Trading relatively in line with peers on valuation, GAMCO Investors (GBL) nonetheless represents a prime short opportunity. Run by investing legend Mario Gabelli, it appears he has lost his mojo. Jarringly, the vast majority of company investment vehicles have underperformed benchmarks on one, three, and five-year time frames despite having above average fees compared to other mutual funds. By extension, ratings on these funds (as measured by Morningstar) have plummeted, and assets under management (“AUM”) have fallen, with Q1 2018 having the largest negative sequential rate of change in years. Efforts to raise capital via closed end funds, vehicles that would not see outflows and generate consistent fees, have escalated but have done little to stem the tide.
In my opinion, fee concessions and potential loss of fixed cost leverage via high labor expense will lead to margin contraction and falling earnings. As a wildcard, the only buoy for active equity managers in recent years - strong stock market returns - cannot continue forever. A reversal of this trend would be a major headwind. Fair value is $20.00/share, or 25% downside, with the potential for more losses if equity markets begin to unwind.
Business Overview
GAMCO Investors (“Gamco”) is a small cap provider of investment advisory services to funds, institutions, and private wealth investors in the United States. It does this through its two owned investment advisors: GAMCO Asset Management and Gabelli Funds, the latter probably the more recognizable one for readers. The company is controlled by Gabelli Funds namesake Mario Gabelli, a billionaire investor who holds 91% of voting control and is the company’s Chief Executive Officer and Chairman of the Board. He founded the firm more than forty years ago, and Gamco has been built upon his reputation brick by brick. Heralded as an excellent steward of capital, his proprietary “Private Market Value” methodology, a framework based on the Graham-Dodd style of security analysis, has generated long-term outperformance versus benchmarks (more on this later). This tight grip on the firm by its founder is likely a key reason why the company does not hold any conference calls or actively engage with investors via presentations. No sell-side analysts cover the firm. This makes public perception of the value of the firm entirely dependent on operating results, with relatively thin trading volume given the low float increased volatility.
Despite the age of its business, Gamco is still an incredibly small firm ($758mm market cap) with 96% of AUM employed within active equity style funds. The peers listed below, like Gamco, all have substantial bias towards active equity. While each one has its own nuance, most of these firms trade at similar valuations. In my view, all of these firms have potential downside over the next several years, a continuation of recent years of underperformance versus the S&P 500. However, Gamco has the worst near-term track record of this group. Shares should trade at a discount, not in line with these peers.
*Source: Author calculations using 2017 year-end figures, Bloomberg estimates on forward earnings
As an aside, there is some potential dilution risk that is not accounted for above. Mario Gabelli holds the vast majority of outstanding shares of Class B common stock, a share class which exists to give him total control over voting rights (10 votes per share versus 1 for publicly-traded Class A). 19mm shares of Class B were outstanding as of Q1 2018; total share count of both Class A and Class B totaled 29mm shares at the end of Q1 2018. In May of 2014, Class A shareholders first approved an advisory proposal for the Board to consider conversion and reclassification of Class B into Class A at a ratio of 1.15-1.25:1. The issue has been voted on often in annual shareholder meetings in favor of conversion: See Proposal 7 on the Form DEF14A from last year. Such an action could dilute stockholders 13% with no real material change in ownership control as Mario Gabelli would still have majority voting power. If this event occurred, Gamco would be the most expensive firm listed above on forward earnings.
Poor Performance, Macro Headwinds
The Gamco story is all about performance. There has always been a tilt towards a value investing style, and while Mario Gabelli has a strong long-term track record (15.3% net of fees annualized versus 11.8% for the S&P 500 since 1977), recent returns have been disappointing. For instance, within the Gabelli family of funds, the five largest options (Gabelli Asset (GABAX), Gabelli Small Cap Growth (GABSX), Gabelli ABC (GABCX), Gabelli Equity Income (GABEX), Gabelli Utilities (GABUX)), funds which constitute $11,400mm in AUM, have all underperformed benchmarks on one, three, and five-year time frames. Alongside the relatively high expense ratios, this combination has driven most of these mutual funds to be poorly rated by Morningstar. Versus the same peer group above, Gamco has the highest average fee rate and the lowest average Morningstar rating. While Gamco has always had high fees relative to its peer group, those high fees justified by strong performance. The company made note of this in its 2017 10-K:
To the extent we are forced to compete on the basis of price, we may not be able to maintain our current fee structure. Although our investment management fees vary from product to product, historically we have competed primarily on the performance of our products and not on the level of our investment management fees relative to those of our competitors.
