Friday, September 28, 2012

The Deep Value Cycle (and the Case for Value Investing)

OK, so this is sort of a continuation of my PZN post.  Listening to conference calls, you can tell that Pzena spends a lot of time thinking about value and deep value investing.  I guess that's because he spends a lot of time talking to potential clients and he has to sell them on the idea of deep value investing.

Deep Value Cycle
Anyway, in one of the calls, he discussed a cycle he discovered that recurred over the past 40+ years.  He said there have been four deep value cycles. 

First, I should say that he defines deep value as the lowest quintile by price-to-book value of the 1,000 largest capitalization names.  A 'naive' deep value strategy is to own those (I don't know how often it is rebalanced, though).

Anyway, here is what he said on the 1Q 2012 conference call (April 2012):
  • During the last four value cycles spanning over 40 years, on average, five years after a value cycle peak, a naive deep value benchmark was still 12% behind the S&P 500 index and yet ended up with a 500 bps/year  (basis points) advantage over the S&P 500 index over the length of the cycle, which lasted an average 10 years.
  • This includes 7 years of outperformance during the cycle.
  • Today (April 2012), exactly five years after the peak of the last value cycle, the deep value benchmark is 12% behind the S&P 500 index
He said that investors are caught in a "disaster myopia"; having exaggerated fears of the most recent fearful event (or some such).

He first described this deep value cycle in depth on the conference call held in February 2012.  This is what he said:
  1. Cycles are long, 10 years on average with deep value outperforming in 7 of those years.
  2. Over the past four value cycles, deep value outperformed by 480 bps/year.
  3. Recent experience is consistent with these past cycles.
  4. Last peak was 58 months ago (as of February 2012) and deep value is 11.8% behind the S&P 500 index, almost exactly the same as the average in past cycles.
  5. The recent deep value upcycle started in December 2008, but was interrupted for six months in 2011, but this too is consistent with past cycles.
  6. There is significant pent up opportunity in the value category due to flight-to-safety and across the board, indiscriminate selling of cyclical businesses.
Anyway, I am not much into cycles; I don't want to buy into things and sell things for cyclical reasons.  I know many people try to do that and it often doesn't work out too well.  But as Howard Marks reminds us in his book, even though you won't be able to time cycles right (know when it turns), it is important to be aware of them and where we are in the various cycles (credit cycle etc...).  Large mistakes can be avoided by being aware of them.   This is something I totally agree with.  You can tell when a cycle is nearing an end; when credit spreads shrink too much or blow out too far etc...

This deep value cycle, to me, is similar.  You don't want to try to time in and out of it.  But if you know that the deep value cycle is at a low or in the early stages of outperformance, you want to be aware of it.

Businesses Can Manage in Bad Times Too
In one of his calls, he also reminded investors that even during the high inflation, low growth period of 1975-1982, corporate ROE averaged 13.5%.  Corporations are businesses run by people and not static entities.  If there is low growth, they will manage for low growth.  If there is inflation, businesses will manage for inflation.  So whatever comes our way, businesses will manage through it.

Value Investing Makes Sense
At the PZN website, there is some interesting research.  He has something posted there called the "White Paper".  You can see it here. This was posted in July 2011, so it's a little old, but the story is still relevant.  I will cut and paste some relevant charts here (without permission, but since I am spreading the gospel, I hope they won't mind).

First, people hate stocks now because it has done poorly over the past decade:

Pzena talks about how people measure risk with volatility, Sharpe ratios and other things that measure price movements over the short term.  But as we know, stocks are less risky over the longer term.  Here is how he illustrates the benefit of holdings stocks for the longer term:

OK, so we've all seen this before.   But let's look at how this compares to the favorite asset class of the moment, bonds:

Pzena points out that on an inflation adjusted basis, bonds are really risky.
Here is a frequency distribution:

The range of possible outcomes is narrower for bonds.  This is why people tend to think bonds are less risky than stocks.  Stocks have a much wider range of possible outcomes, therefore it's risky (according to conventional thinking).  But which distribution would you rather own?

Also, Pzena points out that hard assets and commodities are popular now, but here is the true long term story of commodities:

So stocks are looking good, but can we do better than stocks?  Pzena points out that one of the big risks in the stock market is overpaying.  If you stick to value, that is a great risk mitigator for stocks:

So owning cheap stocks not only outperformed the S&P 500 index, but it did it with less volatility than the index, with a lower worst ten year loss and much lower probability of loss.  What's not to like here?

This next step of eliminating the most volatile stocks seems a bit like a post-crisis over-optimization, but still, it's pretty interesting.

Next, he takes a look at the very popular hedge funds.  It has lower volatility but not so good returns compared to cheap stocks:

And he notes that people are running to alternatives such as hedge funds post-crisis, but points out that hedge funds didn't really protect the downside.  I think these returns are from the 2007 peak in the markets through some point in 2011.

So there is Pzena's case for value (or deep value) investing.  The risk/return profile looks very favorable compared to bonds, hedge funds and commodities. 

I know there is going to a be lot of "But..."s, but I do find this a compelling argument.

Current Opportunities
His second quarter 2012 Investment Analysis (July 2012) is also on the website here.

This may not be news to anyone, but he does point out that Europe is cheap now, and buying Europe doesn't necessarily mean Europe has to do well going forward; he points out the global nature of many European companies.

But here's the more interesting chart:

The valuation gap between low beta and high beta stocks is as high as ever.  This sort of value differential is a great opportunity for deep value investors.  Stock investors seem to be rushing to safety; low beta, high yield stocks, consumer staples etc.  while running from the cyclical, high beta names.   Of course this includes financials (and we all know financials are cheap).

It is a pretty stunning chart.  If there is any valuation normalization going forward (this may take time), this would be pretty exciting for deep value investors.

And to close the loop in this post and connecting it to the other PZN post, PZN is a pure play deep value investor.   

If you like the idea of deep value, and think it really is in a cyclically interesting position (poised to outperform), then PZN can be a really interesting play.

