Liontrust sell-off is overdone

Shares in the London-based fund house have fallen by 60 per cent, having capped out last September on the back of rising markets and mounting inflows into environmental, social, and governance (ESG)-related investments. Such has been the carnage that it is legitimate to ask whether the fall now represents a sentiment-driven overreaction, rather than anything particular to Liontrust. The question is whether investors should need to look at the company as an interesting investment opportunity in its own right – if, of course, they can look beyond what clearly promises to be turbulent months ahead for the markets on which it depends.

Judging by its full-year results, published last week, Liontrust has earned the right to a hearing before both value- and income-focused investors. Despite the market gloom, the final dividend was raised by 39 per cent and there was good evidence that Liontrust is still attracting the inflows needed to generate its fees. Net flows into its range of largely ESG-themed funds hit £2.5bn in the 12 months to March, compared with £3.5bn in FY21. A fall in mandates on a headline basis is never ideal, but is largely due to some very difficult comparatives. The year to March 2021 – in which markets boomed alongside surging retail investor subscriptions and interest – was a record year of fund inflows for most types of asset managers, but it was particularly fruitful for sustainability specialists like Liontrust.

Despite the tough comparisons, Liontrust was still the second highest beneficiary of fund inflows in the UK during the 2021 calendar, according to the closely watched Pridham Report.

Operationally, there have been no issues of note, apart from a surprisingly large vote against the management’s compensation package in February, when 46 per cent of shareholders took a negative view of executive pay at the firm. Whatever the individual arguments over pay – and fund management is a notoriously fleshy business when it comes to compensation as it has no assets other than human capital – the profits have continued to flow at the company. Statutory pre-tax profits more than doubled in the year just gone to £79.3mn, even as higher staff costs and members’ drawings bumped up administration costs by £22.3mn to £152mn.

The regulatory imperative

Still, investors can be forgiven for feeling nervous about sustainable finance products, as regulators seek to better guide the way individual investors, large pension funds and institutional investors make ESG-themed investment decisions.

This year is a pivotal one for investment companies marketing ESG-flavoured funds and products. In the UK, following a 2021 Financial Conduct Authority consultation, a new system will be introduced to label investment products such as “sustainable”, “not sustainable”, “transitioning” or “aligned”. This will affect how funds can invest and market themselves, at a time when a growing number of funds are mandated to pursue sustainable strategies. Overall, Liontrust should see the benefit of regulations in its inflows as more investors, including institutions, adjust their priorities to take ESG conditions into account.

The rising tide of regulation is a response to rising allegations of greenwashing within the industry as managers fight to attract the ever-growing piles of sustainability-minded investor capital. Matching actions with deeds has been very difficult, particularly at a time when strong outperformance from miners, oil companies, arms manufacturers and tobacco stocks have led some fund managers to contort their definition of ‘sustainable’ in a bid to attract ESG mandates without sacrificing too much market alpha.

That has led to allegations of misleading marketing, uninspiring asset management and a sense that the wider industry does not really understand the new rules of the game. In this respect, Liontrust should have a natural competitive advantage over many other managers in that charges of greenwashing would never pass scrutiny. In fund management, almost more than in any industry, brand power is the only other asset alongside human capital and still retains its importance when marketing funds to new investors.

The firm’s solid sustainable reputation notwithstanding, management has committed to make “considerable strides” in the way it integrates ESG into its investments processes, explains those processes to investors and regulators, and remunerates executive directors.

Over-discounting?

Aside from the falling price of the assets from which Liontrust earns its fees, it is hard to single out why the market has applied such a steep discount to the shares.

The most likely reason is the expectation that market and economic pain will lead investors to pull their money from funds or reduce their ability to regularly commit to funds. However, according to analysts at Panmure Gordon, downward share price movements have been roughly double the level of actual earnings downgrades, suggesting that sentiment rather than performance is the animating factor behind the scale of the sell-off. The argument then moves on to what level of discount is appropriate as a margin of safety for Liontrust.

The company holds approximately one year’s worth of operating costs in cash on the balance sheet, carries no debt and generates operational gearing on higher revenues, which obviously reverses when revenue growth slows or sales contract. In value terms, the shares have halved in the past two years, despite delivering record profits during that time. The shares traded on a forward price/earnings multiple of 18 in 2020, and an average of 14 over the past five years. Currently, the shares can be yours on just nine times Panmure Gordon’s forecasts for the current financial year to March 2023.

After proving an excellent differentiator for years, might specialisation now account for the discount? Compared with an industry leader like blue blooded investment manager Schroders (SDR), Liontrust’s asset base lacks diversification. We have seen this to a lesser extent with Polar Capital (POLR), whereby a reliance on a once corner of the market – call it a form of typecasting – means that it quickly becomes a proxy for the market’s broader level of volatility. By contrast, a firm like Schroders –  with its own wealth management arm and capacity to take on very large mandates from institutional investors – tends to move in lockstep with the market, rather than massively under- or outperform.

In other words, investors should understand that Liontrust's shares comes with broadly higher levels of risk than its simple exposure to alternative energy producers and technology companies would already imply. This has felt especially true in the months since Russia launched its war in Ukraine. Investors have piled into the shares of bulk commodity producers and unloved defence firms, while spiralling inflation and interest rate expectations have hit the highly-valued favourites of ESG stock pickers.

Despite this, Liontrust's shares start to look like a good value even if you assume assets under management go sideways or erode for the next couple of years. Strip out cash, and the stock trades at just over seven times forecast earnings for this year. A dividend yield approaching 7 per cent, easily covered twice over even if asset values move another leg lower, provides another degree of safety, and looks tempting if equities find something approaching a bottom this year.

Rocky markets may prove unforgiving to Liontrust in the near term, but at just over £10 a share, the shares currently offer a compelling opportunity to take a long-term view on a fast-expanding side of fund management.