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One FTSE 100 financial stock I’d buy and a FTSE 250 peer I’d sell

Simple funds that track indexes like the FTSE 100 and FTSE 250 are strong options for those investing in the stock market. However, it’s possible to earn superior returns by building a portfolio of individual stocks.

Asset management is one class of business with natural market-beating potential. Companies in this sector need relatively low capital expenditure and have high operational gearing. As such, provided they’re sensibly stewarded through lean times, they should act as leveraged plays on the long-term returns of the markets their funds are invested in.

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Of course, as with all stocks, it’s wise to seek a reasonable valuation and margin of safety. With this in mind, let me explain why I’d buy blue-chip management group Schroders (LSE: SDRC) today. But sell mid-cap firm Jupiter Fund Management (LSE: JUP).

Earnings

Schroders has two share classes. One has the ticker SDR and the other SDRC. There’s no difference except that owners of the former have voting rights, while owners of the latter don’t.

It may make sense for big institutions to buy SDR, but I think small private investors are better off buying SDRC. The non-voting shares routinely trade at a significant discount to their voting counterparts. This gives buyers of SDRC the tangible benefit of a higher dividend yield.

I’ll come back to dividends. First, let’s look at the valuations of Schroders and Jupiter in terms of their earnings multiples. The SDRC shares are priced at 2,500p, as I’m writing, and JUP’s at 390p.

City analysts expect Schroders to post earnings per share (EPS) of 194.6p when it announces its 2019 results. As such, buyers are paying 12.8 times earnings. The EPS forecast for Jupiter is 28.5p, giving a multiple of 13.7.

I think Schroders’ cheaper rating is attractive, particularly as its earnings are forecast to increase 8% in 2020. Jupiter’s are forecast to decline 6%.

Dividends

Analysts expect Schroders to pay a dividend of 114p a share for 2019. This gives a yield of 4.6% on the SDRC shares (compared with 3.5% on the higher-priced SDR voting shares).

Meanwhile, analysts expect Jupiter to pay a dividend of 24.4p a share, giving a yield of 6.3%. While this is higher than Schroders, there are two things worth noting. First, Schroders’ dividend is covered a robust 1.7 times by EPS, compared with a skinny 1.2 times for JUP. Second, while Schroders’ payout is forecast to increase in 2020, JUP’s is forecast to fall.

Asset valuation

Finally, I like to look at an asset management company’s market capitalisation as a percentage of its assets under management (AUM). I’ve detailed this in the table below.

  Market cap (£bn) AUM (£bn) Market cap/AUM
Schroders (SDR + SDRC) 8.7 450.8 1.9%
Jupiter 1.8 45.1 4.0%

As a rule of thumb, I wouldn’t buy an asset management stock when it’s valued at above 3% of AUM. I consider Schroders undervalued at 1.9% and see scope for good upside.

In contrast, I consider Jupiter at 4% as overvalued and offering little margin of safety. I’d put current fair value for JUP’s shares at about 100p below where they are now.

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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Schroders (Non-Voting). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.