% of AUM, activist investors, alternative assets, asset managers, catalyst, earnings growth, Goldman Sachs, hedge funds, P/B Ratio, P/E ratio, P/S Ratio, Price/Sales, REIT/MLP sector, short sellers, takeover offers
Continued from here. I was glad to see some comments/debate come back to me re my previous asset manager valuation statement:
‘Obviously each manager has their own unique story/valuation, but big picture these metrics really work: 2.25%-3.25% of AUM for traditional managers and 7.5%+ of AUM for alternative managers.‘
‘Big picture‘, of course, just means on average & over time, there will be plenty of exceptions to the rule..! Actually, readers were really just (smartly) anticipating something I wanted to highlight in my Part 2: I’ve highlighted the benefits/logic of using a % of AUM valuation approach, but how about related risks & questions? Like:
i) Does a sector/industry valuation metric even make sense? We tackled this in my last article – on average, yes, there’s clearly a consistent internal logic to tagging different types of asset managers with a certain % of AUM valuation.
ii) With an asset manager, how do you know you’re really getting what it says on the tin? Managers trumpet their alternative credentials – the reality’s often v different. CDO/CLO fees are really no better than traditional bond fees. Hedge fund of fund managers pretty much look like traditional equity managers. Managers prefer to ignore the impact of (reduced fee) ‘white label’ funds or sub-advisory contracts. They highlight the sexy and tend to forget their more pedestrian AUM. Even Goldman (GS:US) suffers from this: I’m sure many investors don’t realize a majority of their $824 bio of AUM’s simply in fixed income/money market funds.
iii) Surely a manager with low operating/net margins will trade at a discount to the average % of AUM? Yeah, sure! But just as superior margins attract competition & compression, one can expect/hope a manager will expand margins to well-established industry averages. This might take time, or come more rapidly via changing/new management…or even totally new management, as in a takeover! I hope I’ve already illustrated why an acquisition can v quickly be transformative… Alternatively, the market may help – at some point, maybe briefly, you’re likely to be offered an inflated/industry average valuation for an inferior business.
iv) And how do you value bond managers, and those 3-4 other ‘managers’ you mentioned? OK, I’ll cover that too…
Valuing a company can be done in so many different ways. Valuations can be stock specific, and might be based upon a target Price/Book, Price/Sales and/or Price/Earnings ratio(s). Relative valuations (vs. a sector or the general market) might be relied upon either, based on some of the same ratios or EBITDA multiples, for example. Finally, in some instances/sectors, there are certain absolute valuation metrics that make sense, and that often only change slowly over time.
There are pros & cons to debate for all of the above, and there’s no reason to pick just one from the welter of valuation metrics/ratios/techniques available… In fact, while it’s more demanding, I’d argue that assessing a variety of valuation approaches and results is far more useful to you as an investor. To take the simplest of examples, even with a v run of the mill company I’ll usually assess it from at least two perspectives:
The Investor Perspective: Screw the balance sheet, screw debt, screw cashflow, management just told me adjusted EPS was X and earnings grew 25% year-on-year…the P/E ratio‘s only 17, it’s a bloody bargain! This is sometimes sheer lunacy, but how hard do you want to fight this? A high, or low, growth company can be awarded a correspondingly high/low P/E for much longer than you might expect, even if another approach flags up a v different valuation. Of course, there’s a terrible reliance here on the extrapolation of v recent history…but that’s what markets & the media are all about every single day, yes?! Relying on longer term growth rates can alleviate this risk to some extent…
The Corporate Perspective: Yep, I’ve said it before, corporates usually don’t give a flying f**k about adjusted diluted EPS & earnings growth rate, they’re pretty meaningless to them. What they care about is current revenues, operating margins & cashflows, and capex, and the impact on their own earnings. Yes, all v focused on the present-day – the future’s only relevant in terms of how the target business fits in with the company’s own plans. [But what about those absurdly priced acquisitions we sometimes hear about? Well, in every case, I’ll happily bet you the problem was the people involved, not the spreadsheets..!?!] A Price/Sales ratio captures this nicely, based on a company’s operating margin (suitably discounted, if necessary, for significant minorities and/or poor cashflows).
Averaging out the resulting P/E & P/S target valuations is often a good way to establish an intrinsic valuation. Of course, in most instances, both perspectives/valuations will broadly overlap with each other and the actual market valuation. Stocks that look cheap from both perspectives are usually classic value investments to consider. But perhaps the most fascinating stocks are those where different valuation techniques throw up v different prices… Yes, you need to exercise caution – averaging out to a target valuation mightn’t seem like the smartest move here – but then again, it might! What do I mean?! With some stocks, this discrepancy may well point to a ‘disconnect‘ implied in the market valuation, and can represent some of the highest potential opportunities available.
Maybe it’s a slow growth (and low P/E) company that has very high quality earnings. Maybe it’s a company with great operating margins whose valuation is punished due to its leverage. Maybe it’s a fast growing company that’s ploughing all its (potential) earnings power into faster growth. Maybe it’s a resource company that’s barely profitable, or just gearing up its extraction activity, but which has 40 years of reserves on hand. Maybe it’s simply a company in an excellent industry with consistent/high margins, but which has to endure f**king woeful management (I’ve written about one of those recently..!).
All of these situations can prompt the market/investors to focus on one aspect/metric of a company, to the detriment of all others. But this will inevitably change! A change in sentiment, better management, a takeover, whatever… Often, the best stocks/stories we hear about (too late!) from hedge funds are situations just like this. This is particularly true of activist investors/hedge funds: How often have you dug into a stock an activist’s just revealed a stake in, to give up on it…mystified why they bought into such an expensive stock?
Take another look, I would guess there’s often another much higher valuation (and potential price target) they’re focusing on – which of course the market isn’t, at least currently! This might arise from another stock specific, relative or an absolute valuation metric/approach they’ve chosen. They’re smart/disciplined enough to constantly search out and invest in these types of opportunities. And they have the willpower, and the firepower, to act as a catalyst to realize this value if the market doesn’t eventually reach the same conclusion in its own sweet time.
It works in reverse too – some of the best short sellers see the market/investors completely hung up on a specific valuation metric/scenario for a particular stock or sector, while other valuation approaches suggest an entirely different reality. Look at the REIT/MLP sector in the US, for example – with so many investors now obsessively hungering after yield, they keep chasing these type of ‘dividend‘ stocks higher & higher… Every single other metric, virtually all of which look poor/over-valued, is completely ignored.
Yes, it’s easy to fool oneself that you’re getting a good return, when you don’t care about the return of your capital..! And companies absolutely exploit this hunger (ignorance?)! Now I see this yield hysteria infecting other parts of the market too. No surprise really, the actions of the Fed will inevitably create the next bubble & crisis, again. That crisis may turn out to be excessive inflation eventually…but I’m sure it will be preceded by a severe crisis for income investments/investors first.
In fact, just look at your economic history. When investors are finally giving up on yield, that’s usually the inflection point for inflation…and investors then start to desperately scramble for anything offering growth (or even just preservation) in the value of their capital in real terms.
Returning to asset managers, % of AUM is the key absolute valuation metric, and I believe Price/Sales (based on operating profit margins) is the best stock specific valuation ratio. A manager that looks cheap on both metrics is certainly attractive, but one that displays a big discrepancy in valuations may be the true bargain. Think of it this way:
For asset managers, % of AUM helps you find the right neighbourhood, while Price/Sales helps you find the right house. Both are equally important. For other companies or sectors, I’m sure you can draw up a similar analogy. And as everybody who knows their property tells us (or used to!), a bad house in a good neighbourhood’s often the v best investment in the long term..!