(Update, October 10, 2019, 8.30 p.m.: This article has been updated to add appropropriate attribution and sourcing)
If you're reading this article, there is a good chance you are a DIY investor looking for ideas to implement in your portfolio. As more information has become available online, the process of managing one's own money has evolved. Some will say it has become easier because of the availability of information, while others might say that it has now become more complex and overwhelming.
This evolution in investing has also affected how financial service companies operate. Over the last 20 years, 'financials' have become much more diverse in the services they offer and the manner in which they deliver those services, particularly how new processes and technological innovation have become, in some cases, the most important driver of profitability.
That is, except for those financial companies that manage investments for retail and institutional investors through either mutual funds, ETFs, or separately managed accounts. For these firms, which charge fees based on assets under management, their stock prices go as the stock market goes. When the market does well, assets increase due both to organic growth from the investments as well as additional fund inflows from investors putting more capital to work. But when the market declines, assets decrease, and with it, the fees generated for money management.
After almost 10 years of expansion and the market swoon so far in October, what are we to think about the next couple of years for money managers?
The opportunity for money managers still looks promising. My guess is that with increased market volatility, more investors will seek out active management after years of switching allocation to passive, less expensive ETFs. The problem with the 'cheaper' alternatives is that they either invest in an index without taking into consideration any positive or negative developments on specific holdings, or are based on a factor such as momentum, low volatility, value, etc. When the index or factor is in favor, all is good, but as we saw in recent weeks with the drop in momentum stocks and the strong pullback this week across the broader market, sometimes you want someone to pick the best stocks.
With recent economic data looking dour and the trade war still adding a level of suspense to the market's direction, it's no wonder investors are reacting strongly to negative news. Is this a breather in the market's sustained climb higher or is this the next 30% down year?
Cash, meanwhile, continues to build up on corporate balance sheets. The companies in the S&P 500 Index reported a total of over $5.4 trillion in cash and marketable securities in their latest filings and they have been returning cash to shareholders via share buybacks, which will likely come under scrutiny as we approach the 2020 elections.
The investment advisory industry is highly competitive, with new competitors continually entering the industry. Hennessy Advisors, Inc. (NASDAQ:HNNA), a lesser known money manager, competes directly with numerous much larger and well-known institutional managers like JPMorgan Chase (JPM), T. Rowe Price (TROW), BlackRock (BLK), and others. The industry is made up of a broad array of companies and business models ranging from small boutique firms to large financial services complexes.
HNNA is considered a small investment advisory company. To grow its business, it must be able to compete effectively for assets under management either by doing what it does better than its competitors, or differentiating its approach to a more specific target market. The comparison below shows a few additional peers that aren't quite as big as the ones previously mentioned, hower but even so, HNNA is small in comparison.
What attracted me to take a closer look at the stock is its EPS growth over the last 5 years combined with its PE ratio of just 3.42 and P/FCF ratio of under 5. Its dividend also comes up as very stable using my Dividend Quality Score and the recent dividend boost of 25% is evidence of that.
Ryan Bowen prepared the following chart comparing several financial metrics to a handful of competitors that are larger than HNNA but nowhere near as large as the behemoths shown above. Data was published in January 2019 so likely to be from December 2018.
Comparison to Other Investment Management Companies
EPS past 5 years
Taking a broader view of the asset management industry and looking at some of the slightly bigger players, the comparisons are similar. While HNNA's ROE has declined since the end of 2018, HNNA still compares favorably across all metrics, and in line with profit margins of the larger peers. The level of discount to competitors both small and large just doesn't make sense to me.
Hennessy Advisors, Inc. is the publicly traded investment manager of the Hennessy Funds. It offers a number of equity, sector, and multi-asset funds that all employ what they call a repeatable investment process that uses proprietary stock selection formulas that are implemented using a team approach.
The company has been growing through acquisitions dating back to 2000 with the acquisition of Cornerstone Value and Cornerstone Growth Funds. The list of acquisitions are as follows:
2000 - Cornerstone Value and Cornerstone Growth Funds
2003 - SYM Select Growth Fund
2004 - Lindner Asset Management
2005 - Henlopen Fund
2009 - Tamarack Large Cap Growth Fund and Tamarack Value Fund
2009 - SPARX Japan Fund and SPARX Japan Smaller Companies Fund
2012 - FBR Funds
2016 - Westport Funds
2018 - Rainier US Equity Funds
2018 - BP Capital Twinline Energy Fund and BP Capital TwinLine MLP Fund
After the acquisition of FBR Funds and the subsequent move to NASDAQ from the over the counter market, revenues for the firm started accelerating through 2016, where it has flattened.
Source: HNNA Corporate Profile (Website)
The firm’s average assets under management for fiscal year 2018 was $6.7 billion, which is still a formidable size but pales in comparison to the major fund companies and asset managers. As the chart below indicates, AUM has increased dramatically since 2003 and more specifically from 2012 to 2016.
