PRICE (T. ROWE) GROUP TROW S
May 13, 2013 - 1:00pm EST by
jcp21
2013 2014
Price: 75.52 EPS $3.36 $3.80
Shares Out. (in M): 259 P/E 22.5x 19.7x
Market Cap (in $M): 20 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 18 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Asset Management
  • Premium to Peers
  • Secular decline
  • Competitive Threats

Description

Those predicting the decline of the mutual fund industry due to the rise of ETFs have been a lot like the boy who cried wolf. The important part of the tale that most people forget however is that the wolf eventually came. And, like the wolf, I believe passive management will fully arrive and meaningfully reduce the size of the mutual fund industry.

Side comment: I am not intending to argue that there aren’t great mutual funds and/or investors in the mutual fund industry. Many of these investors are VIC members. And although I am shorting TROW realize the company has several outstanding funds.   

Thesis summary: 1) It is becoming even more difficult for long only managers to beat benchmarks 2) TROW is an ideal choice to short within the asset management industry because of its high valuation (20x 13’ earnings) and because, unlike most of its peers, it is still betting primarily on its ability to beat equity benchmarks (as opposed to a more solutions based model).  In other words, the asset manager with the highest expectations is also betting on a highly questionable value generation model (relative value long only).

Catalyst:

-          Only 10% of all mutual funds beat their benchmark in both 2011 and 2012. Furthermore, a large percentage of investors have failed to rise meaningfully above pre-08 peaks despite the massive rally (taxes and fees eating up returns). As a result, most individuals, financial advisers, endowments, pension funds and consultants around the world are seriously considering passive strategies.  Already, retirement services companies (overseeing 401k options, etc.) are increasing the number of ETFs available to plan participants.

In way, it is like people in 07-08 who owned Blackberries didn’t switch right away but were considering the jump after they saw what the iPhone could do. Generally speaking, any industry where a larger percentage of the customers are seriously considering a switch is worth a look on the short side.

-          Studies on the topic show that either all but a small fraction of mutual destroy value over time (5-10+ years) or at best that a small minority do. But, when you factor in the substantial tax drag (calculations later) mutual funds as a financial product do not add value to customers.

-          The steady, positive inflows of assets to ETFs will likely either continue or accelerate in the coming years.

-          Equity asset managers are badly exposed to both fee compression and asset outflows.

-          TROW is one of the best equity asset managers. However, TROW has a long way to fall both because the stock trades at 20x 13’ earnings and because its investors (both customer and shareholders) have high expectations for its funds relative performance.   

-          TROW stock could get cut in half or more as a stock that is already priced for perfection faces serious threats to its industry.

Thesis:

Passive management has been around for a while. However, because of the terrible relative performance from the mutual fund industry in 2011 and 2012, more institutions and individuals are taking a hard look at passive management. There are number of factors working against the mutual fund industry:

1.       If you use statistical software (I used Risk Solver) to run thousands of simulations on a portfolio, you will find that increasing portfolio weighted position count dramatically lowers the odds of outperforming an index. For example, if you run a thousand simulations of a portfolio that holds 95% of an index, the range of out or underperformance is very close to zero). As you add concentration, it turns out that it takes a while to get anywhere close to what you need to beat a benchmark. Assuming equal weighted positions, one needs 25-30 positions or less to ever have a hope of consistently beating a benchmark over time. Yet, most mutual funds have 50-100+ positions.

2.       Going back to the statistical simulation, it is easier to beat the benchmark, holding all other factors constant, with lower correlations. Yet, the markets correlations have only increased with the risk on risk off Fed / macro risk controlled world. Thus, it is safe to assume it will only become more difficult for mutual funds to outperform.

3.       Because hedge funds collect 2 and 20, the mutual fund industry has a much harder time keeping the most talented investors. Read the abstract of this Journal of Finance article - http://economics.mit.edu/files/875. It says that higher SAT scores correlate to better risk adjusted returns. In 2007, someone replicated this study and it showed the same thing (I can’t find the article for some reason). Bottom line: relative value investing is a zero sum game. If the mutual fund industry can’t get the relative talent (due to money issues) they will face problems performing well.

4.       The world has a surplus of capital. As a result, the odds of an undervalued stock developing go lower. Why? Institutional investors need to be consistently net sellers of a stock for another institution to have an opportunity to buy a stock. Undervalued stocks will still show up. For example, ticker XYZ has a fair value of $30-35. It falls to $27. In a pre-surplus capital world, that stock might fall to $25, $23 or even $20. But in a surplus capital world, it isn’t very likely. And, making a 10-15% sounds good but back luck + fees + taxes + mistakes are the cost of active management. 10-15% probably isn’t enough and partially explains why so few mutual funds beat the market.  

