FHI - Federated Hermes: The Future Is Bright

2023-09-08 01:02:21 ET

Summary

• Federated Hermes stock price performance in the past three months wasn't as good as that of the broader market.
• The company views its shares as undervalued, and it is highly probable that FHI will execute share repurchases at a faster pace in the near term.
• I maintain a Buy rating for FHI, as I think that Federated Hermes' future is bright considering my expectations of a share price recovery for the stock.

Elevator Pitch

Federated Hermes, Inc. ( FHI ) shares continue to be rated as a Buy.

Earlier, I assessed FHI's AUM (Assets Under Management) growth potential and the stock's valuation metrics in my prior write-up for the company published on June 27, 2023.

In the current update, my attention turns to Federated Hermes' recent share price underperformance and I highlighted what could potentially change for FHI going forward. FHI's shares were hurt by index exclusion, insider selling, and market share loss in the last few months. Looking ahead, Federated Hermes' potential share buybacks and inorganic growth opportunities are expected to re-rate FHI's valuations in a positive way. As such, FHI's future is bright, which supports a Buy rating for the stock.

FHI's Share Price Underperformance

In the last three months, Federated Hermes' stock price decreased by -5.5% , while the S&P 500 rose by +4.2% during the same time period. In other words, FHI's shares underperformed the broader market by close to -10% in the past couple of months.

I am of the opinion that Federated Hermes' shares have done poorly in recent months due to a couple of reasons.

Firstly, FHI was excluded from the Russell 3000 Index on June 23, 2023, so it was natural that funds whose performances are pegged to the Russell 3000 would have sold their Federated Hermes shares.

Federated Hermes' share price declined by -7.4% from $37.97 as of June 21, 2023 to $35.16 at the end of the June 27, 2023 trading day. At the company's most recent Q2 2023 earnings call in late July, FHI attributed the share price volatility shortly before and after the index exclusion to certain investors "addressing and preparing their portfolios in advance of the Russell change."

Looking ahead, Federated Hermes emphasized at its second quarter results briefing that the Russell 3000 index change is "in the rearview mirror now because our share trading seems to have settled down to more historical levels." More importantly, index inclusions or exclusions are unrelated to business fundamentals, so it is unlikely that the recent changes to the Russell 3000 Index will have a lasting impact on Federated Hermes.

Secondly, SEC filings which indicated insider selling activity might have hurt short term investor interest and confidence in Federated Hermes.

Federated Hermes CEO Chris Donahue's Recent Insider Sells

FHI's CEO Chris Donahue appeared to have sold shares in FHI for May this year according to SEC filings relating to "changes in beneficial ownership." But Chris Donahue clarified at the company's most recent quarterly results call that "there was transfers in trusts that are controlled inside our family" and "distributions due to estate planning", and he stressed that "the big bunch of shares are still owned by the family."

In any case, insider sells are usually considered to be weaker signal than insider purchases, so investors shouldn't be overly concerned by such disclosures associated with Federated Hermes' CEO.

Thirdly, the contraction in the market share for Federated Hermes' core money markets business could have been viewed as a sign of more intense competition.

FHI's share of the US money market mutual funds industry declined slightly from 7.4% as of end-Q1 2023 to 7.2% as of June 30, 2023. However, it might be misleading to take headline numbers at face value. Federated Hermes explained at its Q2 results briefing that the company is more focused on institutional money market funds as opposed to retail money market funds. Therefore, Federated Hermes' market share in the money market mutual funds space could potentially decrease from quarter to quarter, if the retail money market mutual fund market grew faster than its institutional counterpart which is what happened in Q2 2023.

In the next section, I highlight the potential share price re-rating catalysts for Federated Hermes.

The Future For Federated Hermes Looks Brighter With A Few Catalysts

I am of the view that FHI should witness a share price recovery going forward for a number of reasons.

One reason is that the negatives which impacted Federated Hermes' recent stock price performance aren't expected to remain as headwinds for the stock. Investors who needed to dispose of FHI's shares because of the Russell 3000 Index exclusion would have already done so. Separately, Federated Hermes' CEO has already explained why there were changes in his ownership of the company's shares. Lastly, FHI has also clarified that the lower market share in the money markets mutual fund sector isn't a cause for concern, as the company has a greater presence in the institutional segment.

Another reason is that FHI views its shares' valuations as appealing, and the company has the intention of stepping up its share buybacks. At its Q2 2023 results call, Federated Hermes stressed that "we think that our stock is underpriced", and noted that "we will review (share repurchases) as we buy shares based on that thought process." Notably, there is a mismatch between FHI's ROEs and its valuations based on the P/E metric. As per S&P Capital IQ data, FHI is projected to achieve ROEs in excess of 25% for the FY 2023-2027 period, but its consensus forward next twelve months' normalized P/E ratio is just slightly above 10 times, or 10.1 to be exact.

The final reason relates to Federated Hermes' inorganic growth potential. FHI shared at its most recent quarterly results investor call that it is "looking (to expand) in the real estate development (services) area" which it expects to be a "long process" that needs to be supported by "an acquisition." A M&A deal announcement in time to come relating to FHI's expansion in the property development services space might be another catalyst for the stock.

Concluding Thoughts

FHI's shares performed worse than the broader market in the past three months, but a recovery in Federated Hermes' stock price seems very likely. Therefore, I have chosen to leave my Buy rating for FHI unchanged.

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