value and opportunity

Disclaimer: This is not investment advice. PLEASE DO YOUR OWN RESEARCH !!!

A few months ago, fellow blogger Wexboy had a very interesting post on Record Plc, a UK based “specialty asset manager”. Go and read the whole thing, it is worth it.

I try to summarize the business & background  in my own words:

Record Plc provides so-called “Currency overlay” asset management services. Currency overlays are in principle used for two reasons.

1. To hedge an international investment portfolio into one single currency, usually the currency of the investor and/or
2. To gain some extra yield by hedging currency exposures more “dynamically”

It is important to know that they do not manage the underlying assets, but “just” a derivative portfolio hedging the underlying assets and that they do not use their own balance sheet but act solely as an agent for the ultimate client.

Hedging:

Most often, currency overlays are used in fixed income investing. Many investors who are forced to invest in fixed income securities (insurance companies, pension funds etc.) might not have the stomach to tolerate large fluctuations in portfolio value. However, especially if those investors are located in jurisdictions with small local bond markets, they are often forced to invest internationally in order to get some kind of diversification.  Or you are located in relatively large market but you think that bonds are fundamentally more attractive in other currencies (higher credit spreads), but you want to limit the volatility.

The same applies for large asset management companies, which might have a very succesful bond fund and want to offer the fund to investors in different currencies. It is very unpractical trying to clone the fund into separate pools. What asset management companies usually do is to issue share classes of the existing fund in different currencies and “overlay” this share class with the respective currency hedges

Extra yield:

This is an aspect which is quite interesting especially in times of extremely low yields like now. If you are for instance a Swiss based investor, bond investing in your own currency is not big fun. For a 10 year Swiss Govie you have to PAY -0,13% p.a. for the privilege to hold it. Clearly a 10 year USD Treasury looks more attractive at 2,2% (in USD). However, currency markets are fairly efficient. If you invest in your US Govie at 2,2% and hedge all cash flows back into CHF, you will end up getting roughly the same yield as in original Swiss currency, as you have to pay the yield difference between the two currencies via the hedging instruments.

This is where “dynamic” hedging comes in. Usually done based on models, the hedging ratio is not 100% but leaves some exposure open but then captures some of the extra nominal yield offered by the higher yielding currency.

Especially for investors based in low yielding currencies, this can make a big difference between a happy life and death.

Why not “Do it yourself” ?

This is of course a valid question. I think it boils down two 2 key considerations:

1. Operational issues
2. Know how

Operational issues

Hedging currencies has to be done via derivatives. In the past, this was fairly easy in principle. You called a bank, signed a piece of paper and then you would trade. However, following the financial crisis, regulation has changed that significantly. Entering into derivative contracts theses days is much more difficult than in the past (EMIR etc.). You need to sign hundreds of pages (“Know your customer”), be prepared to pay or receive margins on short notice and many other things. And you need to do this with every potential counterparty which multiplies the effort.

For large asset managers or institutions, this might be only an annoyance, but for smaller firms this is clearly an issue. On top of that you have to adjust those hedges on a regular basis which creates a lot of back office work. For a typical pension fund this is even more difficult as normally pension funds cannot do (or not easily) single investments but only subscribe to general mandates.

So hedging currencies is not easy operationally. In the past, many investors already outsourced this to banks but as we will see later this might change.

Know How

Although many investors think that currencies are easy, this is not really the case. The most liquid ones are fairly easy to handle, but once you get into more exotic jurisdictions or longer maturities, things get complicated. Currencies are OTC markets and if you are not carefull, you can get easily screwed both, on trading costs and rates as there are no regulated exchanges. “Naive” speculation often results in disasters when currencies suddenly move like when the peg of the Swiss Franc broke. Really adding return via active strategies is not that easy as it might look like and few can prove a long succesful record in this area.

So overall we can see that especially for smaller or midsized players, it can make sense to outsource currency hedging to a specialist.

Main fundamental factors supporting currency hedging

In my opinion, 3 main factors could further support the attractiveness of outsourcing currency hedging:

1. Currency volatility
2. Ongoing low yield environment
3. Mifid II regulation

Currency volatility:

From my own experience I know that senior management usually only cares about currency risk after a big volatility event. As things often move slowly in insurance and pension organizations, I think many of those institutions are just digesting the more recent events such as the British Pound and the USD. With relatively long lead times for mandates I would not be surprised if Record would score additional mandates going forward. Plus, in the current environment., we might see a lot more FX volatility than in the past. For instance even the Hong Kong Dollar seems to act strange lately. So high volatility in general should be good for those guys.

Ongoing low yield environment

As mentioned above, the longer the low yield environment holds, the more desperate FI investors will get and the more interesting active overlay strategies will become. It is not really surprising that ~86% of the mandates come from pension funds which are struggling the most with the low yield environment.

One of the additional benefits of FX overlay is that there seems to be little correlation between the results of FX overlay and interest /credit spread developments. Especially in a regulated environment this can have a very positive effect on caclulating required risk capital.

Mifid II regulation tailwind

This is from a Deloitte discussion paper:

Currently two FX execution models coexist for FX hedging: trades are either executed through a principal model where the execution desk is the counterparty or through an agent where the FX desk or platform will look for the best quote with

multiple counterparties. With Markets in Financial Instruments Directive II (MiFID II) and the potential best execution requirements, the market seems to be evolving toward agency execution in order to produce more transparency. How do you position yourselves toward your clients on this topic of transparency in execution and pricing?

