Are asset management companies still attractive stocks?

21st Jan '18 by Edmund Shing

6 comments 6481 reads

As a largely small-cap investor, I have been a long-term fan of asset management stocks.

I have been attracted to this subsector (within Other Financials) for a number of reasons:

Asset managers tend to have high profitability, thanks to their relatively low capex needs, high operational leverage and huge potential for economies of scale. As a result of this structurally high profitability, free cash flow tends to be high as does Return on Invested Capital. Overall then, a relatively high quality subsector.
Equity-focused fund managers give a relatively high-quality way to have a leveraged long exposure to bull stock markets, such as the one we have experienced since early 2009. Assets under management (AUM) generally benefit from a double whammy in bull markets; the AUM is boosted by positive stock market performance, and retail investors tend to invest more in equity unit trusts when stock markets are rising.
Merger & acquisition activity can lead to sharp rallies in share price, given that this sector has been rapidly consolidating over the last few years, in an effort to benefit even more from economies of scale.
Given that this subsector generally generates high levels of free cash flow (and has low investment needs), high dividend payouts and substantial dividend growth are also features of successful fund management groups.

This has led me to invest in the likes of Miton (LON:MGR), Polar Capital Holdings (LON:POLR), Premier Asset Management (LON:PAM) and Record (LON:REC) in the past (I am still invested to some extent in the first two currently).

BUT...

I am becoming concerned about a number of potential headwinds for this sector, after a number of very profitable years.

We could be due for a global stock market correction in the near-term, given the stellar performance particularly of the US stock market last year and this month. This would undoubtedly not be good for high-beta stocks like asset managers.
MIFID II costs on trading, research and investor information will likely weigh on the profitability of smaller fund managers in particular (as they have themselves pointed out in prior statements), and seem to favour the largest fund managers like the US-listed Blackrock, who can more easily absorb these extra administrative costs.
There can also be considerable…

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Andrew L

22nd Jan '18

Edmund, Asset managers are one sector that tends to divide opinions and the pros and cons you have listed cover most of the key points. I would add some further thoughts:

I believe Guiness Asset management issued a paper stating that asset managers outperform. This is due to the operational gearing in the businesses. If stock markets rise by 50% and they charge % fees then with a fairly fixed cost base we can see profits increase significantly. In the Pat Dorsey Book - The little Book that Builds wealth - he extolled the virtues of asset managers and their high returns and resilience. However, Terry Smith of Fundsmith has said he wouldn't invest in the sector.

The key is that for asset managers to justify their existence they need to outperform and this is impossible for all asset managers. A period of underperformance can see the asset base quickly disappear. When people look at asset managers they look at companies that have survived. However, what about New Star that effectively failed as a listed asset manager. A number of asset managers are struggling, such as Man Group, and the high fees model is under pressure.

Negative trends include the shift towards passive fund managers like Vanguard and the resultant pressure on fees. We are also seeing a shift towards robo managers in the private client space. Investment platforms also enable people to invest themselves and in these platforms they tend to be less sticky to a particular investment manager.

The crux with asset managers is that you can generate great returns when they are doing well and gathering assets and when stock markets are going up. The latter is a tailwind that tends to benefit all managers.

However, you need to pick a winner and monitor fund flows and performance of its funds very closely. An alternative is to pick a private client focused group like Rathbone. The relationships with private clients tend to be fairly sticky. Or you could buy a platform like Hargreaves Lansdown. There are also listed managers focused on passive funds like Blackrock. Schroders has performed well over the long-term and has private client relationships as well as funds i.e. like Rathbone. Jupiter Fund Management has performed well. The industry appears to be about marketing as much as anything else.

Probably the best asset manager is Vanguard but you can't buy that as it is owned by its investors. Vanguard is a challenge for the rest of the industry given that as it grows in size it cuts fees i.e. it passes on the economies of scale. Other asset managers can't really compete with it on the basis of the fees its charges. Fidelity recently changed its fee structure to keep clients happy.

The crux with asset managers is whether they have sustainable earnings. This is hard to say as how sustainable can investment outperformance be for any one asset manager. Also if they are listed they tend to pursue profit growth - launching lots of new funds - at the expense of their client's interests. This is likely to lead to issues down the line. It is also not clear how listed fund managers can compete with private fund managers. The latter are able to manage for the long-term and aren't trying to extract the maximum short-term fees from clients.

My personal view is that this isn't a sector I would be happy just making an investment and leaving it, unless it was a company like Hargreaves Lansdown. A fund manager experiencing a purple patch can hit a difficult patch in fairly short measure. This can lead to significant outflows and a collapse in profits. Similarly the "talent" can walk out the door fairly quickly. It is rationale for key staff to leave if they can get a better deal elsewhere. This tends to happen fairly frequently.

