End the Siege on Fortress Investment Group

In the July 2007 issue of The Motley Fool Inside Value, I suggested going short the shares of Fortress Investment Group (NYSE: FIG) and buying Goldman Sachs (NYSE: GS) shares as a hedge.

Fortress – the first alternative investments firm to go public in the U.S. – was sporting a post-IPO valuation that was unsustainable. Since June 13, 2007 (the publication of the newsletter), Fortress shares have lost 42% of their value, while Goldman Sachs has given back just 25% [I’ve accounted for dividends in both cases]. Still, FIG is hardly a terminal case; in fact, it has a great franchise and I believe now is the time to consider owning a piece of it. Two things have changed since I first wrote about the company, both of which support my change in stance:

1. As noted, the valuation has come in significantly; and Assets under management [AUM] at the end of the first quarter increased 46% year-on-year to $34.2 billion; and

2. CEO Wes Edens expects $40 billion in average AUM in 2008 with a year-end forecast of $50 billion.

That adds up to a solid company with good prospects selling at a much more reasonable valuation. How reasonable? Marty Whitman’s rule of thumb for valuing money managers is 2%-3% of AUM plus tangible book value. Fortresses is currently trading at 16.6% of AUM; if the stock were to remain unchanged and the CEO’s $50 billion forecast is accurate, FIG would end the year valued at 11.4% of AUM. At first glance, then, Fortress still looks wildly expensive, but bear in mind that Whitman was referring to traditional asset managers (mutual fund companies, for example), that charge fees as a percentage of AUM only. Being an alternative asset manager is altogether more lucrative: Fortress manages hedge funds and private equity funds which charge investors a hefty performance fee on top of that (20% of the return earned on investments, typically). To put these numbers in context, on the last conference call, CEO Wes Edens said that, historically, 2% of their AUM hits the bottom line on an annual basis.

What’s the market missing about this situation? My guess is two-fold: first, the credit crisis has taken a toll on financial stocks of all stripes. A firm like Fortress is likely thought to be especially vulnerable – the opacity of hedge fund strategies allows investors to let their imaginations run wild with thoughts of hidden time bombs buried inside a portfolio. Those fears should never be ignored, but neither should they be exaggerated. I take comfort in the fact that Fortress has a highly professional management, with two Goldman Sachs alumni among its five principals (Goldman is considered to have the best risk culture of the major investment banks).

Second, the market may be extrapolating the halt in LBO activity far into the future and, while mega-deals such as the $45 billion buyout of TXU by KKR and TPG will not be in the cards for a long time, smaller, more sensible deals are already showing signs of life. Reflecting their value orientation, Fortress executives are excited about the current environment, which has created new opportunities in distressed areas in equity and fixed-income markets.

As a value investor, I’m constantly trying to gauge Mr. Market’s mood to profit from his excesses. At the time of its IPO, I wanted nothing to do with the stock. One credit crisis later and it looks a lot more attractive to me now, as a ‘busted’ IPO (an IPO stock that is trading below the price at which it went public.) -- investors who rejected it during its coming-out party should find it is not without its charms.

Disclosure: none

Comments

[Al Rob:]

Remember, there are high water marks on fees. So they earn 20% only on new highs, not a rebound to old highs. I worked for a hedge fund once that didn't earn incentive fees for years..

Also, this is not the most shareholder friendly comp[any.

Your qualitative analysis is good but I think you need to drill down on the numbers a bit more. There is a good reason why FIG trades at this price and sports a"distressed" type dividend yield.

2008 May 30 01:37 PM

[Alex Dumortier:]

Al -- Thanks for your comment.

On the qualitative vs. quantitative aspect, I absolutely agree with you -- using the % of AUM metric is purely indicative; I wouldn't recommend anyone content limit themselves to it in making an investment decision.

This article is a summary of my 'first-pass' analysis which suggests that Fortress <i>may</i> be undervalued at these levels. I'll definitely be doing more detailed work on the numbers to try to peg a range for the stock's value.

On the issue of corporate governance, are you referring to anything specific beyond the dual share classes?

Alex Dumortier, CFA

2008 May 30 02:31 PM