Pzena Investment Management (PZN)

OK, so here's another nail that we can hammer down with our asset management company valuation model.  I have been following this company since the IPO but haven't really taken a close look at it recently.

This is a pure, deep-value investment company run by Richard Pzena.  In case you are wondering, this is the "Rich" in Joel Greenblatt's You Can Be a Stock Market Genius book.  Greenblatt talks about how large institutional investors are at a disadvantage compared to individual investors and smaller investors like himself that can seek the special situations described in the book .

From the book:
I spoke with a professional whom I consider one of the best in the business, a friend I'll call Bob (even though his real name is Rich).  Bob is in charge of $12 billion of U.S. equity funds at a major investment firm.    -  page 18

"Bob" outperformed the S&P 500 index by 2-3%/year over the past decade, and Greenblatt goes on to describe how hard that is with a multi-billion dollar portfolio.

Anyway, so this is Rich's investment management company.

Performance (Pre-crisis)
According to the 2007 prospectus, Pzena was doing really well.  Here are some charts:

AUM grew a bunch during the bull market into March 2007.

And here's the return for the Value Service portfolio from 1995.

This return is before fees, but 6.7%/year of outperformance is pretty impressive over this time period.

And then the crisis happened.   They had a bunch of really awful financial stocks in their portfolio, including Freddie Mac that he really talked up in presentations, as I remember (only read about it on the internet).

Here's the performance through June 30, 2012:

This may be too small to see.  You can try to click on it and see the table a little bigger.  If not, this is in the 2nd quarter 10Q.

In any case, it's not pretty.  They have done horribly in the recent past;  Value Service having lost 5.6%/year in the past five years versus a flat market.

But remarkably, even with this bad short term result, Value Service has outperformed the S&P 500 index (net of fees) with a return since inception (January 1996) of +8.7%/year versus +6.9%/year.  Small Cap Value has outperformed the Russell 2000 by 12.0%/year (net of fees) versus +9.0%.  Small Cap Value seems to have done well even in the shorter time periods.

Anyway, I think it's a really tough time for deep value investors so I don't know that you would want to evaluate managers on just their short term performance.

Many are turned off by Pzena's investments in some of the financials that had problems (including Lehman), but they are deep value investors so things they invest in will go bad every now and then.  I wouldn't write off a manager just because they made a few mistakes; performance over the long term is going to be what matters.

Pzena has regretted putting as much as 4% of the funds into leveraged institutions such as FNM and FRE, and I think he has said he won't put more than 2% into such vulnerable, leveraged institutions going forward.

I know there's a lot of people who will say that they can never trust someone who bought FNM, FRE and other financials going into the crisis.   But Pzena has said that in the last cycle, his largest holding went bust (I think it's Fruit of the Loom), but they still managed to outperform through the cycle.

If you have a situation that might double or go to zero, but you think the odds of zero is even as high as 20%,  you are still looking at a 60% expected return.  On this bet, one out of five times, the thing will go to zero.  If you made this bet and lost money, it's clearly not a mistake.  I would take this bet all day.

But in the stock market, people will call it a mistake.  They don't see the math and the assumptions; all they see is someone buying a stock before it went to zero.  That just doesn't look good. 

The trick is not putting yourself in a situation where if the 20% chance event occurs, you would be out of business.  That's a money management issue (how much of a stock to buy).

I think Pzena said his mistake was to own too much in financials, not so much that he invested in them.

The Bad Years
Anyway here is how the Value Service account did on a net basis during the trouble years compared to the S&P 500:

             Value Service (net)       S&P 500
2007      -12.7%                           +5.5%
2008      -44.4%                          -37.0%
2009     +38.2%                         +26.5%
2010     +15.7%                         +15.1%
2011        -4.4%                           +2.1%

Despite this, Value Service and Large Cap Value has maintained their outperformance on an initial-to-date basis.  

From January 1996 - June 2012:

Value Service (gross):    +9.5%/year     
Value Service (net):       +8.7%/year
S&P 500:                        +6.8%/year

From October 2000 - Junee 2012:

Large Cap Value  (gross):   +4.2%  
Large Cap Value (net):        +3.7%
S&P 500:                             +1.5%

Here are some of the fundamental metrics of PZN during those years:

PZN Fundamentals 

PZN's AUM has plunged to $13.5 billion as of the end of 2011 from a high of over $28 billion in the spring of 2007.  Obviously, revenues and earnings are down too along with AUM.

Vanguard Windsor Fund
PZN got a new mandate recently as the co-manager of the Windsor Fund, which I think is a big deal.  The Windsor Fund is a legendary value fund and is one of Vanguards biggest and oldest funds (since 1958).   According to the August press release, they will manage 28% of the $12 billion fund.   The Windsor Fund was run by the legendary John Neff for 31 years between 1964-1995.  According to Wikipedia (if it's on the internet, it' got to be true, right?), the fund gained +13.7%/year versus +10.6%/year for the S&P 500 index during those years.

Anyway, 28% of $12 billion is over $3 billion, so even just on that, that's a big win.  I'm sure this will help in marketing PZN to other institutions.

So What's PZN Worth?
OK, so what is this thing worth? 

It looks like management fees have been steady in the 0.55% area.  For AUM, the latest figure as of the end of August 2012 is $16.4 billion.  For operating margin, let's use 50%.   They have been able to maintain 45-50% throughout this bear market and Pzena has cut costs, so I think it's OK to assume that they can keep a 50% operating margin going forward, which can very well go up if AUM rises from here.  The cost cutting of the recent past may give a nice operating leverage kicker if that happens.

But anyway, let's use 50%.  You may notice that it seems a little higher than the other asset managers.  I attribute this to the fact that PZN has very few funds and a small team that manages a pretty big portfolio.  

Anyway, plugging in these figures, we get an operating earnings figure of $45.1 million.  For shares outstanding, I will just use the total of the class A and B shares (the way the financials are presented in the filings are confusing; they use only the A shares and deduct earnings attributable to the B unit holders etc... For analyzing the company, that is not necessary).

