|Shares Out. (in M):||46||P/E||22.1||21.6|
|Market Cap (in $M):||2,135||P/FCF||22.1||21.6|
|Net Debt (in $M):||-306||EBIT||154||159|
|TEV (in $M):||1,875||TEV/EBIT||12.2||11.8|
|Borrow Cost:||General Collateral|
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SHORT– COHEN & STEERS INC. (CNS, $45.52) - 20 NOV 2017
CNS’ actively-managed funds are under pressure from ETFs and index funds, we believe 30% of its earnings is vanishing at an accelerating pace as Japan continues to crack down on mutual funds that pay distributions far in excess of their investment returns, and 21% of its AUM is in a very risky strategy. We believe CNS should trade 40% lower in today’s market, and could have 75% downside.
Company: CNS is an asset manager which invests mostly in publicly-traded REITs and preferreds. CNS takes a percentage of the AUM, which moves based on performance and on fund inflows and outflows. AUM is as follows:
CNS’ business is mostly straightforward, but the Japan subadvisory business merits further explanation. This consists of one client, Daiwa, for which CNS manages a US REIT strategy. CNS manages the portfolios but has nothing to do with the sales, marketing, distribution, or policies of the funds. CNS leverages the same investment team that manages its other funds, with almost no incremental expenses. As such it accounted for ~30% of CNS earnings in 2016.
This strategy is available through two funds, one sold through Daiwa brokers (“Broker Fund”) and the other through banks (“Bank Fund”). The funds feature distribution yields of 22% and 20% (!). They have 3.0% upfront sales charges which enable high sales commissions, and 2.4% annual fees and expenses.
This begs a few questions.
How do these funds have such high distribution yields? In Japan, mutual funds tend to pay steady monthly distributions. Funds are allowed to pay distributions not only out of underlying dividends and realized gains (as in the US), but also out of unrealized gains. When the distribution is less than the underlying investment return (dividends plus realized and unrealized gains) the fund builds a reserve which it can pay out later, enabling distributions to be greater than underlying investment returns.
Why do these funds have such high distribution yields? Competition. Japanese US REIT funds were tiny until 2010. The dominant player was Goldman Sachs, whose Fund B featured a high but variable distribution. In 2009 Fidelity’s US REIT Fund B was tiny, with AUM as low as ¥709M ($7M). Until the 2007 peak of the US REIT market the Fidelity fund paid a steady distribution similar to its underlying dividends, for a yield of ~3%. Due to strong US REIT performance until 2007 the fund had built a large reserve. After US REIT stocks started declining in 2007 Fidelity actually raised its distribution, resulting in a ~20% yield. The high yield of the Fidelity fund led its assets to swell over 1,000x (!) to ¥750B by early 2011. Fidelity’s success did not go unnoticed by its competitors. After the market rebounded from bottom in early 2009, the rest of the industry had built enough reserves to start aggressively increasing distributions themselves in 2010. Increasing distributions was a very successful strategy.
Who invests in these funds and why? According to the FSA (Japan’s SEC) these funds are held largely by elderly people, and only 37% of investors understand that part of the distribution comes out of principal. These investors like yield because they do not have incomes and because they have experienced decades of poor performance by Japanese stocks. The funds happened to begin pumping up their distributions at a time when these investors were looking for more yield. In 2007, Japanese interest rates began a steady decline from already-low levels. For example, the 10 year yield went from ~1.8% to below 1% in 2010.
How large are these funds? The funds in the previous graph have combined assets of ¥3.7T ($33B). Of all the mutual funds in Japan, two largest are the US REIT funds from Fidelity and Shinko; Daiwa’s two funds combined are slightly larger than the Fidelity fund.
Active management headwind: CNS faces passive management headwinds more intensely than other active managers because its sector-specific strategies are less able to outperform ETFs and index funds. Because of this, excluding market appreciation CNS’ AUM is down 20% since 2011. For example in real estate, CNS’ largest strategy, CNS has been losing to the competition as represented by its largest mutual fund CSRSX:
This is largely because CNS costs more.
