Who Needs Funds? Buy the Fund Company
Money management is a simple, and incredibly profitable, business.
The stock market's ongoing vitality is good news for investors, but it's even better news for money managers. Fees that asset managers collect are typically a percentage of the funds they handle, so a rising market means higher asset values -- and more profits. A bull market also spurs investors to pour more money into mutual funds, hedge funds, separate accounts and other financial products. Still more profits. Call it a virtuous cycle.
With the Dow Jones industrials near a record level and Standard & Poor's 500-stock index close to a five-year high, it's no wonder the stocks of asset managers have been so popular. They're trading for about 21 times expected 2007 earnings, well above the market price-earnings ratio of 15. They clearly deserve at least some of that premium. Asset management doesn't require huge investment in heavy equipment or armies of workers, so profit margins are extraordinarily high. Over the long term, asset managers earn as much as 40 cents profit on every dollar of revenue before taxes and depreciation. "These are pretty simple businesses, and they can grow to become quite valuable without becoming complex," says Donald Putnam, of Grail Partners, a merchant bank.
Still, money managers, particularly those that specialize in mutual funds, face some stiff headwinds. Closer government regulation -- some of it spurred by the rapid-trading and late-trading scandals earlier in the decade -- has increased costs and trimmed profit margins. So has competition, particularly from low-cost index and exchange-traded funds, which are grabbing 30% of all money going into stock mutual funds.
Putnam, however, is optimistic about the industry's prospects. He thinks average operating profit margins, around 27% currently, will climb back toward their historical level of 40% as companies cut costs and ETF growth levels off. Profit margins for some top-performing companies, such as T. Rowe Price and Franklin Templeton, are already at or near historical highs. Thus, Putnam sees the greatest opportunity in operators that have experienced problems lately and whose profit margins leave the most room for improvement. He also likes companies that operate globally -- the better to safeguard against a possible downturn in the U.S. markets.
One of his top picks, Amvescap, fills the bill on both counts. The London-based company has $450 billion under management, nearly half of which belongs to clients outside the U.S. Mutual funds account for about half its business; the rest comes from serving institutional investors and the very wealthy.
Amvescap's weak spot is the U.S. mutual fund market, where it is best known for its AIM and Invesco fund families, both of which were tarnished in the trading scandals. AIM funds have been lackluster performers, as well. Investors withdrew more than $2 billion from Amvescap's U.S. funds during the third quarter of 2006. But thanks to cost-cutting and strong money flows from investors outside the U.S., the firm's operating margin (excluding a one-time charge) still rose slightly. That's a good sign. If chief executive Martin Flanagan, hired away from Franklin Templeton, can get the U.S. operations in order, Amvescap shares have room to rise. Buckingham Research Group analyst William Katz has a one-year target price of $32 on Amvescap's shares (symbol AVZ), which traded at $22 in mid December.
AllianceBernstein also has a nice balance of U.S. and non-U.S. customers and investments. It manages $680 billion in assets and serves primarily institutional clients. The New York-based company suffered from its involvement in the fund trading scandals and from poor performance during the 2000-02 bear market. But it has made a comeback, thanks in part to its expertise in value investing, a style that has done well for several years. Strong foreign demand for its investing expertise and a growing hedge-fund business are expected to contribute to earnings growth of better than 20% in 2007. At $79, the stock (AB) trades for a reasonable 18 times estimated '07 profits of $4.44 per share.
Solid yield, too
AllianceBernstein, which is 60% owned by French insurer AXA, is structured as a master limited partnership. That means it pays few taxes on its profits and instead distributes them to shareholders. Based on the past four quarters' distributions, the stock yields a well-above-average 4.5%. (Note that AllianceBernstein payouts are not considered qualified dividends and thus do not receive favorable tax treatment.)
Legg Mason's assets were growing by 25% annually when it more than doubled its size by swapping its brokerage operations for Citibank's mutual fund business in 2005. The problem was that Citi's assets were growing by only 6%. The combined company, which manages more than $890 billion, has underperformed analysts' expectations for three straight quarters, and its share price has fallen to $97 from a high in February 2006 of $138.
The real culprit behind Legg's wretched results, however, has been the substandard performance of many of its managers. One of the biggest laggards has been superstar Bill Miller, whose 15-year streak of beating the SP 500 ended in 2006. But as Chairman Chip Mason told analysts during a conference call, the portfolio managers didn't suddenly get "hit with the stupid-stick." Their performance will recover. Meanwhile, Legg Mason now has global presence and a huge sales force within Citibank pushing its funds. Its stock (LM) has risen from a low of $81, and it will likely go higher as the company further integrates the Citibank assets into its system. Morningstar analyst Jeffrey Ptak pegs the fair value of the shares at $114.