PZN had a total of 10.5 million class A shares and 54.3 million class B shares for a total of 64.8 million shares.  Let's call it 65 million shares. 

So the above $45.1 million operating income comes to $0.69/share.  Using the 10x pretax valuation, that would value PZN at $6.90/share.  But this excludes any adjustments for balance sheet items.

On the balance sheet as of the end of June 2012, there was $36.5 million of cash and investments.  There are some accounts payables and accrued expenses, but I assume that is an offset to advisory fees receivable.  I also ignore the deferred tax assets and the liability to selling and converting shareholders as they are pretty much offsets (even though I don't know exactly what accounts for the small differences;  85% of realized deferred tax savings is payable to the selling/converting shareholders so I look at it as pretty much an offset).

So that $36.5 million of cash and investments come to $0.56/share.

Adding that to the above $6.90/share value of the business gives a total value for PZN of 7.46/share.   PZN is now trading at $5.24/share, a 30% discount.

What if AUM keeps going up and margins improve?  Pzena has said margins would improve on increased AUM because costs (compensation/bonuses) won't go up as quickly as revenue.  He did say before that the 70% operating margin they achieved in the recent peak (2007) was unsustainable.  He never guided to any specific figure, but we know 70% is too high, so maybe 60% is reasonable.

Here is a table of what PZN might be worth depending on AUM levels and operating margins.  I assume 0.55% average fees and 65 million shares outstanding (there were no dilutive shares as of the end of the 2Q so I didn't include any; there are close to 5 million total options outstanding but many have higher exercise prices.  To be conservative, you can give a haircut for that, though (even though options exercise will increase cash).

Also, this table excludes balance sheet items (like cash and investments), so you can add $0.56/share yourself.

PZN Value Matrix:  AUM and Operating Margin (OM)

So according to this table, if PZN can get their AUM up to $18 billion and operating margins to 60%, it would be worth $9.14/share (excluding cash/investments on b/s).

If they get their AUM back up to where it was at the peak, which was around $28 billion (according to the chart at the top of the post) and they maintain 60% margins, PZN would be worth $14.22/share.

Deep Value Investing Cycle
Anyway, as I was looking at PZN, I found an interesting thing that Pzena said on one of his conference calls describing the cycle of deep value investing and it was really interesting.  He also has some great information on his website regarding value investing and why it will continue to work.

It is so interesting, in fact, that I was going to put it into this post, but I think it's worth a whole separate post so I'll make that post later.

The bottom line is that deep value has been hugely out of favor, but this pattern of being out of favor is consistent with past cycles.  And if past cycles is any guide, there will be many years of outperformance going forward from here.

This is really an interesting situation and I didn't realize how undervalued it was.  It has always seemed a little expensive to me, but having gone through the above analysis (and seeing that AUM is coming back up), it is looking pretty good now.

In the case of PZN, I would not worry about the board and management at all.  These guys are solid, deep value guys and I like that they don't veer away from what they're good at.  Everyone else seems to be style-drifting to accomodate the increasing risk aversive and market-neutral bias of institutional clients, but I like how they stick to their guns.

Also, they are not pushing funds out left and right to increase AUM at all costs.  They are disciplined and seem to really want to do a good job on the few strategies they run.

As you will see in my next post, deep value and even regular value is hugely out of favor, and despite new highs in the market, it still feels like the stock market is kind of out of favor too.

So what do we have?
  • Stocks may be an underappreciated asset class (bond/hedge fund bubble), even though I am aware of the "stocks are overvalued" argument.
  • Stocks will do well over time, and particularly value will do well, I think.  Pzena demonstrates that deep value may be at a low point (or in the early stages of deep value outperformance) with years of substantial outperformance ahead (see my next post on the deep value cycle).
  • PZN is a small shop with significant operating leverage so if this pans out, they can do really, really well.  And as I said, asset managers will often outperform the asset class due to this leverage etc.  PZN is a small, very manageable operation run by a solid guy.
  • PZN stock is cheap, given the above assumptions.  The simplicity of the business model, of their investment strategy, the transparency etc.  makes this really an easy stock to own (unless of course, you are calling for a multi-year bear market or depression).
The big negative (other than the usual risk of the stock market), of course, is PZN's performance during the crisis.

As I said, I too scratch my head at people jumping into financials in front of the biggest crisis in history, but I also understand that just because someone buys something that doesn't work out shouldn't automatically disqualify them; if they can outperform over time, that is going to be the key issue and PZN has a good chance of doing that.

Thursday, September 27, 2012

WisdomTree Investments (WETF)

OK, so I mentioned WisdomTree Investment (WETF) in my last post.   In my other post looking at DoubleLine, I sort of got a feel for what money management firms are worth.  I got comfortable with the fact that asset managers currently trade for around 10x pretax profits and that's pretty consistent across asset manager types.

Here's the table from that post (as of August):

Asset Manager Valuation

Asset Manager Operating Margins
Also, using the same universe of asset managers, I took a quick look at what the operating margins typically are. If we can get a handle on that, then we can pretty much value any asset manager. I think this is better than using percentage of assets under management (AUM), which varies greatly according to type of assets (equities, fixed income, money market, alternative), fund type etc. (hedge funds vs. mutual funds etc.).

So here are some figures I plucked from the various 10-K's for the last five years.  Surprisingly, operating margins seem pretty consistent across the board and even over time.  It does seem to be a pretty great business.  I would've expected more margin volatility, particularly after what happened during these years.

Operating Margins

The TTM (trailing twelve month) margin, I pulled off of Yahoo finance.  If it differs greatly from my own figures, it may be because I used "adjusted" margins if managers provided that in their 10-K's, and Yahoo Finance may have used GAAP reported figures.

But in any case, it looks like asset managers typically earn 30%-ish operating margins. 

With 30% operating margin assumptions and a 10x pretax multiple valuation, we only need to know AUM and average management fee rates (and maybe some sub-operating income line items) to figure out what an asset management is worth.