5.       Most funds have high R-squared numbers relative to the market. As a results they do not add value. The low R-squared funds, however, did very poorly during the most recent bear market. Thus, it is safe to conclude excessive risk taking is partially responsible for temporary outperformance. Mutual funds, after all, are not required to report their beta exposure. Along these lines, consider the example of Bill Miller (badly underperformed since inception). A lot of the “great funds” available to investors are there due primarily due to luck (or excessive risk taking). Statisticians have shown that the vast majority of hot streaks, for example, in sports (i.e. shots made in a row or hits, etc.) are statistical illusions. Likewise, a significant percentage of the tiny number of mutual funds that outperform over time will eventually revert to the mean or worse if the fund was beta grazing.

6.       Relative value investing is not optimal because it forces managers to consider non- risk/reward issues when managing. It would be like an NBA team maximizing shots while another maximized for points (you can only maximize for one variable at a time).

7.       Many studies show that mutual funds at least do not destroy value. However, those studies rarely include the impact of taxes. Mutual funds have lower after-tax returns (what matters) for two reasons: 1) More ST gains then LT gains. Based on my calculations and using a range of assumptions, this dynamic reduces after-tax returns by 0.2% - 0.6%. More active funds will be closer to the 0.6% and more passive funds will be closer to the 0.2%. 2) ETFs generate only small realized gains. As a result, the annual compounding rate is much higher. The longer the investor’s time horizon the greater the impact. Assuming 50% realized versus 5% and a 27% realized tax rate (a blend between ST and LT) and an average liquidation of 15 years (many institutions will be much longer but I factor in some regular liquidation. Thus, even a perpetual pool of assets has an average life span) the cost is 0.6%. If you take that out to 30 years the number rises to 0.7%. But, once again, less active mutual funds might be more in the 0.2-0.4% range. All in, taxes can reduce returns by anywhere from 0.4% to well over 1%. In world with potentially low equity returns and almost no benefit from active management, investors will find it much harder to justify a long only active manager.   

8.       Slower global nominal GDP growth implies less equity appreciation over time. Thus, there will be ongoing pressure to lower fees. If stocks were generating 10% gross returns, no one is going to worry about a 1% fee. But if equity returns are in the 5-7% range, the fees become a bigger issue.

In terms of TROW specific issues, the company has done very well both in terms of relative fund performance and stock performance. But the storm clouds are gathering.

First, its underperforming peers have pressure to reduce fees to keep assets stable (and stealing assets is essential given the steady outflows). As a result, the industry is fiercely competitive. Furthermore, the continued flow into ETFs makes the situation even more difficult.

Second, institution/separate account flows were -4.3B. I don’t expect TROW to experience declining earnings this year but at 20x any immediate threat to growth is worth noting.

Third, TROW’s bond funds have done poorly which creates another potential drag for earnings.

Fourth, the asset management (institutional and high net worth) world is still shifting towards a consulting type model where financial firms (TROW’s competitors) give both products (broader than long only, typically including absolute return / alternatives) and overall investment strategy advice. These services are nothing new (started in the 90s) but the typical $150m endowment isn’t happy anymore with a collection of mutual funds and bond funds. I think as the advisor/consultant increasingly advises a larger share of assets, mutual funds (and TROW in particular) are more exposed to losing share and margin:

A) Consultants’ feet are held the fire much more quickly than the old sleepy endowment committee adviser (maybe a retired stock broker who is on the board of the company) during a time when markets only went up. Therefore, asset stickiness will go down. B) Consultants are much more likely to point out things like tax drags as they reduce the compounded rate of return. C) ETFs can be a way for consultants to take the pressure off themselves. When most of the long only funds fail to add value, it is very convenient for the consultant to blame it on the industry as a whole and switch to ETFs. The consultant will still have a role though via picking hedge funds, private equity and more alternative investments. D) ETFs allow more value add from the consultant’s standpoint (i.e. a Belgium ETF or various other specialties). Studies already show that asset allocation drives returns more than stock selection. E) Consultants can potentially be tougher negotiators on fees relative to the less active models that were acceptable when stocks only went up.

