Testing times for fund managers

Your estimate of long-term growth will have a major influence on the multiple you pay for a company's earnings. For fund managers, growing earnings generally requires growing funds under management (in the absence of price rises, which seems a very safe assumption for the time being). That in turn, depends on marketing, stock-picking ability and underlying movements in the sharemarket.

The more of these things a fund manager has in its favour, the more likely it will be to increase its earnings. All else equal, that should also make it worth a higher multiple of today's earnings. 

That's the theory, anyway. The trouble is that each of these things can be difficult to assess. That's evidenced when one takes a look at a one-year price chart for Platinum, Perpetual or Magellan. From high to low, or low to high (in Magellan's case), they've moved -46%, -49% and 35% respectively. Investors are clearly having a tough time piecing it all together.

Cause for confusion

There's plenty of cause for confusion. For starters, stock-picking ability is unknowable over the short term, because a winning or losing streak might be the result of good or bad luck, as opposed to genuine skill. And even though it's reasonable to assume stock markets will go up over the long term, given that near term cash flows are weighted more heavily in a discounted cash flow model, the value of a fund manager is heavily dependent on the path the market takes in the short term (known as path dependence).

The type of FUM is also important, with retail money typically attracting higher fees as well as being spread across more accounts and less likely to leave. The unexpected loss of a large institutional investment mandate can move FUM figures around drastically from month to month. There's also the issue of capacity, with some fund managers only prepared to grow to a certain point, worried that size may affect performance.

Each of these factors feeds into our growth expectations. With each highly variable, the multiples the market ascribes to fund managers can fluctuate wildly. So, what's the right multiple to pay?

It's all relative

It's hard to know - all fund managers have a wide range of potential outcomes. Magellan is the poster boy for what happens when everything goes right. The company reported a $4m loss for the 2008 financial year, on fee revenue of $4m, or about 3.3 cents per share. Its stock closed 2018 at $23.54 per share, so you could have paid 275 times management fee revenue (about $9.08) and still earned a 10 per cent annual return for ten years (and that's ignoring dividends). As it is, the stock closed 2008 at $0.52, so you'd have actually made 46% a year.

But alongside this, of course, there's a less well known graveyard littered with the corpses of 'almost' fund managers - so you need to choose carefully and keep portfolio weightings in check. With all that in mind, let's put the three fund managers we currently cover side by side - on brand and marketing, stock-picking ability, additional FUM capacity and institutional/retail client mix.

Brand and marketing

Magellan appears to have a clear edge. For starters, its brochures and websites are covered with graphs showing exceptional performance over virtually any timeframe. By contrast, Platinum and Perpetual's pitch is a relatively more difficult one, given their recent lacklustre results.

But founder and chief investment officer Hamish Douglass has also proven to be a great salesman who's quick to get in front of a crowd or a camera to promote Magellan's message. An investment in sponsoring the 2017 Ashes series also helped reinforce the firm's association with international investment.

Platinum's Kerr Neilson has historically been less promotional. After handing over the role of chief executive to co-founder Andrew Clifford, the plan is for him to get in front of customers more, but this is still a work in progress.

Perpetual's brand seems to be eroding given recent underperformance and it's been getting a  roasting in the media.

Stock-picking ability

Given Kerr Neilson's reduced role, Platinum is a more speculative bet under new chief executive Andrew Clifford. But Clifford has been hand-picked by Neilson and is highly regarded - and we've heard enough investment wisdom from him ourselves to be comfortable with him at the helm.

As for Magellan, the 6 per cent of annualised outperformance over an eleven and a half year period does much of the talking - but Douglass is also happy to do plenty of that. And when he does, he tends to speak a lot of sense.

Both Clifford and Douglass are owner managers, as well as co-investors in their funds, and we still think that both funds have a better than average chance of outperforming over a 10-year period.

On the other side of the ledger is Perpetual. While its flagship Industrial fund still boasts a track record that has outperformed since inception, it's no longer being managed by the people who oversaw most of the success. We're less hopeful about Perpetual's prospects of outperformance.

Capacity constraints

It's possible, though, for fund managers to become victims of their own success. There are only so many good investment opportunities, so the more funds you manage, the more money ends up flowing into lower returning situations. It's why Warren Buffett complains that 'in the early years, we needed only good ideas, but now we need good big ideas'. When a fund manager gets close to its capacity limits, it skews the balance of risk and reward; once your upside is taken away, the only thing left is downside. With a cap on a stock's potential growth, the multiple you're willing to pay for it should fall.

Perpetual had FUM of $27.7b at the end of 2018, with two-thirds of that invested in Australian equities. At $18b, if the company wanted to take a 5 per cent position in a stock, it would mean disclosing a 'substantial' shareholding (of more than 5%) in virtually every company outside the 20 largest stocks on the ASX. It does, however, have a long potential runway of growth in its global equities strategy, with FUM of just $1.3b - as well as its cash & fixed income products (although these generate lower margins).

This is also where Magellan stumbles. It has highlighted capacity concerns in its Global Fund, which now has $52.4b under management and was closed to new institutional investors at the end of 2017. It has more recently purchased Airlie Funds Management, which it believes can grow within Australia.

Platinum, given its international purview and with FUM of just $24.1b, still has plenty of room to grow if things go well, so it wins in this category.

Client base

Retail funds tend to be higher margin and stickier than institutional funds, making them relatively more valuable. Here, Perpetual and Platinum get a tick, with 70 and 75 per cent of their FUM coming from retail clients. For Magellan, though, that figure is only 27 per cent. Magellan also has a greater risk from customer concentration, with 10 per cent of its FUM coming from St James's Place - a single institutional client in the UK.

Platinum ticks the most boxes

Magellan is a great fund manager and, adjusted for the value of cash and investments on its balance sheet, it trades on a forward price-earnings ratio of only 14. However, we're mindful of its capacity constraints, so we'd need a wider margin of safety before recommending it. HOLD.

Perpetual has been a poor recommendation, with its share price down 15% from our initial Buy recommendation just over five years ago and 34% from our highest Buy price of $50, although it has paid decent dividends along the way. The funds management business would need to stage an impressive turn around to win back our confidence, but the lower share price and the growth in its wealth and corporate trust business mean that more of its value is being contributed by those divisions. Indeed another 20% off its share price and we might be interested in buying it again. HOLD.

Platinum, though, comes out as a clear favourite. Given our faith in its ability to perform over time, its high level of retail investment, its solid brand (particularly for Asian investing) and its ability to grow unconstrained by capacity, Platinum is the most consistent performer across the categories, and a 2 per cent fall in its share price would bring it below our recently reduced Buy price. HOLD.