Now that I have this hammer, let's take a look at this WETF nail.

So what is WETF?  I don't intend to go through the whole history, but the short story is that this used to be Jonathan Steinberg's publishing company. The publishing business was called Individual Investor Group and it published the Individual Investor magazine, a magazine Steinberg bought with his family's money.   It was delisted in 2001 and came back to NASDAQ recently (you can see some of their annual reports during the unlisted years at  Older 10-K's before delisting can be seen at after changing into an ETF manager.

Who is Jonathan Steinberg?
Jonathan Steinberg is the son of the famous corporate raider, greenmailer or whatever you want to call him, Saul Steinberg.  You can google him up and read all about him.  I don't know that much about him but he doesn't have the greatest reputation.  I leave that judgement to others.  Johathan is also knows as CNBC's Maria Bartiromo's husband.

I also knew him (not personally) through his TV commercials on CNBC advertising his Individual Investor magazine.

Anyway, Steinberg went to Wharton but dropped out in 1988 to buy the magazine (which was a penny stock magazine with a different name).  He ran this business which included other publications and an investment management business (a hedge fund, apparently) called WisdomTree Capital Management which was shut down in 1998.  Steinberg also published a book called Midas Investing:  How You Can Make 20% in the Stock Market This Year and Every Year.   The book was published in 1996, and his hedge fund was shut down in 1998, so apparently whatever he wrote in that book doesn't work.

Just browsing through some of the 10-K's, it looks like this company (Individual Investor Group) never made money.  They don't have 10-K's going back that far, but just from what is there, the company has lost money in every single year from at least 1994 all the way through 2000.

So this is the baffling part.  He bought the magazine in 1988 and there was the biggest bull market in history since then all the way to the year 2000 and his company never made any money.  His hedge fund didn't work out.  How can that be?

Looking at the filings post 2001 shows that WETF lost money every single year from 2004 through 2010 too.  2011 was the first profitable year.  So as far as we know, 2011 might have been the first profitable year for Steinberg in 23 years.  There was one year that had an extraordinary gain, and there may have been some profits in the years that are missing filings (and pre-1994), but even still, that's an astonishingly long, consistent record of losing money.

It is a bit surprising for a guy that was apparently into stocks as a kid.  He bragged in one article that he was the only 13-year old with a Value Line subscription.
So on that basis, this is not someone you would want to be investing with.
Jeremy Siegel
So somewhere in this story is Jeremy Siegel, professor at Wharton School of the University of Pennsylvania.  He was in the TV commercials advertising the WisdomTree funds and is an advisor to WETF.  The story is that Steinberg shopped this idea to him and he thought it was such a great idea that he signed on.   Well, this may well be true because it does sound like a good idea.

But upon further investigation, I realized that Saul Steinberg was a huge donor to Wharton School; there's a Steinberg Hall and a Steinberg Conference Center and a Saul P. Steinberg Professor of Management chair. 

Saul Steinberg is still on the Board of Overseers at Wharton.  Ron Perelman and James Tisch (of Loews) are on the board too.  (Totally irrelevant, but Jonathan's sister was once married to Jonathan Tisch).

Siegel was also a regular contributing columnist to the Individual Investor magazine (as was, understandably, Maria Bartiromo).

So this sort of dilutes the impact of Siegel's endorsement (not that it would carry much weight to begin with; an endorsement from academia doesn't carry much weight in the world of finance, I don't think, particularly when they are considered the Irving Fisher of the 2000 bubble (Irving Fisher is the economist who said in October 1929, right before the crash, "Stock prices have reached what looks like a permanently high plateau".  Siegel was calling for stocks for the long term.  To be fair, Siegel only talked about stocks for the long term, not for the next five, ten or twenty years).  
Michael Steinhardt
So obviously one has to wonder where the Steinhardt connection comes in (Steinhardt is a hedge fund legend).  I don't have any particular knowledge but it's probably safe to say that there is some Saul connection here too.   Steinhardt and Saul Steiberg are around the same age and they are both Wharton grads, so perhaps that's where the connection is.
Even still, I don't know if Steinhardt, who owns 25.4%, or 31.7 million shares as of the latest proxy, would put his reputation on the line and so much capital for something that he doesn't think is going to work.   At $6.80/share, that amounts to more than $200 million.  That's a lot of money even for a rich hedge fund legend.  Of course, Steinhardt probably paid way less than that.  

There are some filings missing during the unlisted years so I really have no idea what he paid (in December 2006, WETF sold 18.8 million shares for $56.5 million in proceeds, which comes to $3.00/share, but that may not have been Steinhardt.  It could have been another of the large holders (Robinson)).

Of course, Steinhardt's involvement is no guarantee of success either. 

In February 2012, Steinhardt did sell 6.2 million shares in total for $5.33/share in the secondary offering, so either way, he is in liquidation mode.  This also isn't necessarily a bad sign.  Of course shareholders would probably prefer he keep the stock, but it's not unusual for these angel investors to get out once the stock is listed and trading and out of the initial venture stage.

Insider Selling
A quick look at insider transactions does seem to show that WETF insiders have all been selling this year.  This may not be a good sign, but since WETF was just listed on the NASDAQ and many employees including Steinberg had (and has) many options, it is understandable that they would exercise and take some cash out.  Again, this isn't that unusual for a newly listed venture business (which WETF essentially is even though it has existed in a different business/form since 1988).  
So anyway, that's sort of the history and background of this entity.

Let's look at the business itself, which is what I am interested in.

