Opportunities abundant in Aussie financials
Most asset managers and related firms undervalued, with an average discount of 21%
Most asset managers and related firms under our coverage are undervalued, with an average discount of 21%. This compares to the overall coverage of the Australian market, currently at an average discount of 10%. You’re able to explore discounts and opportunities for global markets here.
Above: market valuation for Australia at 13 November 2023
Our conviction in the thesis for listed wealth managers, asset managers, and their related service providers has strengthened after gathering insights from the recent 2023 Super & Wealth Summit, hosted by the Australian Financial Review.
These firms are influenced by similar business drivers and industry trends. Most derive their revenue from funds under management and/or administration, or FUMA, which are driven by asset price movements and new fund flows from clients, and management fees or commissions on these FUMA.
Our analyst Shaun Ler believes investors are overly fixated on headwinds that are mainly cyclical while underestimating the potential for improved earnings as business conditions normalise.
He believes that fee compression will persist as firms strive to remain competitive when faced with larger rivals like industry super funds that are growing in size through mandated super contributions.
We also see ongoing cost-outs as firms keep pace with competition and retain client assets. We also think firms with a diverse product portfolio have a relatively greater ability to attract and retain client assets.
Out of the 12 diversified financial firms under our coverage, only Pinnacle, Perpetual, Iress and Link have narrow economic moats. This means that our analysts believe that they are able to keep competitors at bay and protect and grow earnings for at least the next 10 years. The rest of the companies have no moat.
Undervalued picks from diversified financials
Insignia Financial (formerly IOOF) provides wealth-management advice and products via a multibranded strategy, and a vertically integrated business model. Insignia's advice business provides financial planning services to both the mass affluent and high-net-worth clients. It also owns finance dealer groups that provide compliance and other administrative services to financial planners operating under the dealer group’s licence.
Our fair value estimate for Insignia is $3.40 per share and the shares are currently trading at a 38% discount. The core business drivers for Insignia are net flows, market returns, and fee margins. We assume no value is added from unannounced acquisitions over the next five years.
Insignia lacks an economic moat. We believe growth in funds under advice, administration and management, or FUMA, and positive inflows are partially byproducts of Insignia's acquisitive growth, and not just due to its branding or switching costs. Insignia's reputation was hurt after the 2018 Royal Commission revealed the firm’s poor corporate governance. Higher industry standards, tighter legislation and more regulatory scrutiny have reduced the distributional advantages from its vertically integrated model. These changes will likely limit Insignia's inflows and pricing power.
Challenger’s core business is selling annuity products in the Australian retirement market and, since November 2016, selling Australian dollar-denominated annuities into Japan's large retirement market. The firm’s annuity products provide investors guaranteed regular payments over an agreed term for an up-front lump sum investment and is designed primarily to protect investors from the longevity risk of outliving their savings. Challenger also operates a funds management business, Fidante Partners, which has minority stakes in several boutique global investment managers, and Challenger Investment Management, which primarily manages investments supporting its annuities business.
Our fair value estimate is $7.30 per share and the shares are currently trading at a 19% discount to our fair value. Our valuation implies a fiscal 2028 P/E of 9 times. Our valuation is based on a weighted average cost of capital of 11%. This is higher than the discount rate that we use for other wealth managers, as the core annuities (life) business is higher-risk, essentially being an insurance business paying guaranteed returns.
We believe Challenger lacks an economic moat. In our view, its earnings prospects are bound to many external factors which are beyond its control. These include being restrained by the type of assets it can invest in (and therefore the returns it can generate), its products being commoditized in nature and are therefore replicable by competitors, having to operate in an industry with relatively low barriers to entry, and its margins being tied to fluctuating interest rate movements.
Pinnacle Investment Management Group
Pinnacle Investment Management Group is an Australia-based multi-affiliate investment management firm. The principal activities of the firm are equity, seed capital and working capital, and providing distribution services, business support, and responsible entity services to a network of boutique asset managers, termed as "affiliates." Apart from deriving revenue from its services, Pinnacle also earns a share of profits from its affiliates via holding equity interests in them. The business is growing rapidly with number of boutiques and FUM growing to 15 and around $90 billion in September 2023, respectively, from seven and $23 billion in December 2016.
Our fair value estimate is $11 per share with shares currently trading at a discount of 16%. Our valuation implies a midcycle price/earnings of 20 times and dividend yield of 4%. We apply an 8.8% weighted average cost of capital in our valuation.
Pinnacle possesses a narrow economic moat which means that we believe the firm can sustain a competitive advantage over the next decade. The moat is based on the intangible asset of its brand and switching costs. These sources of competitive advantage help provide stability in, and grow funds under management across various market conditions.
Intangible assets refer to attributes of a company that can be quantified on a balance sheet. In Pinnacle's case the intangible asset refers to brand strength. The aspects of Pinnacle’s intangibles are twofold--to investors and asset managers. To investors (notably institutional and intermediary clients), it is a "go-to" destination for high-performing boutiques that have optimal capacity to deliver outperformance. The latter can be challenging for large asset managers to achieve as their investment universe is narrower. Affiliates are gaining popularity among the public, too, as Pinnacle builds out its retail distribution. Retail money accounts for 26% of FUM as of September 2023, from 8% in June 2013.
Switching costs refer to impediments that make it less likely a customer will switch to another provider. Pinnacle’s switching costs also extend to both investors and asset managers. Investors are sold products across boutiques and asset classes. This follows a deliberate strategy to diversify its affiliates, asset classes, and product structure--Pinnacle provides investors options, enables the upselling of different products, mitigates the downside from redemptions, and minimises negative contagion if any one boutique underperforms.
The proportion of Australian equities funds under management (“FUM”) has fallen to 41% in June 2023--from 67% in June 2016--while exposure to in-demand asset classes such as global equities, real assets, and credit is increasing. FUM invested in private markets (hence hard to be replicated by ETFs) is steadily growing to 17% of FUM. Additionally, product enhancements such as: (1) introducing performance fee-based strategies; or (2) rolling out active ETFs and managed accounts also help it cater to evolving investor needs.