

P/E (Next 12 months' EPS)

21.6

ROE

20.3%

Source: Capital IQ, a division of Standard & Poor's.

The business
But offering indices as performance measurement tools is not the only way to monetize them; MSCI also licenses them so that exchange-traded fund (ETF) providers such as BlackRock's (NYSE: BLK  ) iShares unit can offer ETFs based on the same. For their trouble, MSCI is remunerated on the basis of the assets under management (AUM).

At the end of August, AUM in ETFs linked to MSCI indices totaled $259 billion. The index with the highest associated assets is the MSCI Emerging Markets Index, which accounts for more than a quarter of the total.

MSCI's major competitors in the index business are Dow Jones (a unit of News Corp (Nasdaq: NWS  ) ), Standard & Poor's (a division of McGraw-Hill (NYSE: MHP  ) ), Russell Investment Group and FTSE International.

MSCI's other main business is Equity Portfolio Analytics, which it inherited from its 2004 acquisition of Barra -- the offerings in this area are still branded under the Barra name. Barra's equity return model enables enable investors to optimize their portfolios by breaking stock returns into a set of common factors (style, industry, etc.). The model has gained significant acceptance, to the point where at least one of MSCI's competitors in this area, FactSet Research Systems (NYSE: FDS  ) has integrated Barra risk data within its own application. Better yet, asset owners, i.e., fund managers' end clients, often request Barra risk measurement data when they are selecting investment managers.

Why it's a core stock
Defensible franchise: By definition, when you are hunting for a "core" stock for your portfolio, your first priority must be to ensure that the company has a sustainable competitive advantage. A core stock is one you expect to hold in your portfolio for years to come, and only a lasting competitive advantage can provide above-normal returns over this extended holding period.

Imagine if you had to replicate -- from scratch -- MSCI's comprehensive database of worldwide indices and risk data. In some cases, you'd be required to reproduce indices that go back over 40 years. Do you think that would cheap or easy to do? Of course not! It's an undertaking that would require substantial time, effort, and the sort of expertise that you don't accumulate overnight. MSCI itself did not appear ex nihilo -- it was spun out of Morgan Stanley (NYSE: MS  ) in 2007.

Replicating these assets is a formidable barrier to entry that protects MSCI's franchise and enables it to earn high returns on capital, year in and year out.

Recurring revenues with high retention rates: The vast majority of MSCI's revenues are tied to recurring annual subscriptions. These revenues tend to be very "sticky": MSCI's its average aggregate retention rate over the past three fiscal years was 91%. Combine both these characteristics, and you have a highly enviable revenue model.

Risks
Last week, a European fund manager at BlackRock (NYSE: BLK  ) (which just happens to be MSCI's largest customer), declared that the "cult of equity" is dead. If that does turn out to be the case, it won't be good news for MSCI, with the bulk of its revenues tied to the management of equity portfolios. Although I think we are witnessing a shift from equities toward fixed income, I also think the report of the death of equities is an exaggeration. Still, it is worth keeping this phenomenon in mind in tracking MSCI's results over the next several quarters.

In sum
At 21.6 times the consensus estimate for the next 12 months' earnings, one would be hard-pressed to call MSCI cheap. Compare that to another high-quality franchise with strong recurring revenues, high returns on capital and low capital needs, Automatic Data Processing (NYSE: ADP  ) , which trades at a multiple of 16.5.

As such, I don't recommend jumping into this stock with both feet at these levels. There is nothing wrong with dipping your toe in and opening a small position, but this is a core stock, so there is no hurry to own it. If you expect these shares to anchor your portfolio for several years, you can afford to be patient and opportunistic in building your position. High-quality franchises like MSCI will almost never look cheap, but if the gap with ADP's current multiple were to close, the shares would certainly warrant a more serious buying commitment.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. BlackRock is a Motley Fool Inside Value pick. FactSet Research Systems is a Motley Fool Rule Breakers recommendation. Automatic Data Processing is a Motley Fool Income Investor selection. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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