A summary of the following article by George Whitehouse featured in the Eureka Report, 20 January 2012.

PORTFOLIO POINT: Investors who have steered clear of placing their money in managed funds should consider buying shares in those same funds.

The funds management industry provides an essential service in today’s economy. As a group it engages in the management of unit trusts, investment funds and products for retail and institutional clients. Participants generate revenue by providing services on a fee and commission basis. The industry’s growth is driven largely by the government mandated superannuation scheme that directs 9% of the nation’s wages toward long term savings. This superannuation contribution level is set to rise to 12% by 2020.

The business performance within the industry is particularly sensitive to the market cycles and can be characterised by:

• High profitability
• Low reinvestment opportunities
• Low capital intensity
• High payout ratios
• Little or no debt
• Robust cash flows
• Relatively fixed cost bases

‘Price volatility can be extreme, magnifying market moves both up and down’.

The cyclical nature of markets is clearly visible in the fundamentals of the businesses and the share price movements over time. This volatility is a source of opportunity, not risk to the astute investor with a focus on value and a long term view.

Figure 1. Volatility in share price

Risk comes from holding or buying shares when they are expensive, even if they are financially sound. Risk is mitigated by buying sound operating businesses when they are available cheaper than a fair assessment of value. In our view, a number of businesses in this group are available today at attractive prices.

An analysis of fund management businesses

Fund managers are fairly simple to understand, they offer to manage capital from retail and institutional investors and charge a fee for investing it. This is a little more challenging in practice however easy to understand. If a fund manager is successful (generally by outperforming a benchmark or providing a certain absolute return), it is likely to attract more capital from investors which leads to increased revenue. The industry is essential, as not all members of the community have the time or inclination to protect and grow their wealth.

Figure 2. Industry FUM growth set to much faster than the economy
Source: Rainmaker, ABS

Candidates
Perpetual Limited (ASX:PPT) offers a range of managed investment funds, advice, trustee and superannuation services for retail and institutional investors. The group also provides a range of corporate trust services to fund managers and trustees. Today, around 60% of revenue is derived from funds management activities and the business has funds under management (FUM) of $28B. PPT is currently ranked #11 by FUM, with a 2.6% market share.

Platinum Asset Management Limited (ASX:PTM) is a boutique fund manager which focuses on global equities offering a range of funds covering specific regions and sectors as well as a listed investment company. The business has FUM of $15B. PTM is currently ranked #18 by FUM, with a 1.6% market share.

Hunter Hall International Limited (ASX:HHL) is a boutique fund manager specialising in international equities as well a listed investment company. The business currently has $1.5B of FUM.

BT Investment Management (ASX:BTT) is responsible for the management of the BT wholesale and retail funds, as well as managing mandates on behalf of Westpac who owns 60% of the business. The business has FUM of $42.9B. BTT recently announced its intention to purchase UK based fund manager J O Hambro Capital Management. The acquisition cost of $314M, added $10.7B of FUM to the group and is to be funded broadly by a capital raising at $2.15 per share. BTT is ranked #18 by FUM, with a 4.0% market share.

Treasury Group Limited (ASX:TRG) is an investor in funds management businesses in Australia. Its currently has interests in nine fund managers. The business has funds under management (FUM) of $15.5B. The combined group is ranked #20 by FUM, with around 1.0% market share.

The major banks also have large investments in fund managers with FUM market shares of, CBA ~10%, WBC via BTT ~4%, ANZ ~4.4% and NAB ~1.1.% of the roughly $1.7T of assets under management in Australia. The industry is reasonably fragmented with the top 30 fund managers by FUM (15 with overseas origins) investing around 85% of Australian savings. Industry FUM grew at 13.9% CAGR for the 10 years to 2010.

Like any industry the best businesses to own provide:

• a great product or service to customers;
• display an edge over aspiring competitors; and
• keep costs as low as possible leading to high profitability.

Figure 3. Who is the leanest? Staff Expenses to Revenue

Figure 4. Profitability of companies
“There are economies of scale in funds management business (returns to shareholders) but diseconomies of scale to clients (lower absolute returns).”
We can see from the candidates we have included in this report, PTM and HHL are the standouts from an expense and profitability point of view.

The business of managing client savings is scalable however as FUM grows, maintaining strong performance becomes more challenging especially if the manager is focused on a small market such as Australia.

Studying the businesses in this group shows that many of the managers have products that focus on global markets to alleviate part of this challenge.

