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Continued from here. As I’ve highlighted, (alternative) asset managers have an attractive business model, strong balance sheets, and are generally undervalued. On the other hand, they’re a geared market play. I see 2 ways to alleviate this risk:

i) Ration asset manager allocation in your portfolio. As I’ve discussed,  analyzing, ranking & selecting from the broadest universe of listed managers is the best way to achieve this.

ii) Look for a great story, a great stock, AND a great price. This can significantly transform your risk/reward. Make a poor decision on one attribute, and hopefully the others bail you out. Get them all right, and accelerate & increase your returns…

A great story’s about identifying a compelling investment theme, a v qualitative research exercise. A great stock’s about identifying listed companies that exploit this theme, a blend of qualitative & quantitative analysis. Differentiate based on exposure(s), history & status, quality of business model & management, growth plans or potential catalysts etc.  Finally, a great price is completely quantitative. How do you stock picks stack up in terms of financial strength, growth, intrinsic valuation & margin of safety? There’s no specific order for your research activities. It’s just as valid to start with a cheap value stock, and work back to assess peers/competitors, and to identify a relevant investment theme/trend and its positive (or negative) impact.

Investors often focus on a single investment attribute/style, to the detriment of the others. Witness the wild eyed agri/solar/China/social media freak – any price is cheap vs. expected growth…and then they get crushed on Facebook & the like. At the other extreme, we see the value guy investing just on the numbers, and then getting eviscerated by poor management and a dying business model/industry. Embracing all 3 investment attributes/styles is a real challenge, but definitely its own reward! In the end, a great price is always king of the heap – how do you screw up a great story & stock? Overpay! So, all hail value investing – right, let’s see this in action.

Great Story:

I think you’ve got this – I covered much of the story recently. Here’s my lead-in – clearly I prefer emerging markets! But all is not lost with developed markets. There will be tremendous opportunities in discounted asset/special situation investments – best accessed through private equity (PE), event driven & distressed debt strategies. Other absolute return strategies with low, or negative, correlations with equity markets are attractive too.

While good PE & absolute return managers can, to a fair extent, make their own luck, the best returns may come from distressed debt. I’ve been reading Ray Dalio – in Barron’s, he details an age of de-leveraging in developed markets for years to come. The US is slightly ahead of Europe, but there’s still plenty of action to come in US banking/FDIC assets & the impending wall of real estate debt maturities. And Europe hasn’t even warmed up yet

Speaking with Colony Financial (CLNY:US) recently, they still have plenty to occupy them in the US right now. They’re v interested in European distressed assets, but note (bank) sellers are still unrealistic on price or reluctant to sell (or unable to face the write-downs!). This will change – and once the game of chicken’s over, European distressed assets may well represent a generational investment opportunity.

These days, (specialized) investment funds offer these types of opportunities. But what fascinates me are the alternative asset managers, who are the real pure play exposure. And sometimes the only exposure: There’s precious little access to European distressed assets for private investors right now, but alternative managers offer the chance to get in on the ground floor for what’s to come…

And there’s even bigger game for them to hunt! Spare a thought for the poor old pension funds. They dream of 8% returns, even after earning zip on equities for the past decade. And now bonds promise an even worse decade! They might be slow, but eventually they’ll have to increase alternative allocations & drown the managers in cash. And in their wake sails the real Titanic – developed markets debt investors. Slowly & painfully, these nutters will diversify when they figure out debt offers them 2 stark choices: i) rates remain repressed & they earn negative real returns for years to come, or ii) whew, rates back up and…oh no, wait, doesn’t that imply whopping great losses on principal?!

Great Stock:

Sorry…last article, I neglected to mention 1 more manager that caught my eye:

Fortress Investment Group (FIG:US). Fortress was founded in 1998 by Wes Edens, Rob Kauffman & Randy Nardone (Peter Briger & Mike Novogratz joined in 2002). A new Agreement has just been signed to lock the Principals in for another 5 years. Like all (large-cap) listed alternative managers, this is a top tier firm in terms of assets, talent & performance. They manage funds in 4 categories: i) Private Equity – control-oriented & real estate investing, ii) Credit – distressed asset & special situation investing, iii) Liquid – hedge funds, and iv) Traditional – long-only fixed income. Over 80% of alternative AUM’s in long-term locked-up structures, ensuring stable/predictable management fees.

