3 Reasons Why You Shouldn't Pass Up On State Street Corporation

Solid growth in its core business, impressive profitability and a strong balance sheet support an investment in this financial services company.

Jun 27, 2014 at 6:00AM
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Source: Company

State Street Corporation (NYSE:STT) might be just the outstanding financial services company you have been looking for. With an excellent track record in growing alternative assets under management, peer-group leading profitability and a strong balance sheet, State Street makes a compelling value proposition in the asset management business.

State Street offers investors a comprehensive set of financial services ranging from custodian services including fund accounting and administrative services to investment management and advisory support to research and trading. Given the range of State Street's service offering, the financial services company competes against a range of other players in the business, but most notably against The Bank of New York Mellon (NYSE:BK) and the Northern Trust Corporation (NASDAQ:NTRS).

1. Peer-group leading profitability
Both The Bank of New York Mellon and Northern Trust are respectable asset management franchises which attract mostly institutional investors in their asset servicing and asset management businesses.

Though competition in the asset management industry is fierce, State Street has consistently shown, that it knows how to tackle tough competition.

State Street has regularly outperformed its closest peers in terms of profitability as measures by the pre-tax operating margin, net interest margin and return on equity. In fact, State Street is comfortably leading its competition with respect to those metrics.

More importantly, State Street (with the exception of the development in its net interest margin) only improved its profitability over the last three years. Its pre-tax operating margin, for instance, increased from 29% in 2011 to 30.1% in 2013. State Street's return on equity improved from 9.9% in 2011 to 10.3% in 2013 and has been leading the peer group over all three years.

Both The Bank of New York Mellon and Northern Trust are lagging State Street in each year and in every performance metric.

In other words: State Street is more profitable, on a per dollar basis, than its two closest asset management peers.

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Source: State Street Investor Presentation

2. Attracting funds
Of course, when talking about asset management businesses one has to evaluate a company's ability to attract funds-preferably at a rate higher than the market growth rate. Asset management businesses oftentimes charge fees as a percent of assets under management which is why attracting more funds year after year is so important in order to grow earnings.

The alternative investments market is of extraordinary importance for State Street and it includes funds from private equity companies, hedge funds and real estate investment vehicles. The market for these alternative investments has grown strongly over the last decade due to the high returns and low correlations the alternative asset class offered investors.

Though the alternative investments market grew at a respectable rate of 14% since 2005, State Street was able to capitalize on the investments trend even more by increasing its alternative assets under administration (AUA) from $139 billion in 2005 to $1.3 trillion in 2013, reflecting a growth rate more than twice the market rate.

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Source: State Street Investor Presentation

3. Strong capital base
Business growth does not have to come at the expense of a weak capital base. One only has to look at State Street to see, that high growth and profitability can be combined with strong capital ratios.

One of the main lessons of the financial crisis has been, that bank holding companies need to be adequately capitalized in order to withstand a decline in its asset base. The bank bailouts of 2008/2009 were largely necessary, because banks took on too much leverage and retained too little equity which could absorb losses from soured mortgages and mortgage-backed securities.

As a result of the financial crisis, investors have seen a regulatory push to increase banks' capital ratios. The Tier 1 common capital ratio, for instance, gauges the financial strength of a bank by comparing its core equity capital to its total risk-weighted assets and can be quite complicated to calculate.

Long story short: The higher the capital ratio compared to the requirements of the regulator and compared to its peers, the better the banks' chances to withstand black swan events that could lead to a life-threatening erosion of a banks' asset base.

With a Tier 1 common ratio of 11.4% under the hypothetical supervisory severely adverse stress scenario (a special scenario in the stress tests of the FED), State Street actually came in second place just after The Bank of New York Mellon which took the top spot with a Tier 1 ratio of 12.7%.

Notice also the large difference of State Street's Tier 1 common ratio to the ratios of large-cap banking franchises such as J.P. Morgan or Wells Fargo.

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Source: State Street Investor Presentation

The Foolish Bottom Line
To sum up, State Street has strongly capitalized on the boom in alternative investments, exhibits peer-group leading profitability in the asset management business and remains one of the most solidly capitalized bank holding franchises in the entire sector.

With a convincing record and further growth ahead for alternative investment structures such as private equity and hedge funds, State Street has all the tools in place to continue to grow in the years ahead.

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Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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