The Business
OK, so let's not worry too much about the past and focus on what the current business is all about. WETF is basically an ETF manager that manages fundamental-weighted portfolios.  As I already mentioned, the stock weightings are decided by dividends, earnings or some other factor.  I think WETF is mostly dividends or earnings.
Anyway, here is a look at the growth of the ETF industry (from the WETF 2011 10-K):
As you can see, the ETF industry has seen tremendous growth since 2001.  Even after the financial crisis, the ETF industry has snapped back with AUM far exceeding the 2007 high.  That shows you how much money has moved into ETFs from individual stocks and mutual funds  (some of this also may be non-equity ETFs, international ETFs etc).
Of course, this increase in the ETF business is not entirely a good thing; there are so many ETFs listed now that it is remininiscent of the go-go mutual fund years of the late 90s when veteran Wall Streeters complained that there were more mutual funds than individual stocks.  Sometimes it seems like the ETF industry is now getting there (maybe there are 1,500 ETFs listed now?).
The good thing about ETFs is that it is low cost and for the most part passive; most people are better off indexing.  But the bad thing is that the beauty of indexing has sort of been defeated by the boom in indexing; now there are so many indices and ETFs, how do we know where to invest?  The whole point of indexing is to be totally passive and not make those decisions.  With so many indices and ETFs, it is just as hard or harder now to decide where to put your money.
Not only that, since the ETFs are so low cost and very liquid (for the bigger, liquid ones), it does encourage trading.  In fact, I suspect most ETFs are used for trading and speculative purposes and not really investing (money managers trading the SPY because they don't want to trade futures etc...).  It is so ironic that the idea of indexing came from a passive, low cost approach, but now the ETFs are used so much for short-term trading/speculative purposes.  
But anyway, I think the move towards ETFs will continue and AUM in the sector will continue to go up, but the number of funds may at some point peak out as a lot of smaller ETFs may not survive.  If the cost of keeping them going is minimal, they may survive just so the ETF managers can have a full line of product, but I don't know.   I just can't imagine the number of ETFs going up forever.
So frankly, this is the thing that got my attention.  WETF is run by a guy that hasn't really been successful in anything he has tried so far; I would not put my money with him. 

But here's what got me a little bit interested.  The AUM at WETF has been growing nicely:

The AUM is up to $15 billion as of the first half of 2012.  I think this is closer to $17 billion now as of September (I don't think WETF publishes AUM monthly).

Here is the distribution of that AUM:

Here is the ranking of ETF managers as of December 2011:
                              AUM                       %growth
1.  iShares              $448 bn                   +0.3%
2.  State Street        $267 bn                   +7.6%
3.  Vanguard           $170 bn                   +14.7%
4.  PowerShares        $45 bn                   + 7.7%
5.  Van Eck               $23 bn                   +17.7%
6.  ProShares             $23 bn                   +1.4%
7.  WisdomTree        $12 bn                   +23.2%
8.  Deutsche Bank    $12 bn                    +3.7%
9.  Rydex                    $8 bn                    +3.4%
10.Direxion                $7 bn                     +1.8%
As of the end of 2011, 85% of the equity ETFs that WETF has out outperformed their benchmark indices since inception.  They launched their first ETFs in June 2006.   I think that figure is 74% or so now as of the end of June, 2012.  This may fluctuate over the short term.
Here is the AUM of WETF versus the S&P 500 and some other indices:
WisdomTree AUM versus S&P 500 and other Major Indices
So this is pretty good.  They are accumulating assets at a pretty good pace.
You can see the performance of the various WETF funds here.   I tend to think even with five years, it's a bit too short a time period to evaluate the funds.  
What is WETF Worth?
At the top of this post, I said that we can value an asset manager using a 30% operating margin and 10x pretax earnings. 
Here are the average management fees for WETF for the last three years:
                Average fee
2009:         0.52%
2010:         0.56%
2011:         0.55%
average:     0.54%
The fees, despite the competition seems to be stable.  But let's just use 0.50% for fees.  This may trend down over time with increasing competition.  But for now, let's just use 0.50%.
They have close to $17 billion in AUM now, so that's $85 million in revenues.  At a 30% operating margin, that's $25.5 million in operating income. 
As of the end of June, 2012, there was around 139 million diluted shares outstanding, so that comes to $0.18/share (don't forget, this is not EPS; it's pretax earnings per share).   10x this figure is $1.80/share.  But wait, there is some cash, investments and tax deferred assets. 
Also, I used diluted shares outstanding but didn't include the cash that would come in from exercised options (there are some options with exercise prices slightly above current price levels, but for simplicity I will include them; besides, the breakdown by exercise price is not in the Q).  Of the 16.6 million dilutive shares, 14.9 million of that is from options with an average weighted exercise price of $0.94/share.   If that was exercised, that would add $14 million in cash to the WETF balance sheet.  
So here are the other items:
                                                                                          (per share)
Cash and cash equivalents:       $39.3 million                   $0.28
Cash from option exercise:       $14 million                      $0.10
Investments:                              $9.8 million                     $0.07
Deferred Tax Assets:                $49 million                       $0.35
Total:                                        $112.1 million                   $0.80
Some of the cash may be offset by current liabilities and some cash is needed to run the business, but let's be generous here and just include it all.  WETF has no long term debt or other long term liabilities.
This $112 million comes to $0.80/share. 
So adding that back to our above $1.80/share gives us a value of $2.60/share for WETF.   WETF is now trading at $6.74/share, so on a steady state basis with $17 billion of AUM, WETF is certainly not cheap at all and would in fact be an interesting short.
BUT WAIT!  This is actually not correct.  This is a start-up business with AUM ramping up, so WETF at this point doesn't have the scale to be that profitable.  So using a 30% margin on $17 billion AUM doesn't work. 
If that's the case, if AUM stays at $17 billion, it would be worse than the above analysis as WETF wouldn't be able to earn a 30% margin.   I tend to like businesses where it makes a whole lot of sense as is and any growth would be a bonus.  WETF is certainly not in that category.
When Will WETF Become More Solidly Profitable?
So this is a key question.  At what AUM level would WETF earn 30% operating margins?  Steinberg mentioned in the 2Q 2012 conference call that he thinks WETF can earn a 40% operating margin at $40 billion in AUM, a much lower level than his competitors due to the small, low cost operation he runs.
WETF AUM is in fact growing at a nice pace:
                       WETF AUM growth
2009                  +87%
2010                  +65%   
2011                  +23%
2012 YTD         +40%
So maybe WETF gets AUM up to $40 billion within the next few years.  
Let's redo the above figures using $40 billion AUM and 40% operating margin, and then adding back the balance sheet items like deferred tax asset, cash etc.
$40 billion of AUM and 0.50% average fees would generate $200 million in revenues and $80 million in operating income.  With 139 million shares outstanding, that's $0.58/share.  At 10x pretax earnings, WETF's ETF business is worth $5.80/share.
Adding back the above balance sheet items of $0.80/share, that's $6.60/share.  