If underlying fund performance does not improve, it is highly likely that Gamco will have to lower its fee base to retain existing clients and attract new clients.
*Source: Author calculations, Morningstar data as of May 14, 2018. This is an average score for each company's product and is not cap-weighted. Non-ranked funds are excluded but their fee rate is included.
Putting forward a poorly performing product in an environment where net outflows are the norm and not the exception (see below) is not a recipe for success in this space. The passive ETF market has fundamentally changed the landscape and today both retail and institutional investors are far more cognizant of both the price they pay and the performance of the products they invest in. While improved from 2016's dismal year, the majority of active managers once again underperformed passive funds in 2017. Unless this trend reverses and holds, money will continue to pour out of actively managed funds just as it has consistently year after year over the past decade, recently reaching record outflow levels in 2016 and 2017. Gamco is most at risk for this given poor fund performance and the fee levels. 2018 is not off to a good start as net cash outflows accelerated: Q1 2018 had the largest sequential fall in AUM in years.
*Source: Morningstar, Active versus Passive Fund Flows
*Source: Yardeni Research, Weekly Equity Fund Flows
To put this all in perspective, the S&P 500 is up 34.5% since January 2015; AUM at Gamco is down 12.3%. The situation would have been even worse without the impact of appreciation: $6.7bb worth over this period. Put another way, excluding fund price appreciation AUM would be down 26.6% from Q1 2015 to Q1 2018, representing mid-single digit annual outflows. This trend could reverse. In the past, there were two competing forces at work in the active asset manager space:
- Continued outflows in active management as measured by net outflows. The shift hitting the industry as investors move from active to passive management will continue. While ETFs have their own risks and disadvantages versus mutual funds, the market simply does not see the value in paying for active management strategies. Lackluster performance from managers like Gamco has not helped. Average fees for active management likely will come down in tandem with pricing pressure.
- Tailwinds to AUM from market growth. Outflows do not matter as much when the market is doing well. If you’re an asset manager and the market/your fund are both up 20% (like in 2017) but you saw 5% outflow, you’re not going to be terribly upset with your year. Since you’re billing a fixed percentage fee based on AUM, you’ve increased your take-home that year. If the market is flat, or even down - remember those days – those outflows become more meaningful.
*Source: Author calculations using corporate SEC filings.
In my view, those competing forces could both turn negative. For asset managers, the hot equity markets over the past decade have been a near perfect scenario. Many of these firms likely would have folded in a more normalized equity market, given the shift in capital from active to passive. As an example of what could happen if markets turn south, in 2015, the value of Gamco common equity fell nearly 40% (in advance of the spin-off of Associated Capital Group (AC)) as the company’s products underperformed benchmarks as volatility spiked, the S&P 500 returned less than 2% for the calendar year, and overall AUM declines accelerated. 2018 or 2019 could easily be a year just like 2015. While Wall Street consensus is overwhelmingly bullish – S&P 500 call interest is near three year highs according to CFTC Futures data – I take a fundamentally more bearish stance heading into 2018 and 2019. Frequent readers with good memories remember that I’ve been long active asset managers in the past - Legg Mason (LM) and Federated Investors (FII) are two I’ve profiled on Seeking Alpha and owned profitably – so a natural question is: “Why now? Why the change in sentiment?” That’s broadly a function of where I feel the equity markets are valued at today.
A Desperate Move Into Closed End Funds, Potential Loss Of Operating Leverage
In order to pick up the slack on Gamco’s open end funds, management has been pursuing more closed end funds. Remember that closed end funds raise a fixed amount of capital upfront and cannot be sold except through sale, essentially locking in a set amount of fees for the manager. In 2014, Gamco advised on 11 closed end funds with $6,942mm in AUM. At the end of Q1 2018, the amount of closed end funds had grown to 16, but AUM, however, stood at only $7,768mm. The takeaway here is that new product offerings and add-on issuances of old shares have been very small. Despite management contention that these issues are oversubscribed, demand uptake has appeared limited, and as mentioned, without conference calls and a lackluster investor relations department the ability to question and challenge management on this is low.
