SIF Folio: Super profitability at Tatton Asset Management

My stock screen store cupboard is almost bare once again this week. But there is one new contender which could fit into my rules-based SIF portfolio.

AIM-listed Tatton Asset Management (LON:TAM) describes itself as “powering the UK’s leading financial advisers”. What this firm does is to provide discretionary fund management, a range of IFA support services and mortgage provision for IFAs. In short, it’s a complete ‘back end’ for financial advisers.

Graham looked at Tatton’s 2018 results here and a later trading statement here, where he flagged up strong growth. 

The firm has just published an audited set of results for the year ending 31 March 2020, so now seems an ideal time to take a fresh look at this stock, which has performed well in the interim.

So far, so good

Back in 2018, Graham commented that as Tatton only floated in 2017, he feared a post-IPO mishap. It’s a common phenomenon, but so far these fears have proved unfounded:

One reason for the continued strong growth may be the presence of founder-management. TAM is led by founder and chief executive Paul Hogarth, who floated the company in 2017. Despite selling a chunk of shares in the IPO, he retains an 18.9% holding and is the firm’s largest shareholder. 

We can see this information with Stockopedia’s excellent new(ish) major shareholder feature (on the Accounts menu):

The other major shareholders are all well-known institutional names. I’m encouraged to see this £160m firm already has a strong following in the City. This impression is reinforced by the make-up of the board. Tatton’s chairman, Roger Cornick, was previously chairman of (then) FTSE 100 firm Aberdeen Asset Management.

Is there space for Tatton Asset Management in the SIF Folio? At first glance, the portfolio already appears to have a big allocation to financials:

This allocation to the financial sector currently contains three stocks. The first two of these are pawnbroker H&T Group and German commercial property group Sirius Real Estate. I’m confident there’s no overlap with these. 

However, the third of my existing financials is business broker K3 Capital. This is a recent addition that bears some similarities to TAM, with high margins and owner-management. I feel that K3 Capital could be subject to the same kind of cyclical effects as Tatton.

However, I’m not going to rule out Tatton on this basis. My rules on diversification aren’t cast in stone and if I like the stock enough, I’ll consider adding it.

Impressive results

Before I take a look at Tatton’s quality, value and momentum scores, I think it’s worth taking a quick look at the group’s latest results. As I mentioned earlier, these are fairly impressive.

• Revenue +22% to £21.4m

• Underlying operating profit +47% to £8,714m

• Operating margin: 48>#/p###

• Net cash +5% to £12.8m

• Assets under management +9.6% to £6.6bn (net inflows £1.1bn)

• Gross mortgage lending +17.5% to £9.9bn

I should point out that Tatton is a middleman in all asset management and mortgage transactions. The Paradigm mortgage business works as a distributor, with access to a panel of mortgage lenders.

Similarly, the investment portfolio options offered by Tatton for clients of its member firms are administered by other institutions. However, Tatton plays a role in defining these portfolios and on the whole, they appear to have modestly outperformed the managed fund sector since launch in 2013:

The firm’s value-add appears to be in its scale and reach. The Paradigm Consulting business offers a broad range of support services to its IFA members. These increased by 10.9% to 1,544 last year, representing 66,100 customer accounts. This equates to an average customer investment account size of c.£100k. 

Cash generation from this business is good and although Tatton only takes a slice of the fund management fees and mortgage commissions, it’s still able to generate very high margins and returns on equity. 

Let’s take a closer look.

Value: not really

Tatton Asset Management enjoys a StockRank of 86 and is styled as a High Flyer by Stockopedia’s algorithms:

Unsurprisingly, the firm’s shares are priced for success, not value. The shares look expensive on most trailing measure of valuation:

Despite this, Tatton still passes my screen’s valuation tests. The reason for this is that my screening criteria look at valuation in the context of profitability and growth rate. Here’s how it works.

The relaxed version of my screen that I’m using currently has three rules relating to valuation:

• Rolling forecast P/E between 7 and 30 (TAM: 20.6)

• Earnings yield (EBIT/EV) > 6% (TAM: 7%)

• Rolling forecast PEG (price/earnings growth) <1.3 (TAM: 0.9)

As you can see, Tatton passes all of these comfortably.

I’d also add that although the stock is richly valued, the group’s high return on equity and strong cash generation mean that it can still support an attractive trailing dividend yield of 3.4%.

For these reasons, Tatton Asset Management’s demanding valuation doesn’t necessarily concern me too much.

Quality: star attraction

A QualityRank of 90 suggests great things in the quality department. Tatton’s profitability metrics don’t disappoint. Last year’s return on equity of 50% is outstanding:

Another quality measure that is very important for me is free cash generation. In its latest results, Tatton says it converts c.100% of operating profit into operating cash flow. This is reflected in the close match between [after-tax] earnings per share and free cash flow per share:

I’m very comfortable with Tatton Asset Management’s profitability and quality metrics. My main concern relates to the outlook. As the UK faces a possible recession, is now the right time to invest in a company which ultimately relies on the economic health of Middle England?

Momentum: limited growth

I’ve no idea how well the economy will recover from the impact of the COVID-19 pandemic. Early data as lockdown eases seems inconclusive to me. I think it’s prudent to expect some degree of slowdown, however, if only because of the number of job cuts which seem likely.

Brokers covering Tatton appear to share this view and have trimmed their forecasts over the last three months:

However, these forecasts still indicate eps growth of 10%-15% in FY21 and FY22. If the group’s profitability can be maintained, then I’d suggest the current valuation might still leave room for growth.

The stock’s price momentum certainly appears to be strong:

As things stand, the stock’s MomentumRank of 91 seems reasonable to me.

My decision

There’s obviously considerable uncertainty about the outlook for the UK’s financial sector and the wider economy. But Tatton appears to have a very sticky customer base, with recurring revenue of 85% over the last three years. I’d hope that many of the end clients of its services would stay put during a recession.

Although the valuation is quite full, this appears to be good quality business with a strong balance sheet and very attractive margins. Net cash at 31 March was enough to cover a year’s operating expenses, providing a reassuring margin of safety.

I’ve decided to add Tatton Asset Management to the SIF virtual portfolio and my own real money portfolio. Like my recent purchase of K3 Capital, this is a bullish choice that assumes a fairly prompt recovery. 

My hope is that any disappointment in this regard will be partially hedged by more defensive portfolio stocks, such as B&M, BAE Systems, Finsbury Food and British American Tobacco.

As always, I’d very much welcome your views on Tatton and the outlook for the wider market. How are you positioning your portfolios? Or are you staying in cash until greater certainty appears?

Disclosure: At the time of publication, Roland owned all the shares mentioned except Tatton Asset Management.