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Do US asset managers offer good value?

US asset managers make up a good chunk of our model portfolio, but trying to work out whether they are really good value investments is all about measuring risk
Do US asset managers offer good value?

An interesting quirk of a quality screen that we put together for our American shares portfolio is that it threw in several asset management companies that have the cash flow and profits to also put them in the higher reaches of our value screen.

As we detailed last month, ('How to find the real value in US shares', IC 21.01.21), there are four asset managers in our US value screen - the criteria for which can be found at the foot of this article. We will focus on two of those businesses: Artisan Partners Asset Management (US:APAM) and Cohen & Steers (US:CNS).

But do these companies truly combine quality and value? It will come as no surprise to read that asset managers tend to do well when markets rise. True enough, retail investors felt confident enough over the past 18 months to invest savings accumulated during the lockdowns in the stock market via trading apps and asset managers – as well as acquiring plenty of new stuff that might not necessarily be needed.

The problem is how to evaluate whether the inflow of funds that are the lifeblood of the asset management industry – inflows means earned fees that count as sales – are only a temporary phenomenon associated with a 'feel-good factor', or a validation of a business’s inherent merits.

The question for investors is whether asset managers, fundamentally, are better investments than they are investors of your money. That is a universal question that could be asked of fund managers in all major economies. But the sheer size of the US retail and institutional investor market means the opportunity is relatively greater across the pond. For example, in 2021, US retail investors poured over $1trn (£740bn) into the stock market alone, a level of fund flows that broke a long-standing record going back to 1963. For the US industry, it has been raining cash as transaction fees and investment returns beat all records.  

An analysis of the biggest beneficiaries offers a surprising insight. Between them Robinhood (US:HOOD) (37 per cent), Fidelity (15 per cent) and the giant Vanguard (10 per cent) sewed up well over half of the US market for retail investors, according to consultancy Statista. However, that still left 38 per cent of the market up for grabs, and the companies within our value portfolio populate niches within this market segment.

 

The long view

The niches that both our picks occupy are significant in the context of the broader trends within the funds industry. Larger US mutual funds are converting more of their assets to index trackers in a bid to lower costs. According to the Investment Company Institute, for every $1 that was invested in mutual funds in 2021, ETFs hoovered up over $20, which underlines the fact that investing in the shares of asset managers often makes more sense than in the funds themselves. As mainstream assets go passive, the rise of alternative asset classes – areas like property, private debt and overseas investments – is likely to accelerate. It helps that these assets offer the industry considerably higher fees than can generated by traditional mutual fund business models.

 

Let’s go all Artisan

Milwaukee is probably best known as the centre of the US brewing industry – 'It’s Miller time!' – and for giving its name to a high-end brand of power tools. However, it is also home to several reasonably sized asset management companies that cater to niches overlooked by the big Wall Street players. One of these is Artisan Partners Asset Management, a provider of investment services to institutional clients wishing to access a range of international and global assets and funds.

Artisan is interesting for investors both from a valuation and from a broader investment strategy perspective. It is hard to argue with the valuation. Although the asset manager rode the same tiger as everyone else in the first stages of the pandemic stock market recovery, a perceptible leakage of client funds in the third and fourth quarters of 2021 has led to a gradual underperformance of the share price, both in relation to its peers and the broader market – several months before the market decline started weighing on technology stocks.

Simply put, the smart money started to cash-out well before retail investors caused the S&P 500 and Nasdaq indices to reach their absolute peak in November. But the performance of Artisan’s own investment funds, as well as the direction of its own share price, are bellwether indicators that have less to do with the performance of the domestic market. The heavy weighting of APAM’s funds towards global and regional markets - three times the weighting accorded to US shares - meant a serious pull-back, once the rotation back into the US dollar picked up steam in the fourth quarter, was inevitable.  

Hence the company’s attractively low current price/earnings ratio of just eight. Artisan’s chief attraction, however, is its fat dividend yield, which currently tops 9 per cent. That level of payout – the board has committed itself to paying at least 80 per cent of earnings in any given quarter should conditions allow – means that the cover is relatively thin at just 1.3 times. Usually, when a dividend yield rises above the 8 per cent mark, it is the market’s way of signalling doubts about a company’s ability to maintain that level of generosity over the long term. The beauty of asset management, which is still a people-dependent industry despite the rise of robo-portfolio companies, is that cash coming in the door has relatively few demands placed on it compared with, for example, a large industrial conglomerate.

With little in the way of tangible costs except for say IT, executive furniture, the nameplate on the door and staff bonuses at Christmas, there is little else to do with the money other than hand it back to the shareholders. A definite income buy if you need the dollars, but the value case is also difficult to ignore given that price/earnings ratio, and the fact that global markets' relative attractions versus the US are also increasing.

Steer clear of Cohen?

While asset managers with global equity exposure have seen their share prices pull back heavily since last summer, some have nevertheless enjoyed an extended run. A common thread among the latter group is that they specialise in the exotic assets that are tough for ordinary investors to access, and which can bring serious rewards when the time is right. Cohen & Steers is one asset manager which with its specialisation in alternative asset classes, principally real estate, infrastructure and commodities, has benefited from this kind of secular trend. The reason the company has enjoyed a decent winter so far, in the context of otherwise dodgy markets, comes down to one word: inflation.

With all major economies experiencing the biggest rise in inflation in decades – inflation in the US is currently running at 7.5 per cent, or the highest level in 40 years - investors have been casting around more seriously for inflation-resistant assets. For example, large capital projects, such as infrastructure, with long development, construction and maintenance times, often have inflation uplifts built into the contracts that ensure that long-term returns are protected over the lifetime of the asset. That gives an opportunity for investment funds to gain inflation-protection in a way that doesn’t use expensive government inflation-linked bonds.  

Unsurprisingly, that has prompted large inflows into Cohen & Steers funds over the course of 2021. The result was a 37 per cent increase in the firm’s fees to $148mn for the year, according to Cohen’s last set of accounts. That gives rise to a record return on capital employed of 73 per cent, against the long-term average of approximately 34 per cent. Whether it can maintain that level of return in choppier markets is open to question.

One other potential risk to note with specialist managers is that often the assets in which they invest have risks unique to their class. The high exposure to real estate, by definition an illiquid asset, means that Cohen must balance risk very carefully. Any repeat of the property meltdown in 2006-08 would be disastrous for its funds. Added to that is the rising scope for interest rate rises as the US Federal Reserve becomes significantly more hawkish. This clouds the picture for any business where leverage plays a role somewhere in the underlying business model, whether directly or via a proxy investment vehicle.

 

The case for both

The asset managers in our list are an example of a rare instance where the individual investment is less compelling than both combined. The choice between Artisan and Cohen & Steers boils down to which manager’s valuation contains the greatest margin of safety – to quote the core concept of value investing.

Sitting at price to earnings of 20 times this year’s consensus, Cohen & Steers is at a huge premium to Artisan’s lowly eight times. Having significantly outperformed the S&P 500 over the past year, Cohen is also riding a market high, and that comes with much larger downside risk. However, rather than avoiding the company, which clearly has a quality profile, the more imaginative strategy might be a split capital investment in both asset managers, and to use Artisan’s superior yield to compensate for Cohen’s higher valuation.

That means investors paying an average PE ratio of 14, well below the rate for the underlying index, while managing to blend both income and growth from different sources. Sometimes it is possible to have the best of both worlds.