IOOF gets the royal treatment

They say it's only lazy value investors that buy stocks that are screamingly cheap; wide awake, attentive value investors buy stocks that are merely nicely cheap. So it looks like we'd had too much coffee when we upgraded IOOF to Buy a few weeks ago.

But to be a rational investor you have to have a price you're willing to pay and you then have to be prepared to pay it. Waiting around because a stock looks like it's ‘falling' is letting the market dictate to you and will lead you to lose sight of the value.

The trick is not to blow your budget on the first pass. When a stock is merely ‘nicely cheap' it makes sense to buy a starting position – perhaps half to two-thirds what you consider to be your maximum in the stock. Then, if it falls further – and the value improves – you'll be able to increase your holding.

IOOF is not yet screamingly cheap, but at around $9 it offers a compelling opportunity.

Revulsion

The wealth sector has been under pressure because the evidence heard by the Royal Commission has been (even) worse than expected. IOOF itself hasn't been asked to give evidence, but the overall revulsion shown towards those that have has increased the likelihood of tighter regulatory scrutiny.

The ‘Future of Financial Advice' (FOFA) reforms have already codified the requirement to act in the best interest of clients, as well as banning ‘conflicted remuneration' for non-life-insurance products. It seems likely that the partial exclusion for life insurance products will ultimately be removed.

Beyond that, there have been increasing calls to separate the provision of financial products from the delivery of advice. The banks are probably ahead of the curve on this and have already started to split off their wealth businesses (such as with the sale of ANZ's wealth management business to IOOF), but the concern for IOOF would be that it extended to the provision of platforms.

IOOF could reasonably argue that its open architecture enables its advisers to choose platforms from other providers, but it's possible that regulators will ultimately prefer to see a complete separation.

IOOF would be in a better position than its larger rivals to split its platform and advice businesses. But presumably part of the ‘value' (to IOOF) for having these businesses together is that – notwithstanding the open architecture – advisers are likely to have a bias towards their employer.

That value would be lost if the businesses had to be split. But, by a back of the envelope calculation, Platforms probably account for around half the group value and a one-third impairment of its value would mean a one-sixth loss of value to the group. That would be painful no doubt, but within our margin of safety, and the chances of a separation being required are probably quite small.

Taking comfort

The Commission has also highlighted the risks of being required to pay compensation for poor advice. With over 1,000 advisers, IOOF will clearly have instances of bad advice that will require compensation, but that's no more the case now than it was before the Commission began. There are also a few things here that give us comfort.

The first is to do with IOOF's culture. It really does seem to value its (relative) independence from product provision and appears to go to some trouble to improve the quality of advice given by its advisers, such as with its ‘Advice Academy'.

Ironically, it also provides some comfort that the company had a run-in with ASIC a couple of years ago following various revelations in the media. Most of the allegations related to a period before current management took charge in 2009. However, they resulted in a compliance review conducted by PwC, which was shared with ASIC and resulted in a tightening up of various compliance processes.

Of course, IOOF will soon be taking on ANZ's wealth management business, which has been hauled over the coals in the Royal Commission and arguably has a greater risk of misconduct. However, IOOF highlighted in last week's quarterly update on fund flows that the acquisition agreement would contain various protections. Amongst other things, these will include indemnities for claims relating to pre-completion misconduct made within five years of completion.

Positive momentum

That announcement also noted that the acquisition has passed all regulatory hurdles, while today's final result from ANZ contained some financial information on the businesses being sold. Between September and March, adviser numbers fell from 711 to 661 but funds under advice remained flat at $8.2bn. Meanwhile, a net $0.6bn of funds flowed off the platforms being acquired, to give funds under administration (FUA) of $48bn at the end of March, in line with last September.

For its part, IOOF's announcement last week showed a $1.0bn inflow into funds under management, administration and advice (FUMA). This included a $0.7bn net inflow into its advice business and a $0.3bn net inflow to its platforms – its  21st consecutive quarterly platform inflow. FUMA finished the quarter at $119bn, a touch down from $120bn but not a bad result given weak markets.

So although the Royal Commission has increased some risks for IOOF, that's been balanced by recent fund flow numbers from itself and ANZ, while the lower price provides a greater margin of safety.

With positive momentum in its own business and potential upside from integrating ANZ's wealth business, earnings per share (EPS) should see double-digit growth over the next couple of years (depending on markets). That makes the stock's multiple of about 17 times this year's earnings look attractive, particularly since the earnings come through mostly as cash, enabling a high payout ratio and a fully franked dividend yield of 5.8%.

If you're well below our recommended maximum weighting for IOOF of 6%, then we'd suggest increasing your stake at around $9 – although we'd probably wait for a price closer to $8 before going for the full 6%. BUY.

Note that we would aim to keep overall weightings to the wealth management sector – including the likes of Perpetual and IOOF – below a maximum of about 12%.

Note: The Intelligent Investor Equity Growth and Equity Income portfolios own shares in IOOF Holdings. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

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