In terms of TROW specific as mentioned, the company is not moving as much in this direction relative to its competitors. Instead, TROW is choosing to bet everything on its ability to beat market indexes. Thus, I conclude the company is even more exposed to a large drop even apart from its high valuation.

Another factor to consider is TROW owning a very nice home (i.e. great track record) in a neighborhood that is turning bad quickly. So many mutual fund investors experience poor results. And, over time, those investors will be less favorable forwards mutual funds in general. Thus, it will become harder to sell the product category in general.

Risks

-          TROW outperformance at the fund level exceeds current expectations.

-          TROW successfully generates growth outside of its core business.

-          If the global economy returns to normal and investors stop worrying about markets going down (risk basically) TROW’s business will pick up.

Valuation: I think 10-12x is reasonable over time for a quality company in a difficult, potentially declining industry. The key will be what investors decide with respect to mutual funds. If a large number of people switch to passive investing, TROW could face declining earnings (AUM and fee declines). If, however, few people switch TROW stock will be fine. But at 20x it is worth pointing out that a good outcome is already priced in. 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-          Only 10% of all mutual funds beat their benchmark in both 2011 and 2012. Furthermore, a large percentage of investors have failed to rise meaningfully above pre-08 peaks despite the massive rally (taxes and fees eating up returns). As a result, most individuals, financial advisers, endowments, pension funds and consultants around the world are seriously considering passive strategies.  Already, retirement services companies (overseeing 401k options, etc.) are increasing the number of ETFs available to plan participants.

In way, it is like people in 07-08 who owned Blackberries didn’t switch right away but were considering the jump after they saw what the iPhone could do. Generally speaking, any industry where a larger percentage of the customers are seriously considering a switch is worth a look on the short side.

-          Studies on the topic show that either all but a small fraction of mutual destroy value over time (5-10+ years) or at best that a small minority do. But, when you factor in the substantial tax drag (calculations later) mutual funds as a financial product do not add value to customers.

-          The steady, positive inflows of assets to ETFs will likely either continue or accelerate in the coming years.

-          Equity asset managers are badly exposed to both fee compression and asset outflows.

-          TROW is one of the best equity asset managers. However, TROW has a long way to fall both because the stock trades at 20x 13’ earnings and because its investors (both customer and shareholders) have high expectations for its funds relative performance.   

-          TROW stock could get cut in half or more as a stock that is already priced for perfection faces serious threats to its industry.

Thesis:

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    Description

    Those predicting the decline of the mutual fund industry due to the rise of ETFs have been a lot like the boy who cried wolf. The important part of the tale that most people forget however is that the wolf eventually came. And, like the wolf, I believe passive management will fully arrive and meaningfully reduce the size of the mutual fund industry.

    Side comment: I am not intending to argue that there aren’t great mutual funds and/or investors in the mutual fund industry. Many of these investors are VIC members. And although I am shorting TROW realize the company has several outstanding funds.   

    Thesis summary: 1) It is becoming even more difficult for long only managers to beat benchmarks 2) TROW is an ideal choice to short within the asset management industry because of its high valuation (20x 13’ earnings) and because, unlike most of its peers, it is still betting primarily on its ability to beat equity benchmarks (as opposed to a more solutions based model).  In other words, the asset manager with the highest expectations is also betting on a highly questionable value generation model (relative value long only).

    Catalyst:

    -          Only 10% of all mutual funds beat their benchmark in both 2011 and 2012. Furthermore, a large percentage of investors have failed to rise meaningfully above pre-08 peaks despite the massive rally (taxes and fees eating up returns). As a result, most individuals, financial advisers, endowments, pension funds and consultants around the world are seriously considering passive strategies.  Already, retirement services companies (overseeing 401k options, etc.) are increasing the number of ETFs available to plan participants.

    In way, it is like people in 07-08 who owned Blackberries didn’t switch right away but were considering the jump after they saw what the iPhone could do. Generally speaking, any industry where a larger percentage of the customers are seriously considering a switch is worth a look on the short side.

    -          Studies on the topic show that either all but a small fraction of mutual destroy value over time (5-10+ years) or at best that a small minority do. But, when you factor in the substantial tax drag (calculations later) mutual funds as a financial product do not add value to customers.

    -          The steady, positive inflows of assets to ETFs will likely either continue or accelerate in the coming years.

    -          Equity asset managers are badly exposed to both fee compression and asset outflows.

    -          TROW is one of the best equity asset managers. However, TROW has a long way to fall both because the stock trades at 20x 13’ earnings and because its investors (both customer and shareholders) have high expectations for its funds relative performance.   

