The first post I wrote was on a tiny asset manager named Hennessy Advisors. I think asset management is one of the more attractive business models out there. The business is scalable, has high barriers to entry, recurring revenue, and throws of free cash flow. Nothing is without its risks those. I originally found out about Hennessy from a Zeke Ashton's 2007 presentation at the Value Investors Conference. While it turned out to be a bad call at the time, I still like what he has to say. He has been bullish on equity asset managers for a while now, and this article in Kiplinger's discusses two of his picks: Artio Global Investors and Calamos Asset Manager. While I haven't yet delved into the companies, my previous experience with Hennessy has me thinking about the risks in investing in asset managers. I'm going to just talk about asset managers in general, and one of the underlying assumptions below is that their results are correlated with the overall market.
Asset management is inherently leveraged to the stock market. The two ways a company gets more assets under management (AUM) are by increasing the value of the assets they are already managing or attracting more assets to manage. The beauty of this is that in good times, the funds go up AND more people pour money into these funds. In the bad times though, the funds go down in value AND more people pull money out of these funds. Redemption of these funds can force managers to sell assets, further driving down the value of their holdings. At the same time, the tail end scenarios are truncated because the stock market can't (hopefully) go to zero and it can't go to the sky. Assuming an asset management company has no debts, its cost structure is pretty flexible. I am exaggerating only slightly when I say an asset manager is just a building with people in it.
Just because the stock is good for investors does not mean the business is good for the customers, which can be dangerous to own. At the same time, I can't really conceive of a better system, because while I don't trust a mutual fund manager to invest on my behalf, I don't think Uncle Steve is doing himself any favors by picking stocks. The problem is that on the whole, mutual funds aren't doing Uncle Steve a favor either. The historical performance of mutual funds is pretty shabby, and it would be more beneficial to own a market index ETF. That isn't to say there aren't good fund managers out there, and asset management companies that have strong records of performance (The Sequoia Fund reopened to new investors in 2008 and they have just under $4b in it, but this represents fractions of a basis point in the trillions invested in funds) . While this is essentially a benefit, because I can't see this happening, a human's inherent optimism prevents them from investing in a less sexy ETF, so there are few threats from alternative investment vehicles.
I think the risk boiled down to one thing is the dual effect (I just made one thing into two, financial alchemists look on in awe) of a falling market and outflows from funds. One could argue at this point, AUM for the industry are at a low point from an inflow/outflow perspective adjusting for the changes in market value due to the reluctance of retail investors to jump into the market (this might just be a CNBC meme I've picked up, but the asset managers I've looked at seem have slowing rates of net outflows, or are getting slight net inflows from the 2008-10 period). While the general market sentiment is hard to factor for when analyzing a company, one can just plug in a bunch of scenarios of degrees of bear markets to look at their downside scenario excluding outflows. Human psychology is usually something not to consider when making an investment, unless you are taking advantage of the manic episodes of Mr. Market. I think it would be easy to convince oneself that they have a solid model of the company, but get walloped on the investor psychology aspect.
One incredibly arbitrary way of looking at the downside scenario of investing in an asset manager would be to say every 1% decline in the market results in a .5% increase in outflows. So when the market is down $1, people also withdraw $.50 from the fund. This is incredibly arbitrary though, but I don't know if historical data in this case would be effective. The events driving market action are unique to the time. While there are similar things occurring that drive the market higher and lower, economic realities always differ. Comparing the current US economic position to Japan in the early 90s is not an awful comparison, but there are differences. The same would apply for the stock market in general and the different causes behind the movements.
Another risk is the volatility of the market. A mutual fund can start and end the year at $1000 but spend most of the year at $600 due to uncertainty in X. An asset manager is exposed to this because they are paid on average AUM. They can't do anything about the market movement in general. While a manager's alpha will incrementally improve results and take advantage of alpha, the volatility will still affect the calculation of average assets under management. I do not know if this is standard practice, but Hennessy earns revenue based on average assets under management.
Another risk is 12-1b fees, which allow mutual funds to pass on marketing costs to customers without actually telling them. This is pretty sleazy. A mutual fund investor is basically paying to be advertised to. This is coming under increasing scrutiny from lawmakers, so any asset manager I look at would have to be capable of surviving the hit. Somewhat cynically, there could be upside from this angle because of the increasingly successful endeavors of corporations to influence lawmakers. This ties into my above comment about many mutual funds not providing a net benefit to their investors. Implicit, I hold the belief that I can outperform the market and mutual funds. While I think the product is crappy, the general population, judging from AUM, does not think so. Even if they do believe the product is crappy, they really have little alternative. Aunt Millie will not be picking stocks any time soon.
As with any investment, fundamental value is going to be the driver of investment decisions. I definitely think that asset managers are attractive as a business, despite the risk. One thing that I find curious about Buffett commentators harping about "X Company: Why Buffett Would Love This Company and You Should Too!" that they never talk about the business he is in. He tends to call himself a "capital allocator," but that is just another term for asset manager. As one person, he has proven adept at managing his initial hundreds of thousands to now many many billions, showing just how scalable and high return the business can be. Instead of sourcing funds from retail investors, he does it through insurance float and free cash flow from subsidiaries, but there are many fundamental similarities.
I don't think this post has been too rambling, but it could have been put a lot more succinctly. Only buy things with a margin of safety. Zeke Ashton believes that he is getting a good margin of safety in asset managers. My interest is piqued in his choices, because as I've written above, the risks seem manageable and obvious.
Talk to Andrew about asset management companies and what he might be missing
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