Legg Mason, a hodgepodge of investment managers in equity (Legg Mason, Private Capital, Royce, Batterymarch, Clearbridge), fixed income (Western Asset) and a hedge fund of funds, trades at 12.7x Cash PE for CY 2008 vs. 18x for industry (42% upside to median). Or, based on sum of the parts, you get the entire group of equity managers for free, when $50/share is appropriate (60% upside).
Focus on the equity divisions’ many issues (Bill Miller runs $60B of the $350B in equity/nearly $1 Trillion across all categories), and the short-term underperformance of Western Asset have driven a massive underperformance of LM shares. My theory is that one day, these guys will perform well again (if only for a year) and when/if they do, LM will “be back” with the stock up 40%+.
|
Sum of Parts |
AUM - $B |
MC/AUM |
Division Value - $B |
Value/Share |
|
Permal fund of funds |
35 |
5.00% |
$1.8 |
12 |
|
Money Market |
160 |
1.25% |
$2.0 |
14 |
|
Western Asset |
450 |
2.00% |
$9.0 |
63 |
|
-Minus debt |
|
|
-$1.0 |
(7) |
|
Total LM non-equity |
|
|
|
$82 |
|
|
|
|
|
|
|
Equity division |
$350 |
2.00% |
$7 |
$49 |
The idea is extremely simple and unfortunately has no insight into the coming quarter, when the revaluation will occur, nor do I have a different EPS estimate than the street, (although I think the variability of actual vs. estimate will be pretty low).
Business pieces reviewed
Western Asset:
- An excellent bond manager with its largest funds at 5 stars (Morningstar). 3,5, and 10 year returns for Core funds in top 10% of peers, however YTD returns have been lagging 1-2% vs. peers
- Still, for comparison, the PIMCO Total Return fund has a 5-yr record of 5.32%, vs. 5.56% for Western Core and 6.46% for Western Core + (by far the largest US bond funds Western has).
- Citi thinks 10% organic asset growth likely. To some degree that’s like predicting where the market will end up, but it’s been a good fund family run by good people. My one fear is that they might have basically been long risk, and so benefited from the general tightening of spreads, although I don’t really know how to seperate this from good management (the beta vs. alpha argument).
Hedge fund of funds:
The Permal Group, one of top five, measured by size, in the world. LM paid $800M paid two years ago when assets were ½ as much ($19B vs $35B).
Equity troubles:
- Estimated $5B in outflow last quarter (on $350B in assets). That is before market appreciation, so in theory earnings don’t have to go down as appreciation can cancel out outflows, but obviously most of the funds have underperformed (Legg Mason/Bill Miller, Private Capital/Bruce Sherman, Clearbridge, others).
- On average, the fund managers have performed decently over time. Even this year some funds are outperforming (Private Capital was +1% up over S&P), but the bulk are not.
Catalyst:
- Bill Miller and LM equity funds are mostly US, non commodity/oil, and housing focused. Obviously, with 20/20 hindsight, this was the wrong place to be. While I have no specific opinion on these markets, the sentiment on Bill Miller and his investment ideas is quite poor, and so material improvement could bring the stock back quickly, and with his good long-term record Bill should have an easier time convincing investors that this was just a blip.
- As a side note, I noticed the sentiment readings against the US dollar are at all time lows (e.g. 90% bearish), which causes (or is caused by) the flows out of the US into foreign assets/commodities (things Bill Miller doesn’t own). LM said 87% of all fund flows across all fund families are going international. I think people say, “Yeh, the Euro is overpriced, but everything on the dollar just looks so bad and all other economies are unstoppable.” If the dollar rallied I think Bill Miller would outperform. I’ll refrain from making any dollar predictions, for my own sake.
Risks:
- Philisophically, one could argue that mutual fund managers are victims of increased competition in the equity market place from competitors like VIC board members and that the industry is in perpetual decline, but I’ll leave that to others to decide. Bill Miller would probably say how mutual fund managers are like ant colonies using scent tracts drawn in matrices to scout out food, whatever that means (just kidding – I enjoy his reading, although he goes overboard with the analogies sometimes).
- Western Asset fixed income already has an international presence, but equity funds really do not and Chip Mason and crew are “on the prowl” for a foreign acqusition (European). Personally, I think this is a dumb idea since they’ll be paying with weak dollars, and I’d guess they waste $500 million ($3/share) or so paying too high a price out of desperation.
- Bill Miller bought a 190 foot yacht summer of 2006 for “European Vacations.” Went downhill from there.
Margins:
My work on margins show little risk of margin compression (or expansion). Mix shift between fixed income, money market, and equity would cause change, but it’s a slow process.
I’ll finish with a quote from Way of the Turtle by Curtis Faith to reemphasize how everyone can have a bad streak :
“Most traders do not understand the degree to which completely random chance can affect their trading results. The typical investor understands this even less than the typical trader does. Even very experienced investors such as those who operate and make decisions for pension funds and hedge funds generally do not understand the extent of this effect.