Their particular strength’s in value-oriented asset-based investing, combined with deep industry knowledge & operations management, and supported by strong corporate M&A and Capital Markets experience. They have 3 main PE themes: Financial Services, Senior Living & Care, and Transportation & Infrastructure. Geographical focus is on N America & W Europe, with Asia becoming more important.

Not surprisingly, I’m not so excited with their traditional fixed-income business (via an acquisition of Logan Circle Partners in early 2010). However, half their strategies are top-quartile, while virtually all strategies outperformed their benchmarks since inception. They also increased AUM a rather amazing 19% in Q1 2012! This might prove to be an increase in (cross) selling & market share success story.

Take a look at their long term (Yahoo) price chart. Looks rather sick?! But what’s sick is the absurdly high valuation the market awarded pre-summer 2007. The chart also demonstrates the Fortress team’s exquisite IPO timing:

In contrast, here’s a far healthier AUM chart from Fortress:

And here’s another table I’ve put together:

$ Mio 2011 2010 2009 2008 2007
Yr-End AUM ($B) 43.7 44.6 31.5 29.2 32.9
Avg AUM ($B) 44.2 38.0 30.4 31.1 27.0
Revenues 859 950 584 732 1236
Mgt Fees 509 471 424 598 470
% of AUM 1.15% 1.24% 1.40% 1.92% 1.74%
Incentive Fees 198 369 75 (63) 611
% of AUM 0.45% 0.97% 0.25% (0.20)% 2.26%
Fund Mgt DE 253 358 208 216 525
% of Mgt/Inc Fees 36% 43% 42% 40% 49%

Note: Fund Management Distributable Earnings (DE)‘s equivalent to Operating Profit. I’ve included GAAP Revenues, but otherwise ignore them for analytical purposes (gap between GAAP Revenues & Management/Incentive Fees is basically Expense Reimbursements).

The balance sheet’s v strong, with $1.1 billion of investments – mostly in Private Equity & Credit, which have yielded Fortress’ strongest returns. Commitments to their own PE funds is v manageable at $132 mio. They have $253 mio of debt, but it’s virtually offset by $249 mio of cash. The rest of the balance sheet’s a little easier to analyze, as there’s no fund consolidation. They’ve also re-started a $0.05 quarterly dividend. This is based off net management fees, and an annual ‘top-up’ dividend based on FY performance is also intended, equating to a minimum 6.5% dividend yield. I’m delighted to see (unlike some other firms) they don’t include uncommitted (i.e. non-fee paying) capital in AUM. This represents another $6.4 bio of ‘Dry Powder‘, or future AUM. Now, let’s tackle the more complicated pieces:

Ownership’s simpler than some other firms. Yes, the Principals have control, but it’s a simple voting majority: They own 300 mio B shares out of a total 514 mio A & B shares (all pari-passu for voting purposes). Insiders have a 60% stake, while Nomura (NMR:US) owns 12%. Obviously, the Principals are well compensated, but the size/value of their stake ensures strong alignment with other shareholders. Looking at the latest balance sheet, I was aghast to see $559 mio of equity allocated to Principal’s Interest in Consolidated Subsidiaries. You’re kidding, they own a majority of the listed company, AND half of the underlying business?! What’s left for public shareholders? Actually, it’s a red herring – ‘Class B shares have no dividend or liquidation rights. Each Class B share, along with one Fortress Operating Group unit, can be exchanged for one Class A share…‘ Therefore, assuming ultimate conversion of all B shares, there will be 514 mio A shares outstanding and NO Principal’s Int. in Cons. Subs. Any valuation should be calculated on this basis also.

The other lack of clarity’s around taxation – we’ll be hearing more about evil ‘vulture‘ funds & potential changes in taxation of carried interest. However, Fortress is a partnership, so shareholders are really benefiting from the treatment of partnership income. And I’m happy to assume the REIT/MLP sector will lobby rabidly against any changes in that arena! Changes would be blunted anyway by the ‘tax leakage‘ Fortress suffers on its operations (amounting to about 15% of DE). I intend to value Fortress on a comparable basis to fully taxed companies, so hopefully tax changes are irrelevant (except as a temporary price hit?).