Hennessy Advisors manages 16 mutual funds in the following categories
HNNA got on our radar when we were searching for a dividend growth stock in the financial sector. It had grown its dividend over 28% annually over the last 5 years, and upon closer look, we believe it will continue to do so – although dividend growth is more likely to remain in the mid-teens. Its payout ratio is only 20%, which provides a great deal of safety even if earnings decline.
But why settle for just income when you can get dividend growth AND price appreciation?
The decline in stock price from a high of $26 in 2016 – when AUM was at its highest – to $10.54 as of the date of this article – and $9.46 when I first introduced the stock in The Income Strategist, provides an interesting opportunity for investors with somewhat of a contrarian view. Part of the problem is that EPS for 2018 was $2.61 while 2019 forecasts are closer to $2.01 – but that's $0.40 higher than when I first researched the stock.
What's missing is that 2018 EPS was aided by a one-time charge related to the Tax Cuts and Jobs Act of $0.54 per share. Adjusting for that one-time item, the 2018 EPS was $2.07, so while there is still a decline in earnings, applying a multiple of 15 to EPS of $2.01 still puts the price back up to almost $30.
There are several metrics that we view as favorable when we analyze the company's financial statements. Starting at the top, as we have already mentioned, the company has grown both organically and through acquisitions and revenues have grown at a compound annual growth rate of 18.2% over the last 10 years and 17.6% CAGR over the last 5 years.
As it has grown, it has been able to improve its operating margins from the low 20% in 2010 to the mid 40% range in 2018, resulting in similar increases to net margins, which have increased from 16% to 38% and are now at 27%.
Hennessy also reported a 33% return on equity in 2018, which is lower than its all-time high of 48%, but still very attractive. (It has since declined to around 17% due to a decline in profit margins from 38% at the end of 2018, to 27% in the latest quarter, as well as a slight decline in asset turnover)
Using a DuPont analysis to dig into the details of how the company is generating its ROE, we can see that all three drivers of ROE are trending positively although they have retreated some since the beginning of 2019. (Some of the ROE figures may differ compared to the ROE reported on financial websites because of how the ROE is being calculated using the DuPont method – but they are directionally consistent)
ROE has increased from just under 4% in 2012 to over 29% in 2018. The three components that make up return on equity are financial leverage, asset turnover, and profit margins. In HNNA's case, all three have improved over the last 5 years. Total asset turnover has increased from 0.21 to 0.5, indicating a greater level of sales for the level of assets the company currently has on the balance sheet. Meanwhile, as I already mentioned, profit margins have almost tripled in the same amount of time. And lastly, financial leverage has increased slightly from 2012 but is at half the levels reached in 2015.
Source: YCharts, Author Calculations
As I previously stated, I view the opportunity here as a dividend growth play with upside price potential. The company has increased its dividend from $0.06 per share in 2008 to 2019 estimates of $0.50 per share.
That's a 20%+ CAGR over the last 10 years and 35% over the last three years alone. I don't believe that level of dividend growth will continue, but I can see 15%-18% dividend growth over the next few years where 2019 is already forecast to be 15% above 2018 levels. At a payout ratio of just 20%, there is also considerable safety in this dividend.
While some banks have asset management divisions that do the same thing HNNA does, they also have many other businesses, such as lending, proprietary trading, investment banking, etc. that makes the investment somewhat confusing for investors and certainly doesn't provide much transparency on how the bank will perform. Investing in HNNA, however, is a pure play asset management investment that is driven entirely by AUM, portfolio performance, and the ability of management to reduce costs.
At a 5% dividend yield, I believe investors are getting adequate income from an investment in a company focused on continued growth. And at a payout ratio of just 20%, there is considerable upside to the dividend even if growth slows. By comparison, JPMorgan Chase has a payout ratio of 30%, which, if applied to HNNA, would indicate a dividend yield of over 9%. I'm not saying that will happen, but the margin of safety of the dividend is solid and the company's focus on growth makes its current dividend payout conservative. The current Dividend Quality Score is 94, a slight increase from a score of 93 one year ago.
The company's share price was clobbered due to the decline in AUM after the December selloff and redemptions that were partly driven by underperformance. The stock also has an unfavorable comparison to 2018, and with only one analyst providing coverage, we believe this fact is being overlooked.
The one analyst has a price target of $25 on the stock. I believe the company is financially stable enough to weather the storm and renew its growth trajectory. And in 2020, more favorable comparisons will bring to light the company's solid performance.
Despite the recent increase in the share price (up 10.8% over the last month), I believe the stock is still extremely undervalued.
The stock remains in my Dividend Growth Portfolio as a Strong Buy.
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Disclosure: I am/we are long HNNA. 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: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.