The pressure from passive managers is also liable to impact CNS’s preferred strategy, which has been CNS’ key source of growth and is its second-largest strategy. While one might imagine CNS should be able to outperform in preferreds since it is a security strategy rather than a sector strategy, the reality is that most preferreds are issued by financials so it really is a sector strategy. As with REIT funds, the CNS mutual offering is also more expensive than the competition.
Despite CNS’ higher cost, its preferred mutual fund CPXIX has been outgrowing the competition.
The reason why CPXIX has been outgrowing is that it has outperformed. One reason why it has been able to outperform its largest competitor PFF, is PFF does not invest in 144a issues. PGX does invest in 144a issues, and it has performed inline with CPXIX since 2014. PGX seems likely to gain share given its similar performance and lower fees.
Competition from passive management should be a continued headwind to CNS’ AUM and/or fees.
Japan business is vanishing. The Japanese US REIT funds exist because of their large distribution yields. This cannot go on forever, as the only way the funds can maintain their distributions is if US REITS have similar returns. Otherwise the distributions will eat up the reserves and capital and/or the funds will reduce their distributions. Fortunately for the fund companies, through the beginning of 2015 rising REIT shares did more than offset the large distribution. However, since then REITs have returned 2% annually in JPY and with the large distributions the funds’ share prices have been declining.
Despite the declining share prices, until November 2016 the funds were able to raise enough new capital to offset the distribution-induced degradation of the AUM.
So what turned the tide in November 2016? To get this out of the way, even the worst-positioned fund (Daiwa Broker) has enough reserves to pay its distribution for three years with 0% investment returns. Absent third-party intervention, and assuming investors do not care about the share price, this would be a slow burn.
What happened is the FSA began cracking down on these funds. Commissioner Nobuchika Mori, who was recently reappointed for a third one-year term, has effectively made eliminating high distribution funds a lynchpin of his leadership. In April 2016 he created the Working Group on Financial Markets. In December 2016, after meeting twelve times in nine months, the Working Group put out a report saying:
To promote the growth of household financial assets, the FSA wants financial institutions to take a “customer-first approach” and offer products suitable for long-term investments (e.g. ETFs).
The FSA sees rules as a “minimum standard” and is using a “principles-based” approach to encourage funds to “seriously consider what is good for customers”.
“If a principles-based approach has been found to be insufficient to the behavior of financial service providers, a new examination should be conducted, with a view to possible uses of a rules-based approach.”
In April 2017 Mori gave a speech in which he railed against asset managers for having products, fees, and sales practices that take advantage of unsophisticated investors. (See exhibit.) In June 2017 the FSA invited bloggers to a forum, in an attempt to better disseminate the regulator’s message. A new tax-free retirement account program starting at the beginning of 2018 has strict criteria for funds eligible for investment, including that they not pay dividends.
This crackdown has led to a sea change in the industry. In November 2016 the Fidelity fund cut its distribution, and subsequently its competitors followed suit. After the April 2017 speech fund companies practically stopped trying to sell these products.
Daiwa was the last fund company to start cutting distributions, having cut Daiwa Broker in July 2017 and Daiwa Bank just last week. Because Daiwa has been a laggard in reducing distributions and changing its sales practices particularly in the bank channel, it had picked up market share and its assets had held up better than the industry. Now that its distributions are inline with other funds it will start losing assets. Furthermore, when it cut its distribution Daiwa Bank explained it aims to grow fund assets, minimize any share price decline, and pay a stable distribution. Given the fund’s 20% yield, unless US REITs return 20% it seems clear the fund will have to further reduce the distribution.
We believe negative fund flows for the industry are poised to accelerate as Fidelity just initiated what will likely be another round of more drastic distribution cuts, cutting its distribution in half to a 10% yield. In a statement, Fidelity said it aims to raise its share price over the medium/long term while maintaining a steady distribution in the medium term. Similar to Daiwa Bank, with a 10% yield Fidelity can only meet these goals as long as US REITs continue to return at least 10%. It bears repeating that when these funds had normal yields prior to 2010 they had little AUM.
It is worth noting CNS has little visibility into its Japan business. Because CNS only manages the portfolio it does not know if or when Daiwa will reduce distributions. Similarly the sellside does not understand this business. The headline AUM has been steady the past few years so there has been no obvious reason to be concerned, and researching the issue is difficult because the business is in Japan.