So if we snapped our fingers and magically got WETF AUM up to $40 billion now and it can generate 40% operating margins (which is not unreasonable given my above table of asset manager margins), WETF would be worth $6.60/share.
The stock is currently trading at $6.75/share so the market is already discounting WETF achieving a $40 billion AUM.
In order for this to be a buy, you have to assume that WETF continues to grow AUM beyond that at a nice pace.  Using the above assumptions, WETF would be worth $15/share with an AUM of $100 billion.  Can it get there?  I don't know, but it won't be easy.  If this concept really takes off, I don't think there really is a moat, and any of the other larger ETF managers can launch similar ETFs.   And over the next few years, there may be pressure on fees as they compete for assets. This is what happens in any market when it gets saturated (as the ETF business seems to be getting).
Alternative Valuation Approach
Blackrock paid $13.5 billion for iShares, which I think came to 4.5% of AUM at the time.  By that measure WETF would be worth $5.50/share.  I think someone said that Invesco paid 7% or 7.5% of AUM for Powershares,  but the deal was based on some complicated formula-based contingent payments so it's hard to say what the real price was.  Using 7.5% AUM, that would value WETF at over $9.00/share.
[ Correction on October 2, 2012:  Someone pointed out in the comments below that in fact the Blackrock acquisition came to 0.8% of AUM, not 4.5% because BGI had $1.8 trillion of AUM at the time.  The 4.5% figure is based on the AUM at the time for iShares, not all of BGI which included iShares ]
WETF is certainly growing AUM at a high rate for now, so any acquisition will probably come on the high side.  I have no idea what Steinberg / Steinhardt's thoughts are on acquisitions (selling), but I would imagine that they would want to sell at one point when it gets big enough so they can cash out.  I wouldn't be surprised if Steinhardt would want to sell, having ridden this to success from nothing while Steinberg may not want to, finally having a successful, profitable entity to run.
The problem is that the cost for existing ETF managers to create their own fundamental-weighted index ETFs would probably be much lower than buying out WETF (as I can't imagine any fund management industry board of directors desperately wanting the services of Steinberg). 
I really don't have a view on that.  Maybe someone who doesn't have an ETF business would be interested. 
If WETF started to buy stuff, though, I would be a little concerned given Steinberg's history.
Research Affiliates Litigation
Oh, and there is one more thing.  Research Affiliates is suing WETF for using their idea of fundamentals-weighted indices. 
I really don't know much about law, so take this with a grain of salt, but I find it hard to believe that something like this can be patentable, or enforceable in court.   Can you really patent how to weight an index?  And if you did, is it really enforceable in court?  Yes, you can copyright an index.  I can see that.
I've dealt with derivatives over the years, and the industry copies each other all the time.  When there is one derivatives structure that works well, everyone else copies (credit default swaps or convertible bond asset swaps, for example).   I don't have a particularly good memory, but I don't recall ever having to pay a license fee or anything like that.

Even for listed products, I think at the time, all you can do was get a trademark or servicemark on something and hope nobody uses the same exact name for something (like the Brooklyn Investor Fundamental-Value-Weighted Index Warrants Series A (don't hit it up on Bloomberg; it doesn't exist!)).

(I think DECS and PERCS were listed derivatives products that were copyrighted or servicemarked; you can't use the name "DECS" or "PERCS", but you can create a product with the same structure).
Does the Dow Jones Company have a patent on price-weighted indices?  Who owns the VWAP idea (volume weighted average price)?  What about exponential moving averages?  Who did that first?  (do we care?)
So my impression is, if this concept of fundamental weighted indexing is ownable by someone, I would be very surprised.  
But again, I remind you that I don't really know the details of the lawsuit; I only read what's in the 10-K about it and haven't seen any legal / court filings, so don't read this and go, "whew, we don't have to worry about this lawsuit".
I do like the concept of fundemental-weighted indices and value-weighted indices for the reasons Greenblatt explained in his book.  I also like the asset management business for the reason I stated before; the economics can be better than owning the funds themselves (operating leverage, revenue growth boost from asset net inflows etc.).  This looked like a good candidate to fulfill both.  WETF is the only listed pure-play ETF manager out there.
But upon taking a closer look, it doesn't look too great at this point.  Unless of course you really think WETF can get their AUM to $100 billion and beyond.  If that happens, of course, this can very well work out.
I tend to think, though, that if WETF does continue to grow AUM and it gets to $40, $50 billion, then the other big competitors will obviously take a closer look at this idea.  I don't think there is anything WETF is doing that the other larger competitors can't do.  They have the infrastructure and distribution to be able to do the same thing, probably even better (as some of them have research collaborations with academia/research institutes).
Anyway, I will stay away from this one for now but will keep an eye on it for sure. 
Here are my thoughts in summary: 
  • This is not a management I would be comfortable with.  With something like OAK, I don't worry about management at all. But Jonathan Steinberg has failed to make money since 1988 during the biggest bull market of all time so it is a bit worrisome.  If WETF gets bigger, at some point Steinberg might want to step aside and let someone with experience (and more credibility) run the business and he can become chairman/visionary or whatever.  He can still retain a large ownership and pay himself well.  I would not sleep well at night if I had a lot of money in a company run by Steinberg, frankly. 
  • The most important thing here, though, is price.  WETF already fully discounts a business with $40 billion in AUM and 40% operating margin (versus the current $17 billion in AUM).  But this is growing quickly so this may not be a problem for growth investors.  I like to buy stuff that is interesting now and we get the growth for free (or cheap).
  • Increasing competition from bigger entities will certainly come if WETF keeps growing assets. At $10-15 billion, they can be ignored, but not if they get bigger. This would also put pressure on fees going forward.

