Active investing, inert industry

Good morning. For the first time in what feels like a long while, 10-year US yields did not post a multi-decade high yesterday. They fell 9 basis points instead. In other news, Bill Ackman is closing his much-publicised short position in long-dated Treasuries. Has anyone received more good press out of the Treasury sell-off than him? Email us: robert.armstrong and ethan.wu.

Fund management, or investing in secular decline

Nearly 20 years ago, when I worked at a value investment shop, we used to screen for stocks that were cheap, looking for ideas to pitch to our bosses. At the bottom of those screens, every time we ran them, would be a handful of incredibly cheap stocks that we all knew were not worth pitching. Among them were companies that made paper telephone directories.

These companies’ revenues were in rapid decline, but they traded at price/earnings ratios in the low-single digits, with dividend yields of (as I remember it) 20 per cent or so. The simple maths were that if one of the companies survived for five years without cutting its dividend, you would have made your money back on the yield and receive whatever is left of the company (if anything) for free. I thought about taking a flyer (things happen!), but didn’t. I don’t know what became of those companies, but I’m assuming it wasn’t good, and that it took less than five years. 

These memories leapt to mind yesterday when I read the excellent Bloomberg story by Silla Brush and Loukia Gyftopoulou about the plight of midsized investment managers. Their core business, historically, has been actively managed mutual funds. Brush and Gyftopoulou detail how investors have been yanking their money from T Rowe Price, Franklin Resources, Abrdn, Janus Henderson and Invesco for years — $600bn on a net basis since 2018 just at those five firms, leaving the $5tn among them. Only a strong market has kept assets under management from collapsing.

The money is going to cheaper passive fund products. Meanwhile, money management is a scale business, with high fixed costs. So every dollar that moves to huge passive specialists such as BlackRock and Vanguard makes the competition more uneven. Worse, the companies have tried to change strategies over the years — cutting fees, merging, offering new products — but to no avail.

The outlines of the story will be familiar to FT readers. My colleague Madison Darbyshire’s read on Franklin Templeton, from January, covered the same terrain but focused on a single firm. Her hook was Franklin’s big $6.5bn acquisition of Legg Mason, a crucial part of its renewal strategy.

But history shows that acquisitions in declining industries are a holding tactic at best. Darbyshire recalls the acquisition that created Franklin Resources 30 years ago: 

After buying Bahamian asset manager Templeton in 1992, Franklin was a similar size to Vanguard Group, the third-largest investment provider in the US, with nearly $90bn in assets. Three decades later, passive specialist Vanguard has over $7.2tn in customer assets, six times the size of Franklin.

That tells the whole tale in two sentences. We know what the fundamental issue is: passive products are simply better than active ones for the vast majority of individual investors. There really is only one way for most people to invest, and it isn’t that hard. Own a small but diversified set of asset classes passively, in amounts fitted to your timeline and risk preferences; rebalance regularly; and max out your tax-protected accounts. For 99 per cent of investors, there really is nothing else to do, and if your business depends on retail investors doing something else, you are probably in a wretched business. To argue that higher interest rates and higher volatility will bring back the “stockpickers’ market”, saving active management as a retail investment product, is to place hope above experience.

(This of course raises some uncomfortable questions about my own business, that is, writing Unhedged. If the passive way is right for almost everyone, what exactly am I doing here? A good question, but this isn’t the moment.)

All of this is straightforward enough (to me, at least), but it raises a very interesting and vexing question: can you make money investing in a business in secular decline, such as active mutual fund management? I’m not suggesting that the mutual fund mavens are in as bad a spot as the companies who were publishing Yellow Pages 20 years ago. There is a huge amount of inertia in retail investing. Most people leave their investments alone, and the pathways along which pension money flows to established fund providers are worn to the point of frictionlessness. So these companies probably have quite a bit of time to figure things out.

Here’s what the stocks of the five managers have done over the past five years:

The stocks, like most in declining industries, do look appealingly inexpensive. Franklin and Janus trade at about book value; Abrdn and Invesco at discounts to it. Meanwhile BlackRock is well over two times book. The question is what these companies can do to get their valuations up.

The list of options is not long. One: they can take the Franklin route, and buy up (even) smaller rivals. Two: they can sell new fund products; many of them are doing this by building or buying “alternatives” or private-market funds (Invesco has moved to passive products with some success). Three: they can transform the core business into something new; many of them are trying to do this by becoming wealth managers, paid for advice rather than fund management. Four: they can also aggressively milk their businesses for cash, which they then return to investors in the form of dividends or share buybacks.

The problem with option one is that it hasn’t worked in the past, as we have seen. Strategy two is a challenge because alternatives and passives are turning viciously competitive, and the business is dominated by giant companies such as Blackstone. The problem with option three, moving towards wealth management, is that it is even more competitive than alternatives. Every big bank wants to move further into the business, as Patrick Jenkins noted in the FT yesterday.

There are corporate transformation success stories (Nokia started as a paper mill! Nintendo began with playing cards!), but it is always chancy. Becoming a cash cow therefore has a lot of appeal. All five of the companies make a decent amount of profit. Below is their aggregate net income for the past decade. While the trend since 2015 is clearly down, there is still a big profit pool here, and great years in markets like 2021 provide a boost:

I can think of several stagnant businesses that have delivered good investor returns over time by turning themselves into cash machines. But I can think of only one industry in structural decline that has delivered strong investor returns with a cash-return strategy: tobacco (which inevitably raises the question: is active investing addictive?).

I am reminded of a somewhat famous comment from Warren Buffett at the 2012 Berkshire Hathaway investor meeting. He was asked how to value declining businesses. He replied as follows: 

Generally speaking it pays to stay away from declining businesses. It’s very hard. You’d be amazed at some of the offers of businesses we get where they say “it’s only six times ebitda” and then they project some future that doesn’t have any meaning whatsoever . . . we are in several declining businesses. The newspaper business is a declining business. We do think we understand it pretty well. We will pay a price to be in that but it is not where the real money is going to be made at Berkshire. The real money is going to be made by being in growing businesses and that is where the focus should be. I would never spend a lot of time trying to value a declining business and think I’m going to get one free [puff] — what I call the cigar butt approach were you get one free puff . . . the same amount of energy and intelligence brought to other types of businesses is just going to work out better

In 2020, Berkshire sold its newspaper businesses.

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