Stockwatch: A financial share at a tipping point

Are fund management stocks flying in Icarus fashion, exposed to tighter monetary policy just as the global credit cycle appears to be rolling over? Or are they well-positioned to capitalise on the cult for equities implying continued strength in management and performance fees?

Liontrust Asset Management, a £228 million company in the FTSE Small-cap index, is a pertinent example. I have drawn attention annually since October 2012 at 112p, when a ninth successive quarter of positive inflows affirmed Liontrust's marketing and investment skills; although equities were also benefiting substantially from QE and low interest rates, thus an attractive context to capitalise on.

Now at 460p, the stock is up 21% this year at an all-time high, and the company has just published results for its year to end-March 2017, showing normalised pre-tax profit up 18% to £17.2 million. That's ahead of consensus (as cited by Company REFS, based on four brokers) for £15.5 million, with revenue up 14% to £51.5 million, including £4 million performance fees versus £7.4 million in the 2016 year.

Assets under management are up 36% to £6.5 billion, enhanced to £9.1 billion as of 3 April (i.e. into the new financial year), mainly by the acquisition of Alliance Trust Investments adding £2.5 billion. There has been a seventh successive year of inflows, helped by developing the infrastructure which, together with a broadening of the investment proposition, creates "an excellent platform to continue our growth".

The chief executive rejects the sense of a "squeezed middle ground," - Liontrust can be seen as representing between niche boutiques and global players - arguing it has "a strong proposition in UK/continental European funds and income funds, also risk-targeted solutions".

Over 71% of assets under management reflect UK retail investors where an older wealthier demographic appears supportive, if potentially also exposed if consumer confidence continues to fall and coincidentally equities too.

The total dividend rises from 12p to 15p relative to my sense for underlying earnings per share (EPS) of around 20p, an extent of payout which underlines management's confidence and reflects the shareholder-friendly nature of the business.

See from the table how very low capital spending needs compare with cash flow per share often in excess of EPS. Quite whether a circa 3.8% yield will be a sufficient prop if market volatility intensifies.

Variations in a normalised earnings view

What's less shareholder-friendly - at least to outsiders - is how "people businesses" like this exact remuneration schemes that can clip value; the directors would say they are required to attract/retain the best managers, and are aligned with shareholders where equity is involved.

But it's still a cost that companies try to strip out of a "normalised" view when reporting, and explains profit/EPS variations it's possible to find here. The table shows Company REFS asserting £9.5 million normalised pre-tax profit for 2016 against Liontrust's statement highlighting £14.6 million rising to £17.2 million.

The discrepancy is due to contrasting views on what extent of charges to add back: note 5 to the accounts shows Liontrust including £3.2 million for share incentivisation, £3.1 million for intangible assets' amortisation and £1.4 million for professional services (acquisition/restructuring) within the £8.1 million total which is up from £5.2 million.

I would prefer just to add back the amortisation charge, as the others are genuine costs, to derive pre-tax profit of £12.2 million - hence only a slight increase on £12.0 million in 2016. In terms of HMRC's view on profitability, its taxation charge is up 8.6% to £2.3 million.

Thus, I would tend to regard EPS being around 20p, implying a recent price/earnings (PE) ratio of 23 times. Liontrust is not unusual in this respect: staff costs tend to be high in listed city firms e.g. taking £9.7 million of £20.9 million gross profit at Record (REC) currency managers.

It does, however, help explain why the stock appears "cheap", with Company REFS citing a forward PE around 12 times based on brokers' views of earning power (which support adding back share incentivisation expenses).

Markets are the dominant influence

Liontrust proclaims a "unique selling proposition" of focusing on asset classes where it has particular expertise. And, without "house views", the fund managers can focus on their own ideas. Disciplined risk control is said to prevent buying shares for wrong reasons.

Furthermore, Liontrust managers can focus on managing money instead of administration issues, and invest personally in the funds they run. That's all virtuous indeed, if unlikely to resist a period of market turmoil if stocks are approaching a moment of truth.

More significant, I believe, is the future for equities generally: whether hopes are excessive versus US monetary policy tightening and a possibility the Bank of England will need to start raising rates, or repeatedly miss its inflation targets. This coincides with signs that credit markets have lost momentum sharply e.g. with industrial and commercial lending turning down in the US and China.

Although private investors have given asset managers solid support over recent years, ploughing money into funds, they can easily sit on hands if markets sour. Fund managers more likely to profit from volatility will be those pursuing "alternative" strategies, especially the long/short hedge funds, albeit very difficult to guess which managers will succeed - or indeed access, given most are closed funds.

A latest Bank of America Merrill Lynch survey of fund managers holding £467 billion equivalent in assets, shows a net 44% believe equities are overvalued, up from 37% in May and beating the previous record high set in the 1999 dotcom bubble. The tech-heavy Nasdaq is seen as the most crowded trade, with three-quarters of investors saying they are expensive or "in a bubble".

Meanwhile, the latest pronouncement from the US Federal Reserve shows it turning hawkish to normalise monetary policy - i.e. raise interest rates irrespective of economic data, in order to re-establish fire-power for stimulus ahead of the next downturn. Markets are being quick to react negatively

Run, or lock in gains?

As a less-liquid small-cap, Liontrust isn't too much affected by short-term market gyrations, but the dilemma is if a rout sets in this summer, then it's the kind of stock with a risk of falling sharply.

So, if you suspect trouble ahead, then better follow the Jesse Livermore adage to "sell when you can, not when you need to". There's no crystal ball, however, and this group is positioned well if the long-term case for equities resumes in due course. A pragmatic view is to sell half of one's holding to preserve gains, and with fresh money keep Liontrust in the frame as markets get volatile.

This is exemplified by the chief executive who, once outside the closed period, has just sold 211,157 shares at 450p - about 23% of his holding and possibly the most he can sell without causing upset.  

For a small-cap stock the stake would likely be placed by the company's broker with an institution, i.e. a buyer anticipates long-term upside and it's also a positive how the discount is small.  Even so, that the CEO is hedging his exposure shows the outlook is quite complex, given market valuations generally look exposed yet Liontrust is well-positioned long-term in this industry.