Preferreds are not a good strategy. CNS’ preferred strategy accounts for 21% of AUM, and since 2011 it has accounted for 19% AUM growth excluding appreciation. Without it AUM ex-appreciation would have been down 39% rather than the actual 20%. However preferreds are not a good strategy. The securities are illiquid (see below) and CNS often has ~10% of the issues it owns, which means the strategy is not very scalable and becomes more exposed to liquidity risks as funds managed by CNS and its competitors get larger. Also, most preferreds are issued by financial companies (CPXIX’s holdings are 81% financials), with the attendant risks of that sector. Lastly, they have highly asymmetric return profiles. Because preferreds have long/no maturities and fixed principal values, they are very rate sensitive in a rising rate environment while in a declining rate environment they can usually be called at par.
Near-Term Price Targets
Earnings are largely a function the performance of CNS’ funds -- strong returns beget strong inflows and vice versa.
While CNS typically trades at a premium partly because it is a takeout candidate, an acquirer would not put much value on the Japan business. If you take the 2018 base case and exclude Japan and half the G&A, and value it at 11x EBITDA (above the high-end for active managers), CNS is worth $44.
Bull case: Investments markets return 10% and CNS has 5% net inflows in US. Modest near-term impact from Japan issues and investors do not care about it. CNS does $2.21 of 2018 EPS. Stock trades at high end of recent range. 20x => $46.
Base case: Investments return 7.5%, CNS has 0% net inflows in US and investors worry about passive competition. Larger near-term impact from Japan and investors believe it could vanish at any time. CNS does $2.14 of 2018 EPS, comprised of $0.43 of Japan and $1.71 of core business. Japanese business valued at 3x and core at 15x => $27.
Bear case: REITs and preferreds sell off hard, CNS gets major redemptions across business. Enterprise value is $250M as it was in 2009 => $11.
Exhibit: Highlights from April 2017 speech by FSA Commissioner
“…many companies are seeking their own benefits with little regard for customers’ interests. This trend is conspicuous particularly in the asset management industry.”
“we… must take it seriously that so few investment trust funds can be recommended by asset management experts as useful for sustainable wealth growth for individual investors. Why have investment products that do not seem to put customers first continued to be developed and sold for many years? When I ask… about the reason for this sorry state, I hear the same refrain. Most Japanese investment trust management companies are affiliated with companies selling the products. In terms of the amount of assets under management, as much as 82% of all investment trust funds are ones that have been established and are managed by affiliated investment trust management companies. That leads me to suspect that these affiliated companies are creating products which are convenient for sellers to rake in sales commission fees… Have the business practices… helped customers build up their assets in any way?”
For the top 10 funds in Japan the average sales commission is 3.1% and the average trust fee is 1.5%; it is hard to earn profits with those costs.
In Japan, growth in household financial assets attributable to investment returns over the past 20 years is 19% vs 132% in the US. “Probably, the blame for this huge disparity can be partly placed on the business practices entrenched in the development and sales of investment trust products...”
“Meanwhile, many funds that pay out monthly dividends continue to be popular among customers. If financial institutions are to take a customer-first approach, they should explain that customers cannot enjoy the benefits of compound yields through the monthly dividend type.”
“So far, many financial institutions have continued to roll out products from which people with financial literacy stay away but which most ordinary people can be persuaded to pick without adequate understanding. They have focused on collecting fees with little regard for customers’ interests. As a result, customers find it difficult to build up their assets through investment. Does a business model like this deserve to be preserved in our society? Are managers of financial institutions which continue to develop and sell such products providing their employees with worthwhile jobs? Is this business model contributing to the enhancement of the enterprise value of financial institutions and groups over the medium to long term?
“I heard an episode from a friend of mine. After his mother died, the friend went through her things to sort out what she left behind. He was surprised to find that she had purchased many high-risk, complex investment trust products that are hardly suitable for people living on pensions and savings. Over the past several years, I have heard similar stories over and over again. Perhaps, sales persons from financial institutions were not merely promoting their products to elderly people but were also doing some good by keeping their company when they were lonely.”
Noted how far behind the Japanese asset management industry vs the world in terms of size, sophistication, and compensation.
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