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M&G is misunderstood

Despite its middling long-term investment case, the insurance-led fund manager looks cheap
June 11, 2020

For much of the time since last year's spin-off from Prudential, M&G (MNG) has seemed like a company without an investment case. That shouldn’t come as a surprise. After all, Prudential’s rationale for the demerger – greater focus on growth opportunities in Asia and a closer match “with the interests of our key stakeholders” – gave the distinct impression that it was shedding dead skin. Understandably, many Prudential shareholders – who were handed one M&G share for each one of the Asia-focused group they owned – dumped the stock at the first opportunity.

IC TIP: Buy at 151pp
Tip style
Income
Risk rating
Medium
Timescale
Long Term
Bull points

Fund division cheap vs sector

Insurance arm cheap vs Phoenix

Dividend payer

Improving equity fund performance

Bear points

No clear growth story

Margin pressures

The reaction from capital markets was similarly ambivalent. “On the face of it, M&G doesn’t look like a stock to get excited about,” suggested analysts at Exane BNP Paribas at the time of the float. “After all, it’s a fixed-income-focused asset manager with a run-off insurance business.”

How much value investors should ascribe to each of these divisions has recently come back into focus, after the group’s shares troughed at 86p in March – some 61 per cent beneath their listing price. Since then, the stock has re-rated with the broader market rally, but continues to trade at a discount to other listed asset managers and ex-growth life insurance companies. Although M&G lacks a long-term growth story, we think the defensiveness of its dividend and the cash-generating potential of its two core businesses remain under-appreciated.

The reason for this is twofold: M&G is principally known as a fund manager, while its Heritage insurance business – home to shareholder-backed annuities and with-profits funds – is now closed. Arguably, this has disguised the stability and cash-generation of the latter division, which analysts at RBC expect will contribute around 70 per cent of this year’s profits, and is really the engine behind a goal for the business to generate £2.2bn of capital over three years. Because it is closed to new policyholders, the cash generated from the Heritage arm’s annuity book is also unaffected by the upfront costs of administration, also known as business strain.

Life insurers should not be considered immune from a world economy currently on its knees. Asset values need to remain well above the liabilities that long-term policies represent. Fortunately, M&G’s insurance investments look stable; just 2 per cent of its corporate bonds are sub-investment grade, and carry a stronger weighted average credit rating than any European peer based on RBC analysis. And even if we do see a spate of junk-rated bond defaults over the next five years, these are likely to be offset by mortality releases, given the likelihood of a decline in UK life expectancy this year; a tailwind M&G is unlikely to trumpet.

The resilience of the Heritage arm was revealed in a first-quarter trading update, in which the division was “stable” and generated an adjusted operating profit of £166m. A decline in the shareholder Solvency II coverage ratio in the period, from 176 to 168 per cent, also reflected the strength of the group’s capital. Should equity markets suddenly drop 20 per cent, the group estimates the ratio would only dip a further 5 percentage points.

Of course, the effect of such an event on the profitability of the M&G's asset management business would be more profound. What's more, like Standard Life Aberdeen (SLA), M&G’s investment fund business has in recent years seen a steady stream of investors pulling their cash across the equities, fixed income, multi-assets and real estate offerings. However, the first quarter of 2020 provided some small sources of optimism, including positive retail savings flows, £2.1bn of net inflows from institutional investors, and further inflows to the small but growing multi-asset PruFund business. An improvement in the performance of M&G’s equity funds relative to their benchmarks could also prove a lead indicator for client flows to this higher-margin segment.

However, the reality for non-specialist active investment managers remains challenging. The unwavering allure of cheaper passive funds will continue to pile pressure on margins and the need to cut costs, which explains why the group wants to reduce total staff costs by 10 per cent in 2020. Acquisitions – such as the recent purchase of digital wrap and wealth management platform Ascentric – offer another opportunity to hold back margin erosion and pivot into stickier investment management models.

M&G (MNG)    
ORD PRICE:150.8pMARKET VALUE:£3.9bn  
TOUCH:151-150.8p12-MONTH HIGH:253pLOW:86.4p
FORWARD DIVIDEND YIELD:12.6%FORWARD PE RATIO:6  
NET ASSET VALUE:198p*SOLVENCY II RATIO:176%  
Year to 31 DecOperating income (£bn)Pre-tax profit (£bn)**Earnings per share (p)**Dividend per share (p)
20171.371.3441.6nil
20181.631.0031.1nil
20191.231.3140.915.8
2020**1.060.7824.218.4
2021**1.070.7924.619.0
% change+1+1+2+3
Beta:2.60   
*Includes intangible assets of £1.5bn, or 59.7p a share
**RBC forecasts, adjusted PTP and EPS figures