City Of London Investment Group: A Unique Niche-Market Play In Asset Management

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About: City of London Investment Group PLC (CLIUF)
by: Steven Chen
Summary

If you buy into market efficiency, you probably should avoid asset managers as stock investments because of the industry headwinds.

However, City of London Investment Group may be a rare quality species in this space thanks to its niche-market focus.

Detailed analysis tells me about its competitive edge, growth opportunities, management capability, and valuation.

Source: MarketBeat.com.

Overview

For decades, asset management has been a good area for quality-oriented investors for its high profitability and scalability. However, over the past few years, this industry has seen its secular headwinds increase as the belief in market efficiency and cost-consciousness grows among investors. As a result, there came the "race to zero" (i.e. management fees are being cut even to the lowest possible level) and ongoing shift from active to passive products. In the end, if 80% of the money managers cannot beat the market, why wouldn't investors just buy the whole market? If nobody can time the market, why wouldn't investors just focus on lowering the cost?

It is interesting to know that the investment professional world (including mutual funds, hedge funds, PE/VC funds, financial advisory firms), which is full of talent, generates negative value on an aggregate basis, as hinted by Warren Buffett many times. As was stated in my previous article on Federated Investors (FII), the headwinds are believed to continue for the foreseeable future and that is why I would like to stay cautious on the long-term future of major traditional asset managers.

However, the company that I cover today, City of London Investment Group PLC (OTCPK:CLIUF), is a rare and high-quality species in the asset management space thanks to its focus on a niche market where market efficiency no longer applies. The business has built its reputation by specializing in Emerging Markets closed-end funds with a concentration on institutional clients. In recent years, the group has expanded its range to include Developed, Frontier and Opportunistic Value closed-end fund strategies.

The company's share is listed primarily in London through the ticker CLIG. US-based investors have access to the stock through ticker CLIUF traded OTC, although the latter isn't a favorable choice due to very limited liquidity.

At the end of March 2019, CLIG had $53 billion of funds under management, with offices in London, US, Singapore, and Dubai. The company positioned itself as the leading CEF asset manager with a track record of outperformance over multiple market cycles already. The client base at CLIG has always been overwhelmingly institutional.

Financial Performance

According to the company's most recent (semi-annual) earnings release, the group managed $4.6 billion in FuM on 12/31/2018, compared with $5.1 billion at the beginning of this financial year on 7/1/2018 and $5.3 billion on 12/31/2017. The decline in FuM was mainly caused by the decline of the overall stock market during the fourth quarter of 2018. As the market bounced back later, the FuM edged higher (see below).

Source: CLIG Official Website; data as of 6/12/2019.

As demonstrated below, over the past 5 years or so, the group experienced overall net inflows across strategies, among which, Frontier, Developed and Opportunistic have been the net contributors while the traditional Emerging Markets has been the net withdrawer. Investors may want to keep eyes on this development.

Source: Half Year Report 2018/19.

Over a longer period, the FuM has been more or less impacted by the underlying fund benchmark (e.g. MSCI EM Net Total Return) and so has the level of business income (see below).

Source: CLIG Official Website; data as of 6/12/2019.

The charts below demonstrate an upward trend in both annual sales and FCF margins for the past dozen years, indicative of the good scalability of the business.

Source: GuruFocus; data as of 6/12/2019.

Source: GuruFocus; data as of 6/12/2019.

The returns on tangible book value (one of Warren Buffett's favorite metrics) show the management's good capital allocation skill in the same time frame, although the trend has been decaying towards the average for a recent couple of years.

Source: GuruFocus; data as of 6/12/2019.

The dividend payout is quite high for CLIG shareholders compared to the free cash flow generated (see below), as the management aims for a dividend coverage of 1.2x.

Source: GuruFocus; data as of 6/12/2019.

Asset management is generally an asset-light cash-rich business, meaning that the CapEx requirement is low and FCF margin is high (see CLIG's case below).

Source: Morningstar; data as of 6/12/2019.

Economic Moat

The major investing approach at CLIG here is to benefit from the narrowing of a target CEF's discount to NAV through corporate activities, such as open-ending or liquidation. This approach has been working since the past in terms of generating alpha on the top of the benchmark, and should be working to add value for investors/clients in the future as long as those inefficiencies (i.e. discounts) continue to exist. The discount on CEF to NAV has been an unsolved mystery in the financial world for long, and I do not see any structural change in this market in the foreseeable future.

CLIG has a leading reputation in CEF investing with a decades-long track record of outperforming the benchmark. This is hard to replicate by CLIG's competitors. Additionally, the niche market of CEF investing may not be that big for some bigger traditional asset managers to concentrate their resources on.

