Stockwatch: this non-vanilla finance firm is one to watch carefully

It has ridden high on years of extraordinary monetary stimulus, but can Liontrust move past this if it ends? 

Does a remarkable 28% hike in assets under management since the start of Liontrust's (LSE:LIO) year from 1 April herald its fee income re-rating in due course? Or might it be a contrarian sign of how asset prices are extended versus the real economy – due to extraordinary monetary stimulus? 

The macro context has historically been key

Liontrust Asset Management (LIO) is capitalised around £800 million, with its mid cap stock at exactly 1,300p. It has declared £1.74 billion inflows for the six months to the end of September. 

It has enjoyed a very good run since I first drew attention to it at 110p in October 2012, substantially on a macro theme:

“Quantitative easing has provided an excellent environment for asset gathering, boosting shares while debauching cash value”. 

Back then, Liontrust had enjoyed a ninth successive quarter of positive inflows – helped by its marketing prowess amid rising stock markets.  

Funnily enough brokers were quite cautious on the stock, despite its trading on a forward price-to-earnings (PE) multiple of half the 18x it looks like now. Several directors were buying it however, whereas they seem content now just to hold (beyond nominal small purchases linked to an incentive plan).  

In the Covid-19 triggered sell-off in February to March, Liontrust plunged from about 1,300p to 700p, then rebounded with markets to breach 1,400p in June. It is currently a sideways consolidation as investors ponder. 

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I think this largely explains the 28% rise in assets to £26 billion as a highlight, alongside net inflows of £1.74 billion for the six-month period. Liontrust’s calendar period is fortuitous against a liquidity-driven “risk-on” rally.

In fairness, assets under management will also be bolstered by the acquisition of Architas Multi-Manager, due to finalise by the end of October and introducing £5.8 billion extra. 

Not surprisingly perhaps, the CEO credits “strong momentum of the business over the past few years” to Liontrust’s fund managers, robust processes and strong relations with clients.

Indeed, various funds are winning top awards and are themed to offer things different to plain vanilla strategies: a veritable raspberry ripple of, for example, Economic Advantage, Sustainable Investment and Cashflow Solution.  

But if a moment of truth approaches for market values versus the Covid-afflicted global economy, all asset classes are exposed. 

Looking further out however, the debauching of interest rates – with negative rates starting to manifest – means financial assets of one kind or another will be sought. If cash rots there is pretty much no alternative other than precious metals and property. Liquid markets may plunge but get re-bought. 

A fundamentally favourable business model

This is also why I like a well-run asset management business, if preferably at the lower turning point of the business cycle when markets are anticipating recovery – then in subsequent bull years.

Once fixed costs for the administrative set-up are covered, so long as boards do not let managers get greedy (hedge fund style remuneration in the public company framework) then rising revenues soon boost shareholder value.  

It explains Liontrust’s operating margins in an attractive mid-teen to twenty per cent range (see table) in aid of aided earnings growth. Moreover, there is strong conversion to profit cash with little capital expenditure required. 

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Justifiably the PE has doubled to 18x over eight years, albeit with the dilemma now of looking forward. 

In a similar way, an 8x forward PE would “revert to a better-justified mean” - i.e. upwards.  The risk/reward profile is now a lot trickier in terms of potential mean reversion down. 

This looks the key reason why the stock is consolidated sideways and barely responded to the update. Ultimately you are asking: “Have central banks abolished the business cycle?” 

Prospective 3.2% yield is also no real prop

Despite only basic earnings cover for the dividend, such has been the stock’s appreciation it translates into a modest yield. 

In recent years, cover has only occasionally gone over 1. Plus, if earnings per share (EPS) forecasts of 64p this financial year and 76p in 2021/22 are fair, then cover for a 37p dividend rising to 44p would be about 1.7x. 

Effectively that assumes Liontrust’s asset growth at least consolidates and there is no markets’ de-rating impact on fees. 

The end-March 2020 balance sheet had £40 million cash in context of the dividend costing £15 million, although this board seems likely to think in terms of acquisitions than re-rate the payout or declare a special dividend. 

A dilemma in asset management is markets’ ability to trash the best-laid plans, hence it is wise to grow the dividend in a measured way rather than over-react to near-term prosperity. 

£48 million went on compensation in the last year 

It raises my bugbear about PLCs retaining a private partnership mentality in a public company framework, hence insiders in a different boat for risk-adjusted returns rather than outside investors. 

Reported pre-tax profit in the last financial year fell 26% to £16.5 million as a result of £9.7 million acquisition and re-organisation costs of buying Neptune Investment Management. 

Adjusting for this, profit rose 26% to £38.1 million, but instead of the operational gearing possible under an asset manager business model, profit slightly lagged 27% revenue growth. What happened?

From the 7 July income statement, I calculate administrative expenses as a percentage of turnover has risen from 64% to 72.3%. Note 4 of the accounts breaks the expenses down, for example showing director and employee costs up 32% to £14 million.

Additionally “members drawings charged as an expense” was up 14.3% to £32.9 million and moreover a £1.1 million share incentivisation expense had nearly doubled. 

It is as if they want the ‘drawings’ element of a private partnership besides the share benefits of a publicly listed company, in additional to salaried remuneration (likely pension contributions also).

This is all somewhat well enough in rising markets. No one who has made up to ten times their money in recent years is going to take the board to task at an AGM. But in terms of weighing prospects, in a similar way as we see confidence in financial assets at an all-time high, these managers have an elevated view of their entitlement.

A behavioural finance view might be that this is a cost outside investors must bear in order to attract and retain the best fund manager talent. Although I rather doubt mainstream managers could thrive in the tricky hedge fund domain, where performance fees may take up to 20% of profits.  

It boils down to: will the Federal Reserve remain friendly?

The chief decision here is less fretting over pay or specifics of individual fund performance.

It is whether recent years – and in particular, months – of rising asset prices in response to monetary stimulus and growth in debt, is sustainable. 

Whether the economic disruption from Covid-19 proves chronic and the stimulus measures far less effective in terms of the real economy than inflating assets. 

Whether hopes for vaccines are justified. 

Otherwise market values are liable to hit an inflection point, down. Shares in asset management firms are exposed If the US Federal Reserve maintains stimulus and the US government passes another such bill – yes, the party may well continue, hence Liontrust and others continue to roar. Be aware however, risk/reward is now balanced edgily while insiders have ensured their prosperity. ‘Hold’.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.