Finally, I expect Fortress to gradually re-allocate AUM towards European distressed assets. This is such a gigantic opportunity, I’m confident you’ll see them launch a dedicated multi-billion European fund in due course. Meanwhile, I’m fascinated by their current focus in the US. They’re acquiring the mortgage servicing rights (MSRs) to literally $100s of billions of mortgages. This has culminated in them beating out Warren Buffett for the purchase of MSRs to $374 billion of loans from ResCap, formerly owned by Ally Financial (ALLY:US). Fortress have primarily implemented this strategy via Nationstar (NSM:US) & Newcastle (NCT:US), two listed entities they manage/control.

To step back: Mortgage securitization in the past couple of decades has sharply divided mortgage origination from ownership, particularly in the US. Consequently, mortgage servicers came into existence to provide certain administrative services (including foreclosure…), for an annual 25-35 bps fee (of outstanding loan balances). MSRs can now be easily bought & sold. Because of balance sheet volatility & capital constraints, and the attendant reputational & political risk, the banks are now desperate sellers… Not surprisingly, prices have collapsed!

A significant % of the ResCap MSRs were sub-servicing rights, which dilutes fees to the lower end of the range. Despite that, they appear to have sold at less than a 1.0 Price/Sales multiple. Hmm, so what, you say..!? But this isn’t a regular business, you’re paying 1 times revenues for what might be a v long & predictable revenue stream, i.e. fees on a 30 yr mortgage. To put it another way, you’re paying let’s say 0.19% of a loan balance to potentially receive 7.5% of that balance in fees. Good Lord!? Of course, it’s not so simple: i) you’ve significant expenses, of course, but margins are high and there are economies of scale, and ii) for every mortgage that’s pre-paid/refinanced or foreclosed upon, you lose that revenue stream…

But plenty of foreclosures have already occurred, and at current rates who’s bloody left to refinance?! Current pricing appears pessimistic, and offers an incredible free option on rising interest rates/inflation. Think about it: If/when rates rise, virtually all mortgage prepayment & refinancing activity will grind to a halt, and the duration of the MSR revenue streams will extend out dramatically. Think about some of the ‘greatest trades ever‘, most were asymmetric bets in terms of risk/reward. But asymmetries can be difficult to access as a private investor. But this MSR trade may present such an exceptional opportunity… Obviously, more research is required – MSRs are a pretty obscure financial niche! Ocwen Financial (OCN:US) and PHH Corp (PHH:US) are worth investigating also.

Great Price:

Well, price is still most important, but I think I’ve done enough prep work to finish this off a little more quickly!? First we must revisit Fund Management Distributable Earnings (Fund Mgt DE). This is equivalent to Operating Profit, which is a key metric. But I’m dubious of any non-GAAP management metric – does Fund Mgt DE make sense, or is it just the bad stuff excluded?! Let’s try a reconciliation:

$ Mio 2011   2010
GAAP Net Income (1,117)   (782)
Principal’s Interest in Consolidated Subs. 686   497
Taxes 36   55
Net Effect of Principals Agreement Comp. 360   445
Equity Based Comp. 235   218
Inv Gains/Losses & Net Interest 11   (14)
Contingent Incentive Income & Misc. 42   (61)
Fund Mgt DE 253   358

Principal’s Interest in Consolidated Subs: Strips out the Principal’s Interest from Net Income. Remember, once all B shares convert to A shares, this P&L (and balance sheet) item will disappear.

Taxes/Inv Gains & Losses/Net Interest: Addback, to get to Operating Profit.

Net Effect of Principals Agreement Comp: An accounting entry with NO economic impact for Fortress or shareholders (and absent from 2012 onwards). I guess you’ll have to trust me on this, unless you want to dig through lots of 10-Ks and the S-1.

Equity Based Comp: A non-cash expense.

Contingent Incentive Income & Misc: Fortress does not record contingent (i.e. subject to clawback) incentive income for GAAP, but includes it as a DE addback.