Tuesday, September 25, 2012

The Big Secret, Magic Formula, WisdomTree etc.

I just finished reading The Big Secret for the Small Investor, and thought it was really good.  I know, I know.  This is old news.  It's been blogged and discussed to death, I think.  But I haven't kept up with my reading and I just happened to come across this at the local library so I checked it out. 

I don't know how much professional investors would get out of it as there is not much new in here other than the idea of using a value-weighted index to outperform other index types (even though I really enjoyed reading it).

Here is the blurb from the book on ways individuals can manage their money:

  1. They can do it themselves. Trillions of dollars are invested this way.  (Of course, the only problem here is that most people have no idea how to analyze and choose individual stocks. Well, not really the only problem. Most investors have no idea how to construct a stock portfolio, most have no idea when to buy and sell, and most have no idea how much to invest in the first place.)
  2.  They can give it to professionals to invest. Trillions of dollars are invested this way.(Unfortunately most professionals actually underperform the market averages over time. In fact,it may be even harder to pick good professional managers than it is to pick good individual stocks.)
  3. They can invest in traditional index funds. Trillions of dollars are also invested this way.(The problem is that investing this way is seriously flawed--and almost a guarantee of subpar investment returns over time.)
  4. They can read The Big Secret for the Small Investor and do something else. Not much is invested this way. Yet...

Valuing a Business
Greenblatt is a great writer and he really describes well how a business should be looked at, how it should be valued etc.  He also explains really well why most people and money managers can't outperform the market (chasing performance etc).   This section alone is worth a lot for novice investors and people starting out, and it's even great for pros to refresh themselves on what they're trying to do.

Importance of Owning Stocks
He also does a great job explaining why most people should put a substantial amount of their net worth in stocks.   But he also says that that doesn't mean people should be 100% in equities all the time; like he said in his essay, people should own as much stock as they can tolerate the occasional (and inevitable) 50% decline in the market (which nobody will be able to market-time in and out of consistently).  He provides a tip for avoiding the emotional traps of investing (just keep a constant ratio in stocks at all times, bull or bear market.  And don't try to time it as that is one of the biggest factors in causing people to underperform!).

In the book, he explains that most money managers can't outperform the S&P 500 index, so he starts there and then improves on the S&P 500 index step-by-step finally arriving at the value-weighted index.

Value-weighted Indexing
The problem with traditional indexing is that you end up owning more of the most expensive stocks (and large cap) and less of the smaller, cheaper stocks.  Greenblatt explains that this is why equal-weighted indices tend to outperform over time compared to market-cap weighted indices (such as the S&P 500 index).   Equal-weighted indices put the same amount of money in each stock regardless of market-cap so this bias goes away.

He also explains that fundamental-weighted indexing tends to outperform the market-cap weighted indices for the same reason; it doesn't own more of the bigger cap and more overvalued stocks, but weights the index according to some fundamental factor like dividends, earnings, sales or some such thing.  So it eliminates the bias of owning more of something overvalued.  (It would still have a large cap bias as you would still end up owning more of a big company than a small company based on fundamental factors).

Greenblatt's solution is an improvement on all of the above.   Since Greenblatt is a value investor, he is most interested in value.  So therefore, instead of using something arbitrary like market capitalization to weight an index, or something a bit more meaningful like fundamental factors, why not just weight the index based on valuation?   Own more of something undervalued and less of something overvalued.

That makes total sense, and he has shown in his other book ("The Little Book That Beats the Market") that valuation matters and works.

Greenblatt set up a website for this book and here is some of the data posted there.  The website is:

Check out the results of using a value-weighted index:

Pretty impressive.  If the figures are too small, you can just go to the website and see all of these figures.

I know many people will be skeptical of this and say that the index was probably optimized somehow.  But Greenblatt is a real money manager and he is not out there doing stuff to make money off of selling books.  He understands that the problem with these 'models' is backfitting / over-optimizing (that's why the Magic Formula is so simple; just two factors.  He knows he can improve on them by testing various factors and weights, but then the model wouldn't be as robust.  What is so impressive about the magic formula is how simple it is and how consistent the results tend to be over time).

But the Problem is...
So we can read this book and go, what a great idea!  And then what?  Where do we buy value-weighted index funds?  Alas, there aren't any.  In the book (and at the website), he directs us to equal-weighted index funds and fundamental-weighted index funds and some value-based ETFs (which is not the same idea Greenblatt describes), but there are no value-weighted funds.

I guess Greenblatt is hoping to push the ETF industry into creating them so he wouldn't have to do it himself.  He is obviously more interested in teaching than trying to make money off of his ideas.

But What About the Magic Formula (MF)?
There has been a lot of talk about the MF on blogs, websites and whatnot, how it works or it doesn't work etc.  But for the most part, I tend to think the time period has been too short to make any real evaluation, not to mention the fact that we had a huge financial crisis since then. 

As Greenblatt has said himself, the MF can underperform for long periods of time.  This is precisely why it will continue to keep working over time.  If something works too well and too consistently in every time period, then it would probably very soon stop working (think of those "I can guarantee you 1%/month consistently with less volatility than the S&P 500 index!".   How long did that last?).

In the case of the MF, Greenblatt did set up a company to invest using their method and they do have mutual funds available.

Here's the website:

And here's a composite index of returns based on the strategy from the website:

This is way too short a time period to evaluate returns so this may not be too meaningful.
But as a way to invest money, I am a big believer in this approach.  I would bet that over long periods of time, this approach would outperform the index and most money managers.

So Which Mutual Fund is Better?
Formula Investing runs four mutual funds (with small minimums):

  • U.S. Value 1000
  • U.S. Value Select
  • International Value 400
  • International Value Select

So what's the difference?  The "Select" funds invest in 75-120 names whereas the Value 1000 (and 400 for the International) invests in 1,000 names.

