Platinum lashed by dismal market

The release of Platinum Asset Management’s first-half result, due Thursday afternoon, matters not. Net profit will be around $65m; the company announced as much a month ago (see 10 Jan 12 (Long Term Buy – $3.57)).

Of more import is the longer-term outlook. On 2 Feb 12 in Fund managers spring a leak (Hold – $20.25)), we downgraded Perpetual because of the sombre outlook for fund flows (the current is likely to be stronger going out than it is coming in). Similar factors are at work at Platinum Asset Management.

Whilst this remains Australia’s best international equities manager, with the benchmark MSCI index falling 7.4% over the year to 31 December, Platinum’s funds under management (FUM) fell from $18.3bn to $15.1bn over the period.

Fund outflows are once again an industry-wide phenomenon, causing industry revenues to sag like a marquee in a thunderstorm. There are, however, a couple of important differences between Perpetual and Platinum worth exploring before arriving at what, in preview, will be a similar conclusion.

Worst calendar year

First, whilst Perpetual‘s funds have continued their outperformance, the short-term performance of Platinum’s main funds has been weak. The latest quarterly report explains that 2011 was ‘the worst calendar year in the Platinum International Fund’s 16 year history’. The MSCI index fell 7.4% but the International Fund recorded a drop of 12.0%.

With self-doubt and soul-searching the value investor’s lot, chief investment officer Kerr Neilson has indulged in a spot of public self-flagellation, as a story published on 1 Feb 12 in the Australian Financial Review makes clear.

Underneath the self-imposed admonishments, Neilson knows that short-term underperformance doesn’t matter, as long as it eventually reverses. Here, there are reasons for confidence: Platinum’s funds have underperformed before, only to make up the lost ground, and more, in subsequent periods. The problem is that underperformance doesn’t attract inflows, particularly when investor sentiment is as negative as it is now.

Investors are happy to send fund managers a nice fat cheque once confirmation of outperformance is clearly visible. That means there’s a lag between fund performance and inflows. Chart 1 paints the picture. The Platinum International Fund delivered a searing outperformance of more than 15% in calendar 2009, leading to the $2.6bn of inflows in 2010.

The second point of difference is that Platinum’s 2012 outflows are likely to be much less serious than Perpetual’s. Its money is much ‘stickier’. Platinum’s fund performance has always bounced back, and most clients know it.

The ones that don’t are trying their luck elsewhere, which explains why fund flows have been negative since April 2011. Perhaps $800m might be withdrawn in the 2012 financial year, implying that, along with Perpetual, Platinum’s revenue will fall in 2013.

The third difference—and it’s a big one—has to do with costs. Expenses at Perpetual Investments, that company’s funds management division, amounted to 67% of revenue in 2011. At Platinum, barely ten minutes’ walk towards Sydney’s Circular Quay, they amounted to just 19% in the same period. To call Platinum ‘low cost’ is to damn it with faint praise.

Table 1 shows the extent of operating leverage (see Shoptalk from 2 Feb 12) for each company when faced with a 10% revenue decline on profit before tax. Platinum’s lower costs mean profit will fall less if markets weaken further. Conversely, its profits will rise by a lower amount if markets jump.

Perpetual is the funds management stock to own if you’re bullish on markets; Platinum the one if you’re not.

The final difference is that Platinum has been leaning into an Australian dollar headwind. With its managed funds holding international assets, their value has suffered as the Aussie dollar has risen. Platinum manages its currency risk but holds little local currency. This decision—while costly over the past two years—should eventually prove correct.

Having re-visited our base case for Perpetual, it’s time to do the same for Platinum. In Platinum on the road again from 13 Jan 11 (Long Term Buy – $4.86) we outlined our road map for the next five years. As with Perpetual, potholes appeared in the first half of the 2012 financial year. Outflows resumed and performance deteriorated, which meant our assumed average funds under management for 2012 is a full 18% lower than our expectations of a year ago.

Difficult environment

The accompanying spreadsheet, updated from the January 2011 review, is a more sober assessment of fund flows and performance to 2016 (input your own assumptions in the yellow cells). Table 2 summarises this ‘base case’, illustrating that Platinum shares, which will carry a ‘high-teens’ price-to-earnings ratio for some years, are not sufficiently attractive to buy.

A strong market recovery, a dramatic turnaround in performance, or a lower Aussie dollar would improve earnings but one can’t count on that. Instead, we’d rather prepare for a more difficult environment for funds management businesses given their history since the global financial crisis.

The stock is up slightly since the last update on 10 Jan 12 (Long Term Buy – $3.57). This remains a very high quality business but, on valuation grounds alone, we’re downgrading to HOLD.

The model Growth and Income portfolios own shares in Platinum Asset Management.