Surveying the adjustments above, and digging/confirming in the 10Ks, I’m comfortable Fund Mgt DE’s a sensible metric & broadly equivalent to underlying Operating Profit. We could debate if Equity Based Comp’s an expense, of course – but from my perspective, I’m usually happy to exclude as it’s non-cash, somewhat contingent & vests over time. It promises share dilution, but what company doesn’t these days? I usually stick to historical figures for valuation, so I expect dilution to be absorbed in current/future growth. And if everything goes pear-shaped, share dilution’s another negative, but you’ll have bigger things to worry about..!

OK, let’s calculate current Net Cash & Investments, and incorporate it as a distinct component within 3 different valuation approaches I want to investigate:

$1,091 mio Investments + $249 mio Cash – $253 mio Debt = $1,087 mio Net Cash & Investments = $2.11 Net Cash/Investments per share

Wow, Fortress is trading on a 1.5 Price/Cash multiple, i.e. the underlying asset management business is valued at only $513 million!

% of AUM:  Fortress’ management/incentive fee history deserves a true 7.5% of AUM alternative valuation. However, I’ll mark down for the 35% of AUM in fixed income management (which merits a 1% of AUM valuation, at best). A blended rate would be around 5.25% of AUM. A little unfair actually, as Fortress still earns a hefty 1.2% in management fees despite Logan Circle’s lower fees. End-March AUM’s at $46.4 billion, which equates to:

$46.4 bio * 5.25% of AUM + $1,087 mio Net Cash/Inv = $3,525 mio

Current Price/Sales:  Management & incentive fees are currently at 1.15% and 0.45% of AUM, respectively. Since incentive fees are relatively subdued right now, in a historical context, I’m not penalizing them in my valuation. Fund Mgt DE’s at 36% of revenues (i.e. of management/incentive fees, a lower/better measure of total revenues than GAAP revenues). This deserves a 3.25 Price/Sales multiple, corresponding to:

$46.4 bio * 1.60% Total Fees * 3.25 P/S + $1,087 mio Net Cash/Inv = $3,504 mio

Historical Price/Sales:  Management fees averaged 1.20% in the past 2 years, reflecting the impact of Logan Circle. Incentive fees are volatile, so a long term average makes perfect sense in arriving at a (long term) intrinsic valuation. The past 5 years span some v good & bad years – the average incentive fee was 0.74% of AUM. To be conservative, I won’t average up the DE margin, so I’ll stick to an unchanged Price/Sales multiple:

$46.4 bio * 1.94% Total Fees * 3.25 P/S + $1,087 mio Net Cash/Inv = $4,015 mio

btw Before going further, let me return to the 6.5% dividend. Yes, the tax treatment’s a little more complicated, but why look a gift horse in the mouth? The dividend’s funded from earnings, so shouldn’t dilute FIG’s intrinsic valuation over time. I don’t buy a stocks simply based on their dividend, so it’s really a free lunch! And worth a little extra hassle/paperwork… If you’re in the US, you probably have/can access a tax exempt account – a perfect place for some FIG stock. Outside the US, you can probably avoid the paperwork, but might suffer tax withholding – but sure it’s all extra return anyway! If you’re willing to complete a W8-BEN you can likely eliminate some/all of the withholding (DYOR, of course!).

OK, reviewing all of the above, I’m not opting for an average valuation. My last valuation of $4.0 billion, based on a total average 1.94% on current AUM, looks perfectly achievable longer-term. Particularly as it’s only an ex-cash 6.3% of AUM, which has been far exceeded in the past. Or even the present – look at current valuations for KKR (KKR:US), Och-Ziff (OZM:US) or Oaktree (OAK:US)!

This equates to a $7.80 Fair Value per share, for an Upside Potential of 151% compared to the current $3.11 share price. I now have a 2.7% portfolio stake in FIG. My allocation would be higher, except: a) I intend to raise cash (I sold a larger undisclosed holding to fund my FIG purchase) in the next few months, but stand ready to buy at bargain prices, and b) I’m currently exposed to a similar investment (theme) exposure with my Colony Financial (CLNY:US) stake. Cheers, folks!

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