I think if you want to see the MF work, it's going to be more pronounced with fewer names.  With a 1,000 stock portfolio, I can't imagine it diverging too far from the index.   Of course, Greenblatt suggests in his book that 20-30 names (the MF results in the The Little Book That Beats the Market is based on a 30 stock portfolio.  I initially wrote 8-10 names here, but that was wrong) is enough diversification, but that's not going to work for an open-end mutual fund.

So I would go with the "Select" funds.

U.S. or International?  Right now since the International funds seem to be performing so horribly, and since the problems on the planet seems more focused around the world ex-U.S., I would tend to lean towards the International.  Isn't this where the values would be? 

I know we are all pretty confident that China and Europe is going to implode.  It's a no-brainer right now to be out of those countries.   But that's sort of the whole purpose of value investing, especially the mechanical kind where we override emotions, right?  To go in when nobody want to.  Greenblatt did say in a presentation not too long ago that any time you look at the list of values that the MF website spits out, most people would hate those names.  There would be good, sound, rational reasons why you wouldn't want to own those names.  But that's precisely the reason why those names are on that list, and that's why the MF tends to outperform.

So on that basis, I would go with the ugly-looking International Select fund, out of the above Formula Investing funds.  But if you decide to do that, don't look at what the fund owns.  I guarantee you that you will change your mind.  You will say, "yuck!" and not get into the fund.  Also, I can guarantee you that the week after you buy into it, something will happen and the NAV of the fund will plunge.  Then you will kick yourself for reading something on a blog.  But don't worry.  If you decide to buy, don't worry about what it does over the next month or even year (If you are going to worry about short term performance, then just don't buy it!).

Or how about some sort of balanced approach?  Keep a constant percentage in each of U.S. and International, and then rebalance every now and then so that you would sell the one that did well and buy the one that did less well (so you sell dear and buy cheap).  But there may be costs associated with that so I don't know.  It's just a thought.  I don't do anything with mutual funds myself, and when I did own them, I tended never to rebalance anything.

Anyway, I have no problem at all recommending these funds to friends and family members etc. for their equity exposure.   I am that comfortable with the approach of these funds and the people involved (Greenblatt).

So having said that, if you are friend or family and are reading this, look through your equity mutual fund holdings and if you own anything that is blah, some fund you own that you bought for a reason you don't remember and it's so-so or worse, then get rid of those and roll it into one of these funds.  If you own mutual funds that you like, though, and is doing well, there is no reason to dump those. 

I know most people tend to accumulate too many different mutual funds and stocks (as they are sold to them by various people.  Most of these things sounded like good ideas at one time or another. But for some reason, people tend to buy stuff and never sell so they have this sort of financial attic of stocks and funds collecting dust.  When you look carefully, sometimes you say, "What the...?").

If that's you, then clear some of that stuff out and just invest in one of these funds.  You will do better.

Magic Formula or Value Weighted Index?
As far as mutual funds go, only Formula Investing exists, and according to the Value Weighted Indexing website, there really isn't a fund to invest with the "Big Secret" approach.   So this isn't really a choice.

But if we had to make a choice, I would tend to favor a more concentrated Magic Formula approach since it would have fewer names and therefore potentially higher alpha.  A value-weighted index fund would have many names in the portfolio so maybe a more limited alpha (even though the outperformance of the value-weighted index in the above table is pretty substantial).

These Won't Ever Be Popular
By the way, these approaches, whether it's the MF or value-weighted index won't really get popular.  Why?  Because it's not good for the 'industry'.  With all these mutual funds companies with armies of analysts and portfolio managers including 'stars', why would they push hard to point out that they can't outperform the S&P 500 over time, and then advertise something that even beats the S&P 500 index?

Why would brokers push these on clients?  If they did, they would never be able to convince clients to sell them to buy into whatever the next big thing is (and earn commissions).

(This reminds me of a conversation I had with a broker trying to get my business many years ago.  I told her that I had all my money in Berkshire Hathaway (I didn't own any at the time so I lied...) and that Buffett works for me for $100,000/year and he has a great track record over decades.  No front-end loads, back-end loads, 12b-1 fees or any other such nonsense.  Does she have any funds like that?  Does following analyst recommendations and buying their IPOs lead to Buffett-like performance?  Why do I need a broker when Warren does all the work for me, and I bet his broker is better than any broker I can hope to find.  Of course, she never called again: mission accomplished.)

Or How About Something Else?
And here's an interesting twist to this whole thing.  It is often much more profitable to invest in a money manager than in the funds they themselves manage (even if the funds perform very well).  This is due to the operating leverage that the fund management company enjoys and the added kicker of revenue growth above and beyond investment performance due to asset accumulation.

So even if the stock market only returns 5%/year going forward, if they have net inflows that amounts to 5% of AUM, that would lead to a 10%/year growth in revenues. With constant margins, earnings would grow faster than the market and if the valuation is unchanged, the value of the fund management company grows faster than the stock market.

That's one layer of the leverage.  But then you have the operating leverage too.  If AUM grows in existing funds or the marginal cost of launching new funds is low, then operating margins can go up as AUM increases.  So that adds another potential kicker to the valuation of a fund management company.

This doesn't always work.  I think in many of the recently IPO'ed private equity and hedge funds, the AUM growth seems to come primarily from launching new strategies (that usually entails acquisitions of whole portfolio management teams that run the new strategy), so the operating leverage doesn't really kick in as much. 

WisdomTree Investments (WETF)
So this naturally leads to WisdomTree Investments.  The hedge fund legend Michael Steinhardt owns a big chunk of this thing so he is obviously a big believer in the fundamental-weighted index concept.  Who knows, maybe WETF will eventually launch value-weighted index funds.

Anyway, I was going to take a quick look at WETF in this post, but since this is already getting long I will make this another separate post.  As a preview, I will say that it is an interesting company but doesn't look particularly cheap to me at this point unless AUM continues to grow at a high pace.