In short, the listed fund manager sector is often sold as a leveraged bet on rising markets. However, many have struggled and the disruptive headwind from the internet and trackers is an issue. In my view, this is a sector to be wary of and closely watch any individual investment. I am not convinced it necessarily outperforms the market in the long-term and we tend to have survivorship bias i.e. only follow the listed fund managers that have outperformed.

I would challenge the idea that all listed asset managers are the same. They have different exposures to index trackers, to private clients etc etc. A couple of bad years of performance can see a listed fund manager go from being a stock market darling to an investment dog. If our objective is to determine which listed fund managers will have funds that outperform then how exactly do we do that? Lots of investors thought Man Group had cracked the enigma of outperformance but its quantitative AHL fund is reported to have struggled.

Edmund Shing

Excellent comment ratioinvestor,
your reply certainly adds a lot to what I wrote!

Yes I am minded to remain only in those fund management groups that have:
a. demonstrated good growth in assets under management from inflows over time, and also
b. whose product line offers funds that are well-differentiated from the competition.

But all in all, I would agree that these are bull market investments, not buy-and-hold, and in bear markets can see valuations slashed dramatically as the operational leverage works in reverse to pressure profitability.

But I would return to my contention that we have already seen quite an element of merger & acquisition activity in this sector (e.g. £SLA) and are likely to see further consolidation between mid-market players in the near-term.

Edmund

Edmund - I am not convinced on the consolidation argument for a knowledge focused business. It can be shown that mergers reduce costs and therefore increase profits. Superficially they appear to be attractive.

However, if they hit the long-term performance then they are unattractive. GSK has been a woeful performer and it is probably no coincidence that it is the product of a number of mega deals. In the pharmaceutical sector it is all about people and discoveries. Saving some costs as a result of a merger is secondary.

Mergers or acquisitions in fund manager can be problematic given that staff may walk away. It is also the case that M&A in fund management happens when a company is in trouble i.e. the takeover of New Star. Successful companies don't tend to merger they tend to remain independent.

I agree that this tends to be a bull market sector. However, it is not homogenous with there being a number of companies exposed to secular trends such as Hargreaves Lansdown. The quality of earnings, and the quality of businesses, in the sector varies significantly. My issue is that for a lot of the companies you have to monitor them very closely. This takes up a lot of time. Time that could be spent finding secular growth stories in less volatile sectors.

To turn the argument around and what you are essentially saying is this: if you time fund managers right and pick they right ones you can do very well. This is of course true. But isn't it hard to do successfully? It is like saying that while resource stocks are a difficult sector if you time it correctly and pick the right one you will do very well. While this is literally true getting both the timing and the stock right can be hard. It is possible but is it probable. Probably a bottom up type investment approach. However, it is fair to say that a number of listed fund managers have recently done very well.

In summary, while lots of things are possible are they probable? Is it probably that I can pick a good fund manager at the right time that will do well and avoid any issues? Possibly.

Wimbledonsprinter

Interesting comments. Nearly all the asset managers do have high stock ranks - as high quality (low capital requirements, high cash generation), value (most are paying good divs and trading on low teen P/Es) and strong momemtum (levered play in a bull market). I hold City of London Investment (LON:CLIG), which has most of the attributes above - also exposure to emerging markets (which I feel I am underweight otherwise) - it also has exposure to $/£ exchange rate (like most UK based managers, managing international assets).

As pointed out, when a manager starts to underperform - assets can leave quickly. But I belelieve that the longer a manager’s track record, the more stable the asset base. For example, if the manager has a 20 year record of outperformance and many long-term investors, then if the manager underperforms for a couple of years (and this is not associated with an obvious reason - eg star manager resignation), then I think usually investors are more tolerant.

I would also point out that investment banks are very similar to asset managers as leveraged plays on the market. I also hold Numis (LON:NUM) - but slowly selling as valuation rises)

garbetklb

I'm v wary about holding any financial stocks which have "stars". These "stars" tend to have an inflated opinion of their worth, ignoring/forgetting tat it's normally the employer who puts them in the position to be able to handle all the funds.
Could ANY Investment Bankers do their job without a huge balance sheet behind them? Yet they are very good at asking for a significant portion of the "profits" when the market is going up. But when the market is going down it's very much a case of "not my fault guv".
I try to avoid investments where there is over-remuneration of any kind - and if the sector is prone to over-remuneration, surely it's difficult for a responsible paying employer to attract talent?

Talking of survivorship bias have a look at the story of Absolute Capital Management. It was listed in London and collapsed fairly quickly. It is somewhat of an outlier but does highlight the risks. New Star, which was listed, came close to collapse but was bought by another manager:
www.independent.co.uk/news/bus...

Are asset management companies still attractive stocks?

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Edmund Shing

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