The largest expense for all fund managers is their employee expenses. This leads to the typical view that their best assets go down in the lift each evening. The rating agencies and asset consultants know this and focus on the teams that allocate capital and the processes to assess depth and rigour the manager displays. The term ‘key man risk’ is often discussed by investors and ratings agencies alike. Key man risk is hardly a new concept to Perpetual which previously endured the loss of highly regarded investment managers such as Anton Tagliaferro and Peter Morgan who left to establish competitors. More recently, John Sevior has left and it is speculated he will set up a boutique competitor; this has arguably been responsible for some of the short term share price weakness. Fund managers know this and often encourage key staff to hold equity in the business to reduce this risk. This indeed was a key reason that PTM floated, to enable a market for staff that chose to sell part of their stakes. In the recent acquisition by BTT of J O Hambro Capital Management, part of the payment was to lock in the key staff via an equity remuneration scheme. Each of these businesses has a number of key staff often holding meaningful equity stakes. Over time, it is the task of the individual boards to ensure adequate succession planning so that the transition of key people is minimised. Astute investors should quiz their boards at the annual meeting on this key issue.

The cost of operating a fund is lower the greater the quantum of FUM. This makes it difficult for new fund managers who are growing their assets from a low base, to compete on fees. Institutional investors with large amounts of capital often do not normally find it feasible to place capital in investment funds below a certain size. The relatively fixed cost base of fund managers means the businesses have significant operating leverage. The challenge comes in bear markets. FUM contracts due to markets movements, inflows slow or turn to outflows as sentiment turns sour, even if the manager is producing strong performance. This all leads to revenue falling, often magnified by the loss of performance fees. When combined with the largely fixed cost bases, earnings can fall dramatically leading share prices to fall meaningfully, a 50%+ fall is not uncommon. A point illustrated by the recent PTM profit downgrade. This however comes full circle in the next bull market when expanding markets lead to FUM naturally growing, fund inflows as sentiment turns positive for risk assets which leads to revenue growth often magnified by performance fees. Over the cycle, revenue is well supported by cashflow as the manager debits portfolios on a monthly basis. Earnings grow meaningfully above the market in most cases which tends to drive share prices much higher until the cycle repeats. This cyclical nature of markets and businesses leveraged to markets provides ample opportunities for alert investors who can tolerate share price volatility.

One challenge for the investor is that of forecasting FUM flows, a key determinant of revenue. In the short term there is no reliable indicator of FUM flows, however over longer periods, funds flow toward strong performance. Managers know this and invest in marketing and sales activities to increase awareness of the manager’s success.

The competitive advantage for a fund manager is their performance which is driven by their investment process and team. Performance is the ultimate aim of any fund manager, judged relative to a benchmark or on an absolute basis. This prized measure affects fund inflows and outflows. There is ample academic evidence over reasonable time periods that suggest fund managers as a group add little or no value. However within the group there are managers that consistently create value for clients. These are the ones to focus on and become part owners when they are available cheaply as success for clients leads to success for owners. Of particular focus is the adherence to a particular documented investing discipline (view example), a key red flag is if you notice a manager deviating from the discipline they espouse as poor performance is likely just around the corner with the resulting pressure on FUM.

Figure 5. Company Valuation Estimates

Figure 6. Value & Price: PPT

Figure 7. Value & Price: PTM

Figure 8. Value & Price: HHL

Figure 9. Value & Price: BTT

Figure 10. Value & Price: TRG

Observing value and price over time, all of these businesses were clearly expensive in 2007, as was the market in general. Indeed around 2007 was a great time to sell a fund manager following a number of strong years on equity markets, as did the smart money at WBC in floating BTT and at PTM via their IPO. At their troughs in 2009, each business was available cheaply as was the market. Today, the market cheap and each a number of these businesses are available at an attractive price, illustrating the magnified correlation these businesses have with general market levels.

Forming part of the overall investment return investors can expect the dividends that these businesses produce. One of the characteristics of this industry is low reinvestment opportunities as the operating businesses themselves are capital light. This leads rational management to return excess capital to owners and is observable in high payout ratios. As can be seen above, pre-tax dividend yields are at close to historical highs similar to those available during the recent financial crisis. This indicates that the sector is broadly out of favour and/or the market is questioning the sustainability of the dividend payments.

Figure 11. Elevated dividend yields

One of the hardest things for an investor is to buy a cyclical business in a downturn – think of retailers in a recession and fund managers in a share market downturn. However from an investment performance point of view, being a contrarian often produces outperformance on an absolute and relative basis. One must remember that equity markets always recover and go on to break new highs, although this hangover may last a little while longer.

As John Templeton was famous for saying, “if you want better performance than the crowd, you must do things differently from the crowd”. We suggest focusing much of your attention on separating the ideas of price and value, focusing on value and using price as a guide to opportunistically transact. If you are looking for high ROE businesses that have strong and reliable cash flows, no net debt, often have owner managers and provide an essential service then investing in a fund manager may be for you. Fortunately a number are available at a fair price today.