Fund managers at a discount

Rather than investing with them, now might be a good time to invest in them.

PORTFOLIO POINT: Investors who have steered clear of placing their money in managed funds should consider buying shares in those same funds.

The funds management industry provides an essential service in today's economy. As a group it engages in the management of unit trusts, investment funds and products for retail and institutional clients. Participants generate revenue by providing services on a fee and commission basis. The industry’s growth is driven largely by the government mandated superannuation scheme that directs 9% of the nation’s wages toward long term savings. This superannuation contribution level is set to rise to 12% by 2020.

The business performance within the industry is particularly sensitive to the market cycles and can be characterised by:

  • High profitability.
  • Low reinvestment opportunities.
  • Low capital intensity.
  • High payout ratios.
  • Little or no debt.
  • Robust cash flows.
  • Relatively fixed cost bases.

'Price volatility can be extreme, magnifying market moves both up and down.

The cyclical nature of markets is clearly visible in the fundamentals of the businesses and the share price movements over time. This volatility is a source of opportunity, not risk to the astute investor with a focus on value and a long-term view.

-Volatility in share price
Company
5 year high ($)
5 year low ($)
Variation (%)
Perpetual Limited (PPT)
84.58
19.03
77.50%
Platinum Asset Management Limited (PTM)
9.11
2.6
71.46%
Hunter Hall International Limited (HHL)
18.5
2.61
85.89%
BT Investment Management Limited
4.84
1.02
78.93%
Treasury Group Limited (TRG)
16.75
2.29
86.33%

Risk comes from holding or buying shares when they are expensive, even if they are financially sound. Risk is mitigated by buying sound operating businesses when they are available cheaper than a fair assessment of value. In our view, a number of businesses in this group are available today at attractive prices.

An analysis of fund management businesses

Fund managers are fairly simple to understand: they offer to manage capital from retail and institutional investors and charge a fee for investing it. This is a little more challenging in practice, however easy to understand. If a fund manager is successful (generally by outperforming a benchmark or providing a certain absolute return), it is likely to attract more capital from investors, which leads to increased revenue. The industry is essential, as not all members of the community have the time or inclination to protect and grow their wealth.

Candidates

Perpetual Limited (PPT) offers a range of managed investment funds, advice, trustee and superannuation services for retail and institutional investors. The group also provides a range of corporate trust services to fund managers and trustees. Today, about 60% of revenue is derived from funds management activities and the business has funds under management (FUM) of $28 billion. Perpetual is currently ranked number 11 by FUM, with a 2.6% market share.

Platinum Asset Management Limited (PTM) is a boutique fund manager that focuses on global equities offering a range of funds covering specific regions and sectors as well as a listed investment company. The business has FUM of $15 billion and is currently ranked number 18 by FUM, with a 1.6% market share.

Hunter Hall International Limited (HHL) is a boutique fund manager specialising in international equities as well a listed investment company. The business currently has $1.5 billion of FUM.

BT Investment Management (BTT) is responsible for the management of the BT wholesale and retail funds, as well as managing mandates on behalf of Westpac who owns 60% of the business. The business has FUM of $42.9 billion. BTT recently announced its intention to purchase UK based fund manager J O Hambro Capital Management. The acquisition cost of $314 million, added $10.7 billion of FUM to the group and is to be funded broadly by a capital raising at $2.15 per share. BTT is ranked #18 by FUM, with a 4.0% market share.

Treasury Group Limited (TRG) is an investor in funds management businesses in Australia. Its currently has interests in nine fund managers. The business has funds under management (FUM) of $15.5 billion. The combined group is ranked number 20 by FUM, with about 1% market share.

The major banks also have large investments in fund managers with FUM market shares of, CommBank about 10%, Westpac via BT about 4%, ANZ about 4.4% and NAB about 1.1.% of the roughly $1.7 trillion of assets under management in Australia. The industry is reasonably fragmented, with the top 30 fund managers by FUM (15 with overseas origins) investing about 85% of Australian savings. Industry FUM grew at 13.9% annually for the 10 years to 2010.

