(source: pixaby - public domain)
Shares of Oaktree Capital (NYSE:OAK) traded lower last week, following the company's second quarter earnings report.
The pullback is a bit of a surprise, considering OAK's strong Q2 performance. Today, I'll take a look at one metric that may be causing investors to sell shares of OAK. I'll also explain why I think these bearish investors are off the mark. (And why OAK should still be a great investment opportunity.)
But before we dive into the details, let's take a look at exactly how Oaktree Capital operates.Oaktree Capital - A Specialty Private Investment Company
As a private equity group, OAK raises money from accredited and institutional clients, and invests this money into specific opportunities. Under the guidance of legendary investor Howard Marks, Oaktree Capital focuses on niche opportunities such as corporate bonds and distressed debt securities.
(Source: company presentation)
Like most private equity companies, OAK charges fees on assets managed for investors. Incentive fees are generated when Oaktree books profits. These fees are taken out of the net returns that the company's clients receive.
Oaktree has a strong history of positive returns. Not only is the company generating absolute returns for its investors. OAK has handily beat the market over the years. As a result, Oaktree Capital has become a highly respected name in the private equity industry.
(source: Company Presentation)A Strong Quarter For Distressed Debt
In the weeks leading up to Oaktree's quarterly report, I started building the case for OAK. My belief was that relative performance, coupled with a healthy Q2 for distressed investments, would lead to earnings growth.
Here's what I wrote to my Contract Income Alert subscribers in July:
…investors are putting a lot of money into traditional high-yield bond funds. And if "normal" investors are flocking to this area, you can bet that institutional investors are doing the same thing. Only they're likely putting their money with the industry legend - Howard Marks - by investing Oaktree Capital funds…
…high-yield bonds are trading higher. A lot higher! And that means Oaktree Capital is likely generating huge profits because the investments Howard Marks made this spring are trading sharply higher.
As it turned out, I was right. Strong returns for high yield bonds helped to drive OAK's performance during the second quarter. This led to a 79.5% increase in adjusted net income per class A units (essentially earnings per share).
(source:OAK Q2 Announcement)
There were two reasons OAK's earnings jumped:
First, the company reported profits across nearly all of the firm's different investment strategies. Second, OAK had more capital available to invest into these strategies, thanks to record-breaking capital raised in 2015.
(source: Company Presentation)
With so much strength in the company's business, one would expect shares of Oak to trade sharply higher. But that's not what happened…The Metric That Caught Investors' Attention
Investors seem to be focusing on Oaktree's Assets Under Management (or AUM). For the second quarter, AUM finished at $98.1 billion. This compares to last year's level of $103.1 billion.
An annual decline in AUM is concerning to investors. If Oaktree is managing less money, it will be difficult to grow investment fees.
But although this headline number is disappointing, the details are more encouraging.
The first thing investors need to recognize is that AUM actually increasedduring the second quarter. At the beginning of the quarter, Oaktree's assets under management were $96.9 billion. At the end of the second quarter, assets were $98.1 billion. And this increase was in spite of $2.7 billion distributed to investors from various funds.
The reported decline in AUM was actually old news. The annual pullback in assets was actually from the previous three quarters. (Not from the second quarter of 2016.) So the annual AUM decline is not a reflection of lower assets during the second quarter. Instead, this is a reflection of investors pulling money out of funds during previous quarters (when distressed assets were out of favor).
This year, Oaktree should be able to continue to raise assets, thanks to institutional and retail investor's growing appetite for yield. With interest rates at historic lows (including negative interest rates around the world), investors are desperate to find positive returns.
Oaktree Capital should be a strong beneficiary of this demand. That's because Oaktree Capital is one of the most well-respected firms in the alternative investment industry.
(source: Company Presentation)
The company also has a record $22.8 billion in "dry powder." This is capital that is held by OAK but not yet invested in specific opportunities. As this capital is put to work in future quarters, investment fees should continue to grow.A Second Opportunity To Own Shares of OAK
The decline in OAK shares after the Q2 earnings report is a good example of the fickle nature of markets.
Oaktree Capital reported strong growth in earnings (and a quarterly increase in assets under management). But investors responded poorly. This is likely because investors were concerned about an annual decrease in AUM.
I believe the response of sellers is misguided. Not only did Oaktree experience growth in profits and AUM, the company's current prospects look very good.
In particular, Oaktree Capital should have great opportunities to put some of their dry powder to work.
The high yield debt market has been highly correlated with oil prices this year. So far during the third quarter, oil prices have been moving lower. A rebound in U.S. drilling has led to higher production and larger crude oil inventories.
This opens the door for more opportunities to invest in distressed energy bonds. And Oaktree has plenty of capital available to buy these bonds.
At this point, I see three advantages that should drive Oaktree's earnings (and stock price) higher.
- A positive reputation that should result in new contributions from investors.
- Excellent opportunities to invest this capital into discounted high yield bonds.
- Existing investments with unrealized profits available to harvest.
To top all of this off, keep in mind that OAK has a historical dividend yield of 4.2%.
OAK pays a variable dividend tied to the company's quarterly earnings. So as future earnings grow, the company's dividend should also increase.
At today's price near $45.50, OAK represents a tremendous value. Shares could easily trade up to the 2015 highs near $57. This rebound should occur in conjunction with fees generated from OAK's record breaking capital raise in 2015.
In fact, shares could actually move higher. This, due to the compounding effect of higher assets and strong fees generated. Ultimately, OAK's AUM should eclipse the peak level from last year. Meanwhile, the company's quality investment performance should drive incentive fees.
I'm still a fan of the stock, despite a misguided pullback following Q2 earnings.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have recommended OAK for subscribers to my Lifetime Income Report and Contract Income Alert newsletters.