    -          TROW stock could get cut in half or more as a stock that is already priced for perfection faces serious threats to its industry.

    Thesis:

    Passive management has been around for a while. However, because of the terrible relative performance from the mutual fund industry in 2011 and 2012, more institutions and individuals are taking a hard look at passive management. There are number of factors working against the mutual fund industry:

    1.       If you use statistical software (I used Risk Solver) to run thousands of simulations on a portfolio, you will find that increasing portfolio weighted position count dramatically lowers the odds of outperforming an index. For example, if you run a thousand simulations of a portfolio that holds 95% of an index, the range of out or underperformance is very close to zero). As you add concentration, it turns out that it takes a while to get anywhere close to what you need to beat a benchmark. Assuming equal weighted positions, one needs 25-30 positions or less to ever have a hope of consistently beating a benchmark over time. Yet, most mutual funds have 50-100+ positions.

    2.       Going back to the statistical simulation, it is easier to beat the benchmark, holding all other factors constant, with lower correlations. Yet, the markets correlations have only increased with the risk on risk off Fed / macro risk controlled world. Thus, it is safe to assume it will only become more difficult for mutual funds to outperform.

    3.       Because hedge funds collect 2 and 20, the mutual fund industry has a much harder time keeping the most talented investors. Read the abstract of this Journal of Finance article - http://economics.mit.edu/files/875. It says that higher SAT scores correlate to better risk adjusted returns. In 2007, someone replicated this study and it showed the same thing (I can’t find the article for some reason). Bottom line: relative value investing is a zero sum game. If the mutual fund industry can’t get the relative talent (due to money issues) they will face problems performing well.

    4.       The world has a surplus of capital. As a result, the odds of an undervalued stock developing go lower. Why? Institutional investors need to be consistently net sellers of a stock for another institution to have an opportunity to buy a stock. Undervalued stocks will still show up. For example, ticker XYZ has a fair value of $30-35. It falls to $27. In a pre-surplus capital world, that stock might fall to $25, $23 or even $20. But in a surplus capital world, it isn’t very likely. And, making a 10-15% sounds good but back luck + fees + taxes + mistakes are the cost of active management. 10-15% probably isn’t enough and partially explains why so few mutual funds beat the market.  

    5.       Most funds have high R-squared numbers relative to the market. As a results they do not add value. The low R-squared funds, however, did very poorly during the most recent bear market. Thus, it is safe to conclude excessive risk taking is partially responsible for temporary outperformance. Mutual funds, after all, are not required to report their beta exposure. Along these lines, consider the example of Bill Miller (badly underperformed since inception). A lot of the “great funds” available to investors are there due primarily due to luck (or excessive risk taking). Statisticians have shown that the vast majority of hot streaks, for example, in sports (i.e. shots made in a row or hits, etc.) are statistical illusions. Likewise, a significant percentage of the tiny number of mutual funds that outperform over time will eventually revert to the mean or worse if the fund was beta grazing.

    6.       Relative value investing is not optimal because it forces managers to consider non- risk/reward issues when managing. It would be like an NBA team maximizing shots while another maximized for points (you can only maximize for one variable at a time).

    7.       Many studies show that mutual funds at least do not destroy value. However, those studies rarely include the impact of taxes. Mutual funds have lower after-tax returns (what matters) for two reasons: 1) More ST gains then LT gains. Based on my calculations and using a range of assumptions, this dynamic reduces after-tax returns by 0.2% - 0.6%. More active funds will be closer to the 0.6% and more passive funds will be closer to the 0.2%. 2) ETFs generate only small realized gains. As a result, the annual compounding rate is much higher. The longer the investor’s time horizon the greater the impact. Assuming 50% realized versus 5% and a 27% realized tax rate (a blend between ST and LT) and an average liquidation of 15 years (many institutions will be much longer but I factor in some regular liquidation. Thus, even a perpetual pool of assets has an average life span) the cost is 0.6%. If you take that out to 30 years the number rises to 0.7%. But, once again, less active mutual funds might be more in the 0.2-0.4% range. All in, taxes can reduce returns by anywhere from 0.4% to well over 1%. In world with potentially low equity returns and almost no benefit from active management, investors will find it much harder to justify a long only active manager.   

    8.       Slower global nominal GDP growth implies less equity appreciation over time. Thus, there will be ongoing pressure to lower fees. If stocks were generating 10% gross returns, no one is going to worry about a 1% fee. But if equity returns are in the 5-7% range, the fees become a bigger issue.