'There are economies of scale in funds management business (returns to shareholders) but diseconomies of scale to clients (lower absolute returns)’

We can see from the candidates we have included in this report that Platinum and Hunter Hall are the standouts from an expense and profitability point of view.

The business of managing client savings is scalable, however as FUM grows maintaining strong performance becomes more challenging, particularly if the manager is focused on a small market such as Australia.

Studying the businesses in this group shows that many of the managers have products that focus on global markets to alleviate part of this challenge.

The largest expense for all fund managers is their employee costs. This leads to the typical view that their best assets go down in the lift each evening. The rating agencies and asset consultants know this and focus on the teams that allocate capital and the processes to assess depth and rigour the manager displays. The term “key man risk” is often discussed by investors and ratings agencies alike.

Key man risk is hardly a new concept to Perpetual, which previously endured the loss of highly regarded investment managers such as Anton Tagliaferro and Peter Morgan, who left to establish competitors. More recently, John Sevior has left and it is speculated he will set up a boutique competitor; this has arguably been responsible for some of the short term share price weakness.

Fund managers know this and often encourage key staff to hold equity in the business to reduce this risk. This indeed was a key reason Platinum floated: to enable a market for staff that chose to sell part of their stakes. In the recent acquisition by BT of JO Hambro Capital Management, part of the payment was to lock in the key staff via an equity remuneration scheme.

The cost of operating a fund reduces as the quantum of funds under management grows. This makes it difficult for new fund managers, who are growing their assets from a low base, to compete on fees. Institutional investors with large amounts of capital often do not normally find it feasible to place capital in investment funds below a certain size.

The relatively fixed cost base of fund managers means the businesses have significant operating leverage. The challenge comes in bear markets. The level of funds under management can contract as a result of market movements, as inflows slow or even turn to outflows as sentiment sours – even if the manager is producing strong performance.

This all leads to revenue falling, often magnified by the loss of performance fees. When combined with the largely fixed cost bases, earnings can fall dramatically leading share prices to fall meaningfully – a fall of 50% or more is not uncommon, a point illustrated by the recent Platinum profit downgrade. This cyclical nature of markets and businesses leveraged to markets provides ample opportunities for alert investors who can tolerate share price volatility.

There is ample academic evidence over reasonable time periods that suggests fund managers as a group add little or no value. However, within the group there are managers that consistently create value for clients. These are the ones to focus on and become part owners when they are available cheaply as success for clients leads to success for owners.

Of particular focus is the adherence to a particular documented investing discipline. A key red flag is if you notice a manager deviating from the discipline they espouse as poor performance is likely just around the corner with the resulting pressure on funds under management.

-Company valuation estimates
Company:
2012e
2013e
Perpetual Limited (PPT)
$21.28
$21.71
Platinum Asset Management (PTM)
$4.34
$4.45
Hunter Hall International Limited (HHL)
$5.41
$5.59
BT Investment Management (BTT)
$1.73
$1.77
Treasury Group Limited (TRG)
$5.56
$5.82

Investors can expect the dividends these businesses produce to form part of the overall investment return. One of the characteristics of this industry is low reinvestment opportunities because the operating businesses themselves are capital-light. This leads rational management to return excess capital to owners and is observable in high payout ratios.

As can be seen above, pre-tax dividend yields are at close to historical highs similar to those available during the recent financial crisis. This indicates that the sector is broadly out of favour and/or the market is questioning the sustainability of the dividend payments.

One of the hardest things for an investor is to buy a cyclical business in a downturn – think of retailers in a recession and fund managers in a share market downturn. However, from an investment performance point of view, being a contrarian often produces outperformance on an absolute and relative basis.

One must remember that equity markets always recover and go on to break new highs, although this hangover may last a little while longer.

George Whitehouse is a senior analyst at Clime Investment Management. Clime uses MyClime, its online stock valuation and research service, to determine the value of a stock and assist with its stock selections. For a free two-week trial to MyClime, click here.

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