Edmond Jackson's Stockwatch: No room for error at this financial services firm

What to make of Hargreaves Lansdown? Should you buy into a drop over 30% from its peak or beware a wider sentiment change underway? Financial shares are often a leading indicator - banks typically a good 'buy' at the early stage of a market upturn, in anticipation of economic recovery - and investment services a prime means to play a bull market gathering pace, likewise its debacle.

The five-year chart for this UK investment services group amplifies the market story of recent years: recovery from 2010 as loose monetary policy boosted asset prices hence trading activity; a drop in the second half of 2011 amid fears over US and eurozone debt, shrugged off in early 2012 with buying becoming more determined. By early 2014 the chart appears to show a final blow of exuberance, this featuring typically in racier stocks I've considered. Lansdown has appeared to find a support level with a bounce from about 1,000p to 1,080p although it is not yet definitive.

Lansdown is a vigorous example of how the bull market hit reality that monetary stimulus is being withdrawn just as political risks are increasing. The US is tapering off money printing and central banks pondering the tricky task to edge interest rates back up, having massively expanded their balance sheets. Suddenly flash-points have appeared, from Ukraine to the Middle East, hence the sentiment change to "risk-off" and protecting gains. Yet investors are broadly aware there is still no real alternative to equities for yield, interest rates being unlikely to rise by much. Unless central banks' juggling act collapses, it all makes for a strategic sense of "buy the dips".

Prone to volatility

Within this context, Lansdown is prone to volatility. It is quite a victim of success because attracting new clients and trading activity in the pro-equities climate, created high expectations for earning power. Company REFS shows the average annual price/earnings multiple (P/E) has ranged from the mid-twenties to low-thirties during the last five years; which is supported by Lansdown being a leader in its field but takes considerable risks as regards to any cyclical downturn.

Personal savings and investments offer long-term growth in that all UK political parties are eager to see people take more responsibility and ease demands on public finance. But the sector is fundamentally cyclical too. Mind a key point from Lansdown's statements: "Earnings have a direct relationship with the value of investments within our administration; therefore the level of world stockmarkets has an effect on profits outside of our control."

Lansdown is a warning how the bull market got overblown, with cyclicals rated as growth stocks. This is not an international mass-market technology stock such as ARM Holdings. Lansdown's size works both ways: its high profile made it a beneficiary of the Royal Mail flotation, which introduced 27,000 out of 77,000 new clients in the six month period to end-December 2013; however even after the shares' drop this is a circa £5 billion company hence exciting growth rates get harder to achieve. Inevitably this has meant changes in the market's opinion as to what rating is appropriate.

The table shows that at about 1,050p currently, the shares trade on about 30 times projected earnings for the year to end-June 2014, reducing to 25 times. Yet after earnings growth sometimes well in excess of 20% annually, such rates are moderating. The price/earnings to growth (or PEG) ratio is 2.5 to 1.4 where typically a value below 1 defines value. Lansdown qualifies for the PEG - a classic measure of growth stocks - due to its recent years of uninterrupted growth, however these have benefited from exceptional global monetary stimulus.

So the de-rating is rational and intrinsically this big-cap deserves a P/E no higher than 20 times, implying a target price nearer 800p. Whether it falls further in the near term depends largely on political risks now weighing on markets - especially if the Ukraine crisis goes from bad to worse, as this is already hurting eurozone recovery. The Middle East is not seriously worrying investors because oil prices trade at a nine-month low. But if events blow up and markets enter a stormy period then Lansdown is a usefully liquid stock for short-sellers.

No scope for disappointments

Yield is also a significant factor. The table shows very low capital spending needs versus strong cash flow, so a high payout policy is justified. The prospective yield is currently cited as 3.7% by Company REFS; but mind how this is based on forecasts for a dividend re-rating over 30p a share implying virtually all forecast earnings will be distributed. This leaves no scope for disappointments; such projections exemplify recent exuberance. So beware assuming the dividend yield implies support; if the wider political and financial context deteriorates then as a matter of prudence the board might rein back dividend growth - i.e. you could be looking at a circa 2% yield, not near 4%.

Some directors have reduced their equity exposure this year while others have opted to maintain very substantial holdings; implying confidence Lansdown is a strong business for the long run. For example on 3 July a director and her husband sold 70,682 shares at 1,272p; then on 4 July a further 32,687 at 1,275p, to own 660,000. Another director with a smaller holding of 5,308 shares, sold this entirely at 1,267p. Selling may be partly motivated by a window before the closed period ahead of prelims due 3 September, also to lock in gains after a strong run. Otherwise at end-June a senior manager exercised options on 15,355 shares at 195p thereby increasing his stake to 19,044. Two directors exercised options and only sold shares to cover the cost and pay tax; for example one manager increased his stake from 749,454 to 832,247 shares. Such examples imply some profit-taking but this is not a situation of concerted selling which implies high risk.

Risk continues to weigh on the downside because Lansdown's P/E is still high, just when markets are coming to terms with political dangers and a reduction in stimulus. Equally it can become a trading buy for recovery, its liquidity and high profile being ideal for long/short traders. On a long-term investment view however Lansdown has probably had the best run in terms of P/E rating. For a tuck-away financial share, consider a smaller emerging asset manager once markets are on firmer footing.