    In terms of TROW specific issues, the company has done very well both in terms of relative fund performance and stock performance. But the storm clouds are gathering.

    First, its underperforming peers have pressure to reduce fees to keep assets stable (and stealing assets is essential given the steady outflows). As a result, the industry is fiercely competitive. Furthermore, the continued flow into ETFs makes the situation even more difficult.

    Second, institution/separate account flows were -4.3B. I don’t expect TROW to experience declining earnings this year but at 20x any immediate threat to growth is worth noting.

    Third, TROW’s bond funds have done poorly which creates another potential drag for earnings.

    Fourth, the asset management (institutional and high net worth) world is still shifting towards a consulting type model where financial firms (TROW’s competitors) give both products (broader than long only, typically including absolute return / alternatives) and overall investment strategy advice. These services are nothing new (started in the 90s) but the typical $150m endowment isn’t happy anymore with a collection of mutual funds and bond funds. I think as the advisor/consultant increasingly advises a larger share of assets, mutual funds (and TROW in particular) are more exposed to losing share and margin:

    A) Consultants’ feet are held the fire much more quickly than the old sleepy endowment committee adviser (maybe a retired stock broker who is on the board of the company) during a time when markets only went up. Therefore, asset stickiness will go down. B) Consultants are much more likely to point out things like tax drags as they reduce the compounded rate of return. C) ETFs can be a way for consultants to take the pressure off themselves. When most of the long only funds fail to add value, it is very convenient for the consultant to blame it on the industry as a whole and switch to ETFs. The consultant will still have a role though via picking hedge funds, private equity and more alternative investments. D) ETFs allow more value add from the consultant’s standpoint (i.e. a Belgium ETF or various other specialties). Studies already show that asset allocation drives returns more than stock selection. E) Consultants can potentially be tougher negotiators on fees relative to the less active models that were acceptable when stocks only went up.

    In terms of TROW specific as mentioned, the company is not moving as much in this direction relative to its competitors. Instead, TROW is choosing to bet everything on its ability to beat market indexes. Thus, I conclude the company is even more exposed to a large drop even apart from its high valuation.

    Another factor to consider is TROW owning a very nice home (i.e. great track record) in a neighborhood that is turning bad quickly. So many mutual fund investors experience poor results. And, over time, those investors will be less favorable forwards mutual funds in general. Thus, it will become harder to sell the product category in general.

    Risks

    -          TROW outperformance at the fund level exceeds current expectations.

    -          TROW successfully generates growth outside of its core business.

    -          If the global economy returns to normal and investors stop worrying about markets going down (risk basically) TROW’s business will pick up.

    Valuation: I think 10-12x is reasonable over time for a quality company in a difficult, potentially declining industry. The key will be what investors decide with respect to mutual funds. If a large number of people switch to passive investing, TROW could face declining earnings (AUM and fee declines). If, however, few people switch TROW stock will be fine. But at 20x it is worth pointing out that a good outcome is already priced in. 

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    -          Only 10% of all mutual funds beat their benchmark in both 2011 and 2012. Furthermore, a large percentage of investors have failed to rise meaningfully above pre-08 peaks despite the massive rally (taxes and fees eating up returns). As a result, most individuals, financial advisers, endowments, pension funds and consultants around the world are seriously considering passive strategies.  Already, retirement services companies (overseeing 401k options, etc.) are increasing the number of ETFs available to plan participants.

    In way, it is like people in 07-08 who owned Blackberries didn’t switch right away but were considering the jump after they saw what the iPhone could do. Generally speaking, any industry where a larger percentage of the customers are seriously considering a switch is worth a look on the short side.

    -          Studies on the topic show that either all but a small fraction of mutual destroy value over time (5-10+ years) or at best that a small minority do. But, when you factor in the substantial tax drag (calculations later) mutual funds as a financial product do not add value to customers.

    -          The steady, positive inflows of assets to ETFs will likely either continue or accelerate in the coming years.

    -          Equity asset managers are badly exposed to both fee compression and asset outflows.

    -          TROW is one of the best equity asset managers. However, TROW has a long way to fall both because the stock trades at 20x 13’ earnings and because its investors (both customer and shareholders) have high expectations for its funds relative performance.   

    -          TROW stock could get cut in half or more as a stock that is already priced for perfection faces serious threats to its industry.

    Thesis:

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