Source: Shareholder Presentation, May 2019.

The strategic focus at CLIG is another source of economic moats for the company. Unlike many of its peers, CLIG focuses on long-term institutional clients, investment performance to drive business, and tries to avoid hot money. More importantly, the management never stepped out of their circle of competence in CEF investing.

CLIG also has the technology and risk management mindset embedded in their corporate culture, both of which are indispensable in today's financial world.

The longevity across a diversified pool of institutional clients along with the specialist investment expertise in Closed-End Funds across different product segments should protect the business to some degree from market downturns.

Source: Half Year Report 2018/19.

Source: Shareholder Presentation, May 2019.

As we notice below, discounts of CEFs are not so correlated across EM and developed markets. Also, even during the period of deepening discounts, which could adversely impact the FuM, CLIG proved its capability of high profits.

Source: Shareholder Presentation, May 2019.

Long-term Prospect

Analysts project an 8.5% annual increase in EPS at CLIG in the near term, according to SimplyWallSt below. I think the number here is rather on the optimistic side.

Source: SimplyWallSt; data as of 6/12/2019.

Over the long haul, the growth will be driven by expansions in terms of geographic locations as well as products.

The company has been increasing range of investment markets to be covered, building upon its core expertise in CEFs. Diversification products, including Developed, Frontier and Opportunistic Value, now occupy approximately 21% of FuM (or 15% of total income) and are still growing rapidly YoY.

Source: Shareholder Presentation, May 2019.

In 2018, the management also identified a REIT team, which will be managing the last segment of Closed-End Fund diversification products.

Meanwhile, expansion of the client base globally in the US, Europe, Asia, and the Middle East will continue.

Lastly, the management also indicated an interest in seeking acquisition opportunities.

Overall, I would reference the track record for the past 5-10 years and expect the top line to grow at 3%-5% and the FCF at 5%-7%, given the above reinvestment opportunities and retention ratio.

Management & Shareholder Interest

CLIG just experienced its management change in March. Barry Olliff, the founder of the company, retired from his CEO and CIO roles after over almost 30 years with the company. Mr. Olliff is widely recognized throughout the global asset management industry as an expert in the Closed-End Fund sector. He will continue to play an active executive role on the Board throughout 2019 and will remain available as a consultant to CLIG for a further two-year period in order to provide a degree of continuity to both clients and shareholders thereafter.

To replace Mr. Olliff, Tom Griffith was appointed as CEO and Mark Dwyer was promoted to Group CIO. Mr. Griffith and Mr. Dwyer are both CLIG veterans, having spent decades with the company, and both have taken various senior management roles for years.

The management set themselves the unique KPI of compounding the total return of a CLIG share by 7.5% to 12.5%, through a cycle (typically a rolling 5 years), on an annualized basis. A quick check on the past returns tells us about the outperformance of CLIG against its peers.

Source: Half Year Report 2018/19.

In terms of ownership structure, we see below that the insiders control almost 17% of the whole company, indicating the alignment of shareholder interest.

Source: Shareholder Presentation, May 2019.

During the past few months, insider trading has not been active - only one buy transaction - according to SimplyWallSt.

Source: SimplyWallSt; data as of 6/12/2019.

One more thing worth mentioning here is that Barry Olliff claims to only sell when CLIG shares are at specific price levels after his retirement: i.e. sell up to 500,000 shares at each level of 450p, 475p and 500p subject to close periods. This is another welcome sign of protecting shareholder interest.

Valuation

SimplyWallSt comes up with a 36% discount on the fair value at the current price of 420p, through its Excessive Return Model (see below).

Source: SimplyWallSt; data as of 6/12/2019.

Source: SimplyWallSt; data as of 6/12/2019.

To me, both the discount rate and the expected growth rate are underrated here. I would use 12% for the cost of equity (considering the management's KPI) and 5% as the growth rate (as was projected above), which should give me a fair value of 456p - a modest discount here.

According to GuruFocus, both EV/EBIT and P/FCF are below their respective trendlines as well as respective historical averages, confirming the underpricing of the stock.

Source: GuruFocus; data as of 6/12/2019.

Source: GuruFocus; data as of 6/12/2019.

Summary

Per my first full analysis of the stock, CLIG appears to be a decent niche-market play in the asset management area. The business has a decent economic moat, a shareholder-friendly management team, and opportunities to reinvest its retained earnings at attractive rates of return. Most importantly, the share seems to trade at below its intrinsic value, and such a case is not easy to find in today's market. For long-term quality-focused investors, CLIG may be worth a look as a potential buy opportunity.

Disclosure: I am/we are long CLIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please be aware that mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.