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A prominent South African asset manager working in the bosom of a large life assurer’s fund management division once bragged to me that an asset management business is a “licence to print money”. Many asset managers generate fees as a percentage of assets under management. So, regardless of how they do their job, as long as the fund pot is sizeable they continue to rake in a steady annuity income. You don’t have to become an asset management entrepreneur to grab a stake of this licence, though. Instead of handing your money to an asset manager to invest on your behalf, invest in the asset manager’s shares. In this article, Cadiz Asset Management’s head of equities, Graeme Ronne, highlights a way to access global asset manager profits: through one of the world’s best-known and most successful asset management companies, Franklin – owner of Franklin Templeton Investments. If you’re looking for a fresh idea for your global investment portfolio, read on. – Jackie Cameron
By Graeme Ronne*
Franklin Resources (Franklin), more commonly known as Franklin Templeton Investments, is one of the world’s largest fund managers with $715 billion in assets under management (AUM) and offices in 35 countries. The company was founded in 1947 by Rupert H. Johnson Sr. and has a proud history and impressive track record.
Franklin: An impressive long-term track record
Franklin has been a very attractive investment over the long term: since 1985, $1,000 invested in Franklin would have generated a total return of $209,805 (209 times your money) compared to $25,955 for the S&P 500 and $14,323 for the MSCI World Index, an outperformance of over 9.6% per annum (p.a) over world markets. Chart 1 shows that over the past three years Franklin’s share price has fallen 50% from the peak as they lost a significant portion of their AUM to passive funds, due to underperformance. This is understandable, as up until recently, world markets have been trending – expensive shares kept outperforming while cheap shares kept underperforming.
This resulted in passive funds outperforming active funds. As the market value weight of the expensive shares increased in an index and money flows shifted to passive funds, there was a natural tailwind driving these shares even higher. As an active manager, Franklin avoided these expensive shares. This led to their flagship Franklin Income Fund ($79 billion) and Templeton Global Bond Fund ($41 billion) underperforming the market, placing pressure on their asset base. However, the recent sharp rise in US bond rates and the recovery of ‘value’ shares has driven a significant turnaround in both absolute and relative performances. This bodes well for a turn in the recent trend of net fund outflows.
A quality business with a proven track record of above-average profitability
Franklin has a proven track record of above-average profitability through an entire market cycle (as shown in Chart 2), outperforming the average global business by more than 7% p.a. over the past 18 years. This has been driven by good long-term investment performance, stable investment management base fees (as shown in Chart 3), operational cost discipline and excellent capital management. The high return on equity, low capital requirements and strong cash generation are signs of a quality business
Shareholder-oriented managers with ‘skin in the game’
Investors familiar with our philosophy and process understand that the quality of management is a key investment criteria. We prefer to invest in companies with management that have ‘skin in the game’, a demonstrated history of good capital allocation and operational efficiency. In our view, the Johnson family meets all three criteria. The Johnson family collectively hold 38% of the company and remain well entrenched, with CEO Gregory Johnson having taken over in 2005 from his father, Charles B Johnson. In addition, various family members hold management and directorship positions.
The Johnson family have built the company through organic and acquisitive growth, displaying very astute capital allocation and foresight to remain at the forefront of the evolution of the global asset management industry. This is clearly demonstrated in the above-average returns generated over the long term (Chart 3) and the vast amount of cash returned to shareholders through dividends and share buybacks (Chart 4). This has been a key contributor to the total shareholder return earned by investors over time.
Strong balance sheet provides significant downside protection
Low capital requirements and strong cash generation has resulted in a cash-rich balance sheet despite the vast capital returned via dividends and share buybacks. In fact, the equity market drove the share price so low over the past three years that net cash and investments (US$9.6 billion) reached 45% of the market value of the company. This provides a significant margin of safety to our valuation and allows the company to continue to buy back shares at attractive prices and pay dividends. Franklin is trading at a low point in its earnings and valuation cycle We prefer to purchase shares that meet our qualitative criteria – business quality, management and proven track record of above-average profitability – when they are typically out of favour and trading on depressed earnings and valuation multiples.
Firstly, quality businesses with good management have the ability to grow their intrinsic value over time, and secondly, purchasing these shares at a low point in their earnings and valuation cycle provides a margin of safety to buffer against unforeseen negative developments. Franklin is trading well below the 15th percentile of its historic price to book (PB) multiple (as shown in Chart 5) and has only been this cheap on two other occasions, both of which were significant equity market corrections. In addition, Franklin’s return on equity is depressed relative its long-term cycle, signalling that it is at a low point in its earnings cycle.
The asset management industry tends to be cyclical as revenue is driven by underlying changes in assets under management. This is driven by equity market movements, net fund flows and the impact on fees from changes in the competitive landscape and regulation. As we’ve seen earlier, Franklin’s investment management fees have been relatively stable over long periods of time. It is therefore very useful to assess the valuation by comparing the market capitalisation to the average AUM (as shown in Chart 6).
Historically, Franklin has traded at 3.8% of AUM over time but we were able to purchase it at only 2.4% of AUM. If we strip out the large net cash and investment balance of US$9.6 billion, then we effectively purchased the operating assets at 1.1% of AUM or a price to earnings (PE) ratio of 5X. Over the long term, Franklin has traded at an average PE ratio and free cash flow multiple of 17X respectively. This highlights that the equity market has historically rewarded the share for its above-average profitability.
Attractive asymmetric payoff profile
In our view, Franklin is an example of a mis-priced share, driven to cheap levels by an overly pessimistic market that has extrapolated the recent cyclical downturn into perpetuity. The market appears to have forgotten that Franklin has navigated many market and performance cycles in its 69-year history. On each occasion, it has come out the other side stronger and subsequently has significantly outperformed the market. This can be seen in Chart 1 in 1999/2000 and 2008/2009. In terms of our philosophy and process, Franklin meets all of our investment criteria: a high-quality business with strong management and a proven long-term track record of above-average profitability. The share is currently out of favour, and trading at the bottom of its earnings and valuation cycle, with a significant margin of safety provided by its cash-rich balance sheet. In conclusion, we believe the shares of Franklin represent an attractive asymmetric payoff profile – limited downside with significantly more upside potential.
- Graeme Ronne is Head of Equities at Cadiz Asset Management
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