MSCI (MSCI) has been a primary benefactor of the rise of index and ETF investing over the past decade. Since 2010, the share of the U.S. equity market in passive investing has risen from around 20% to over 50% today. The number of ETFs has also risen from 2500 in 2010 to over 6500 today. Most amazingly, the number of indices rose to over 3.7 million in 2018 (70X higher than the number of public stocks), however, this figure has since fallen to just under 3 million.
MSCI is a leader in indices as that is their “bread and butter” business. This meteoric rise of passive over active has meant significant revenue gains to MSCI. That said, MSCI’s stock price is now increasing at a much faster pace than the company’s revenue as shown below:
In fact, they now trade at the extremely high valuation of 14.6X TTM revenue. Investors are obviously expecting extremely large revenue and margin expansion over the coming years.
But, what if that growth does not come? Looking at their 3Q 2019 presentation we can see that the bulk of their sales comes from their Index data (46%) and Analytics (42.5%). While these are mainly recurring revenue streams, pressures are mounting in the business.
This includes loss of spending power on behalf of ETF issuers due to intense recent expense ratio cutting, which will almost certainly result in license fee reductions either by demand from clients or by growing competition. Remember, it is not very hard to create an equity index (speaking from personal experience).
Even more, there is considerable evidence that passive investing has created market distortions that will eventually lead to its underperformance. If this occurs, it will be MSCI who takes the biggest hit.
A Look at MSCI’s Valuation
Given the expected pressures on MSCI’s core business, I would not assume they will continue to grow revenue at the current pace over the next few years (if at all). That said, the market seems to believe that MSCI’s growth will continue in an exponential line upward.
To begin, take a look at the company’s income data over the past few years:
As you can see, they have seen their revenue nearly triple since 2010. While this is a very strong growth rate, there is little reason to believe it will continue into the 2020s for reasons that will be explained in the following section.
Interestingly, they managed to grow revenue during the Financial Crisis which is logical considering many investors were moving toward passive investing. This may mean investors today do not believe MSCI has cyclical risk. This is partly true, but it seems clear they have more cyclical risk than in the past as data suggests passive investing itself may be in a bubble. More on this in the following section.
Moving on, take a look at their margin data over the past decade and a half:
They have grown gross and net margins likely due to growth in their higher-margin indexing business. That said, operating margins and revenue per employee which are my preferred metrics have been pretty stagnant. Because revenue per employee has not increased too much, they may have difficulty expanding revenue due to the historically tight financial services labor market.
At any rate, the company is extremely expensive. Take a look at their valuation data below:
The current average valuation for U.S. large-caps is 24X and the long-run median is 15X. This means that, given no improvement in margins, the company will need to increase sales by 60% to 150% in order to fit the large shoes investors have given them. Personally, considering the large squeeze on margins across the financial services industry and growing competitive pressures, I seriously doubt they will be able to achieve such growth.
Pressures Facing MSCI’s Revenue
The major issue I see with MSCI is growing pressure in the Financial Services industry to cut costs. As I mentioned earlier, barriers to entry in the index providing business are extremely low.
Issuers are becoming increasingly interested in ‘self-indexing’ where they simply design their own indices to avoid paying hefty fees for using MSCI’s. There has been talk of this risk for years, but now that expense ratios have hit extreme lows it may override the “network effect” inertia of index providers. In fact, the company Research Affiliates is working on backtesting tools that aim to make the “self-indexing” process even easier for issuers.
When secular economic trends are favorable, the big get bigger. As passive investing has become increasingly popular and ETF issuers have seen strong income growth, they have had little reason to doubt the high fees paid to index providers and really have limited incentive in self-indexing. That said, there is mounting evidence that money flows may shift back toward active.
As a personal example, I mainly cover ETFs and see the great value they provide, but have found considerable valuation differences today between sectors that have increased my interest in stocks. Borrowing a chart from a past article I wrote “Michael Burry Is Correct About Passive Investing: Here Is The Proof” we can clearly see that the larger a company is, the lower is its earnings yield:
As a company’s market cap rises, it fits into more and more indices which means passive ETF flows will rise. This often further increases the company’s market capitalization and sometimes ends with persistent outperformance in what is known as the well-studied “index effect”.
More research is needed to know the true extent of this problem, but considering a major value pitch of ETF issuers and index providers is the “Outperformance of Passive“, this is highly problematic. Not only would a hit to total ETF AUM slow licensing growth and put negative pressure on fees, but would also directly cut their asset-base performance fee revenue.
Now, one could rightly argue that the “Analytics” side of their business would gain from a move back toward active. Looking at their revenue gained from analytics and the specific tools they offer, this appears to be a stronger part of their business. Still, barriers to entry in the software business are relatively low and that they will be facing an uphill battle.
The Bottom Line
MSCI is certainly an innovative firm, but we are reaching a point where customer growth in the industry is fading and businesses will need to more directly compete with each other.
We are already seeing price competition among ETF issuers. Index providers have been generally immune, but a small crack toward self-indexing will likely quickly turn into a significant wedge as network effects supporting indexers fade. If there is indeed a “Passive bubble”, its popping will likely act as a major catalyst for this.
Again, I find MSCI’s Analytics business impressive, but again it seems clear that growing competition will slow growth. Remember, for MSCI to be at fair-value today the company must achieve very high revenue growth so any negative pressures will likely drastically lower its valuation.
In all likelihood, I believe their revenue and income five years from now will be about the same as it is today due to expected price pressure and difficulties finding new customers. Given the 15-24X “fair” P/E ratio for large-caps, this gives us a target price of $100-$170. Due to its high momentum, I would not short the stock today, but I may do so in the next few weeks or months.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in MSCI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.