Description

Westwood Holdings Group (WHG) $34.62

Summary

Westwood Holdings Group (WHG) is an investment management and trust firm based in Dallas, Texas. The firm manages three primary investment strategies: US Value, Emerging Markets and Global Convertibles. $21 billion in assets under management (AUM) are spread across Institutional, Mutual Fund and Private Wealth distribution channels.

Westwood has experienced moderate AUM outflows in recent years, as have most active managers. The stock valuation has compressed well in excess of the declines in the business. This presents a very asymmetric reward-to-risk opportunity in WHG shares. If rising interest rates and increased equity market volatility result in outperformance of active strategies, resulting in accelerating asset inflows and revenues, WHG stock could perform very well. If the current environment persists, WHG is well positioned with a solid balance sheet with $14/share in net cash, an 8.5% dividend yield and a low valuation.

Background

Stating the obvious, the last several years have been challenging for most active investors. The lack of market volatility driven in part by artificially low interest rates orchestrated to lift the economy out of the 2008-2009 recession have had several unintended consequences in financial markets. This combined with the accelerated growth of indexing strategies has both resulted in relatively low active industry alpha, outflows from active managers and increasing fee pressure on remaining assets. Westwood is one of many firms that have suffered over the last several years with revenues and profits peaking in 2015 even as AUM has continued to rise, primarily due to market returns.

The investment advisory business is generally a fantastic business model. There are no receivables, clients and assets tend to be sticky yielding revenue stability and visibility and there has been a great tailwind of positive market returns over the last several decades boosted by increasing capture of investors’ savings into managed strategies either directly or via institutional proxies like pensions and 401(k)s. Historically, these characteristics yielded high valuation multiples for investment firms.

The world has changed over the last decade and the quality of the investment business has declined. Increasing competition and the ubiquitous dissemination of financial information has reduced alpha and, in combination with the growth of passive investment strategies has resulted in fee pressure, resulting in anemic revenue growth and earnings pressure. This has resulted in sharp multiple compression for investment firms that are not growing.

The Opportunity

I am clearly talking my own book here, but I believe that rumors of the death of active investment management have been greatly exaggerated. In the most optimistic case, the unwinding of the artificially low interest rate environment of the last decade and the end of the 30-year bull market for bonds will create an environment in which active managers can outperform the market and the return of volatility to markets will shift asset flows away from passive to active strategies.

In a more moderate outcome, active managers are able to stem fee pressures and can resume modest revenue growth. In either case, earnings should stabilize grow and valuation multiples should expand to reflect this.

The Data

Currently, WHG is trading at 1.6x TTM EV/Revenues and 5.5x TTM EV/EBIT, and 10.2x TTM earnings and only 6.4x earnings net of cash) Comparably sized active managers like Diamond Hill (DHIL) trade at similarly attractive multiples of around 6x earnings net of cash, while much smaller firms like Hennessey (HNNA) trade at even lower valuations (I believe all are attractive). In comparison, a behemoth like Blackrock (BK) trades at 10x EBIT. Historically, active managers traded in a valuation range of 10x – 15x EV/EBIT.

My base case assumptions are that over the next two years, revenues stabilize and exhibit moderate growth for the industry. Under this scenario, it would not be unreasonable to assume that multiples expand to the low end of the historical average of 10x – 15x EBIT. This would represent over 50% growth from the current quote before considering the growth of cash and investments on the balance sheet over this period.

If my assumptions prove to be incorrect, the downside is well protected by several factors including: a balance sheet with $14/share in net cash and investments, a current dividend of $2.88/share yielding 8.5%, a highly variable cost model that can be flexed down if situations warrant and a robust market for investment advisor acquisitions.

Catalyst

Rebound of active management, revenue stabilization/growth, earnings growth and multiple expansion should result. if not, balance sheet strength and high dividend yield should protect downside. industry consolidation is always a possible catalyst.