From The CIO’s Office

The US stockmarket ended the week on a high note after strong reports from big banks kicked off the earnings season with a positive tone. The Dow was boosted by Disney, after it announced details of its proposed new streaming service to counter Netflix, Amazon Prime and others. Elsewhere, market sentiment was also boosted by a rebound in Chinese exports for March. Over the week as a whole, the S&P and Nasdaq both rose 0.5% while the Dow finished down 0.1%. All three benchmarks are within 2% of their all-time highs reached in September 2018

Weekly Market Moves

Listed Active Asset Managers
Are they irresistibly cheap or a Value Trap?

In this section we consider the value that Mr Market is putting on some listed fund active managers in the UK and the US. There was a time when conventional active fund management was a great business. You just had to build up AUM (assets under management), fees were stable and since costs were mostly fixed, the business model had huge operating leverage. Clients were relatively loyal even when managers mostly under performed benchmarks.

In the last decade or two, the active managers have been assailed by the rise of absolute return hedge funds (which claimed to offer downside protection and better risk-adjusted return) and the relentless and impressive rise of low cost passive and index tracking investment vehicles such as ETFs. The latter have grown very strongly in the last
twenty years and have captured huge market share. The bulk of this growth has been accounted for by just three companies – Blackrock, Vanguard and State Street. Many other large companies including companies, which are large active Fund Managers, such as JP Morgan and Fidelity etc, have struggled to grow their passive business.

The growth of passive investing has put huge downward pressure on the fees that active managers charge and has led to deep concern about the economics of their business models.

The bear case is that these changes are part of a “secular shift” under way among investors (especially younger tech savvy savers and investors) toward ultra-low-cost index funds. This trend benefits a few passive managers (including the behemoth Blackrock which has a foot in both camps) and e-brokers but is a headwind to the majority of
traditional active asset managers.

The stock prices of the listed asset managers have underperformed and their valuations on some metrics look attractive as can be seen in the table below.

The US managers are on forward P/E Ratios in the range of 10 -13 times and Free Cash Flow Yield of 9.5% to 15.6%.

The share price of Franklin Resources (BEN), has declined roughly 40% in share value over the past five years. The firm’s focus has been on value investing since the days of the legendary investor John Templeton. A quick look at the balance sheet indicates that about 50% of the total assets of USD 14.4bn is made up of cash and short term  investments.

Asset managers historically have sold for 2.7% of their assets under management (AUM) and Invesco’s currently pending acquisition of Oppenheimer Funds represents a multiple of about 2.4% of AUM. These numbers to some extent cover a time period when the prospects for the industry were better than is the case currently. The key question is the extent to which the fundamental outlook for the industry has worsened so a much that a much lower valuation is justified.

Franklin currently trades at 1.8% of AUM and this could be attractive enough for buyers including the current 40% controlling shareholders or private equity vehicles who could buy out existing minority shareholders and take the company private.

Legg Mason (LM) has declined by 31% over the past year and about ~50% over the past five years, is even cheaper than Franklin Resources (currently trading at 0.4% of AUM) and is worth investigating further as a potential candidate for investment. It currently offers a dividend yield of 4.5% and the company’s cash flow is strong enough to have allowed it to buy back around USD 300mn to 350mn worth of stock every year for the last five years and this
accounts for about 10% of the current market cap.

These numbers suggest that these stocks are cheap at current valuations and many be worth investing in. If one believes that passive investing and ETFS will continue to gain market share at the current pace, one may exercise caution. However, if the performance of the funds managed by these managers stabilise or improve and AUMs
stabilise, these stocks look cheap and should perform. The active managers cannot compete on fees but perhaps active fees are now low enough for active managers to compete on service and performance.

In our view, these stocks should be investigated further for potential purchase. At these levels, one does not need good news but merely an absence of bad news.