The silver lining for many of these asset managers, including Gamco, has been the deployment of free cash flow to reduce leverage. Gamco held $64mm in gross debt at the end of Q1 2018: $40mm on 4% PIK Notes associated with the spin-off of AC late in 2015 and $24mm of 5.875% Senior Notes. After quarter end, management made another $10mm payment towards the PIK Notes. While this debt matures in 2020/2021 respectively, Gamco will likely pay down all of this debt as Mario Gabelli made the move to waive all of his compensation for Q2-Q4 2018. While a kind gesture, I find it baffling at the massive amount of compensation he has been drawing down: more than $70mm/year average over the past three years. His compensation is generally between 45% and 50% of the firm’s entire compensation budget, which seems lofty given both company stock performance and fund performance - both of which are below peer averages. Given his voting power, shareholders have little say in material changes. While compensation is somewhat variable, earnings per share could collapse in a bear scenario for markets.
Why This Opportunity Exists
In summary, there are a few reasons why Gamco is being overvalued by the market today besides all of the fundamental reasons stated earlier. Most of those reasons are related to the company's size, liquidity, and its potential investor base:
- No sell-side or institutional coverage and low trading volume even for its size (less than $1mm in share value per day) point to a very passive investor base. There are no motivated buyers outside of ETF fund flow.
- The poor company track record flies under the radar, only occasionally making the news (e.g., this Wall Street Journal article from 2015). Nothing has changed on that trajectory since 2015, leading to a slow bleed as current holders steadily head for the exits.
- Low short interest is also a function of visibility. Short sellers will come to this firm, but likely only once results start to degrade materially and the thesis is confirmed. Low volume could quickly push short sellers, most of which have above average capital, into a short squeeze scenario. Q1 2018 points to an acceleration in a downturn which is drawing more short sellers (such as myself),
The idea is quite asymmetric because of this. Outside of a sudden change in investing performance by company funds, there isn't much to motivate a buyer to establish a position here. As shown earlier, Gamco trades in line with peers. Why would any large institutional investor, whether that be hedge funds, pension funds, or actively-managed mutual funds, establish a stake alongside a controlling (and arguably well overpaid) founder, below peer fund performance, and above peer average declines in AUM?
In setting a price target, see the below sensitivity analysis:
Note that the fee rate is lower than the average mutual fund expense above because fund AUM is only a little over half of overall Gamco managed assets. The company's institutional sub-advisory business, as well as its nearly $2bb in money market funds, generate substantially less fees. In 2017, annual revenue divided by quarterly AUM was 85bps. The wide disparity in targets shows just how sensitive asset managers like Gamco are to underlying market performance, outflows, and average fee rate per dollar of AUM. In the case of Gamco, over the past five years, annual operating expenses have averaged $216mm. The bear case would be enough to make the company close to unprofitable - a drastic change from 2017’s $133mm in pre-tax income - by 2019 unless Mario Gabelli makes significant concessions on his compensation.
At current market valuations of AUM (see the first graphic), shares have 13% downside as a base case over the next eighteen months. If the bear case unfolds, downside is 38%, substantially more. When judging each likelihood, remember that Q1 saw a 5.2% sequential collapse in AUM alone. That's a greater than 20% run-rate decline, in line with the bear forecast. If declines stay on trend, it would certainly not be outlandish, particularly if indices actually post declines in 2H 2018, to see falls in AUM ahead of even my bear scenario estimate.
The primary risks present here include a long-term concession by Mario Gabelli on his compensation (I would point out that the share price pop following his 2018 concession was short-lived) and a re-rating of the valuation multiples of Gamco (and active asset managers as a whole) to higher levels. I see little reason for the latter given the overwhelming bullish sentiment on Wall Street and lower short interest likely means healthy positivity for the sector.
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