The participating banks in this study clearly think they can continue doing their stuff but in my opinion under Mifid II, the agency model will make life easier for clients, especially for the fund industry and therefore will become even more attractive than it is right now. Although a lot about Mifid II is yet unclear, this could potentially be a very strong tailwind for a player like Record Plc which has no conflicts of interest and avoiding conflict of interest is at the heart of the Mifid II regulation.

Competition (Currency overlay)

There are very few specialist firms of which Record is both the oldest and the biggest. According to Wikipedia, Neil Record the founder actually invented currency overlays in the 1980ies.

The real competitors so far have been the banks but as discussed above and with the various Forex scandals, it looks like that the specialists have some competitive advantages.

One interesting aspect is the cooperation of Record and ETF provider WisdomTree. For WisdomTrees currency hedged ETFs, Record provides only the trading signals and WisdomTree is executing the trades. It will be interesting to see if there will be more such arrangements. This business model woudl obviously scale quite well.

All in all I would say that Record’s competitive position in this segment is good and improving. There is clearly the risk that if Mifid II is really hard on the banks, that more people will set up their own shop. However in Asset management, track records are important and the one from Record cannot easily be copied. Not a hard moat but still a significant competitive advantage.

Updates since Wexboy’s post: Annual results & Tender offer

After Wexboy’s post, Record released its full FY 2016/2017 results. The numbers were very good. AUM and revenues were up +10% (or more) yoy and EPS increased from 2,55 pence to 2,91 pence.

Secondly, they updated their capital management policy with the effect that this freed up ~10 mn GBP plus the promise that in the future any profits will most likely be fully distributed unless they need additional regulatory capital.

Thirdly, they announced and executed a tender offer using the 10 mn GBP of freed up capital. As a result, they bought back 22,3 mn shares at around 0,45 GBP/share, reducing the share count by a little more than 10%.

Some of the long time Management shareholders tendered part of their shares, especially founder Neil Record but more on that later.

Pro’s and Con’s

At this stage a quick list (also derived from info from Wexboy):

Pros:

+ secular tailwinds (low-interest rates, volatility regulation)
+ competitive advantage esp. due to track record
+ management has significant equity interest
+ good capital management

Cons:

• old management seems to be selling (founder via Tender offer)
• fee pressure in AM will also apply to FX overlays
• Brexit (but revenues are mostly in non GBP denominated currencies)

Management ownership

Especially for financial companies, alignment of management/employees and shareholders is important. There are enough examples where this went wrong. In Record’s case, management owns a significant amount of the company.

Founder and Chariman Neil Record owns around 31%, Leslie Hill, Head of Client Relationship 8,1%, Chief Investment officer Bob Noyen 4,7% and the CEO currently 1,4% of the company. The comparibly low stake of the CEO seems to relate to the fact that when Record went public in 2007, he was not yet part of the company, whereas Hill and Noyen are very long term employees.

Management salaries are around 600-800 k GBP, which is on one hand a lot for a small company but for the financial sector in relative terms quite OK (considering for instance the 8,5 mn GBP total comp for the prevous CEO of Provident). Interestingly, the CEO is only number 3 in terms of total compenstaion, the long-timers Noyen and Hill earn more than the CEO.

Although Record is stock listed, the large ownership of management seems to be rather similar to a classical partnership.

Chairman reduces stake via tender offer

If a founder and Chairman reduces his stake, then this is usually something to watch. In Record’s case, it was clearly communicated:

The Company’s Chairman, and largest Shareholder, Neil Record has irrevocably undertaken to fully participate in the Tender Offer with respect to his Basic Entitlement and has indicated his intention to tender an additional 8,017,632 Ordinary Shares. As a result Mr. Record’s percentage of Ordinary Shares will not exceed its current level of 32.06% and may decline to a minimum of 27.06% following the Tender Offer.

Neil Record established the Company in 1983 and has made very significant contributions to its development since then. Mr. Record served as Chairman and Chief Executive Officer from the Company’s admission to trading on the Main Market of the London Stock Exchange in 2007 until the appointment of his successor as Chief Executive Officer from 1 October 2010, from when he remained as Chairman. Mr. Record is a Non-executive Chairman, and holds all his Ordinary Shares directly in his own name.

Given these latter two facts, Mr. Record considers the Tender Offer and the potential to tender Ordinary Shares in addition to his Basic Entitlement represents an appropriate opportunity for him to reduce his overall holding of Ordinary Shares (subject to participation in the Tender Offer by other Qualifying Shareholders) whilst giving the opportunity to other Qualifying Shareholders to participate.

Mr. Record intends to continue as the Company’s Chairman and to play an active role in supporting its management and overseeing the continued development of its business for the foreseeable future. No material changes to Mr. Record’s involvement in the Group are anticipated as a result of the Tender Offer.

Neil Record hasn’t sold any shares since March 2008. At the age of 64 it might be not that unreasonable for him to diversify his wealth somehow. i don’t know much about his personal affairs, but in general returning share to the Company at a fair price is preferable for instance to the shares being passed on to some uninterested and unqualified heirs.

Valuation

Wexboy has written a lot about valuation. To keep it simple: Record’s earnings for the current year are estimated at 3,4 pence per share or a P/E of 13,2. Personally I would not deduct any net cash as this is a regulated business and I assume their current capital is adequate.

This gives us an earnings yield of 7,6% which will most likely translate into a similar dividend yield under the current capital management policy as the business needs very little capital for growth.

Further as described above, i think assuming a growth rate of between 5-10% would not be totally unreasonable. So this would give me an overall expected long term yield (all other things equal) of somewhere between 12,6 and 17,6% p.a.

To me this looks attractive. A business like this in my opinion should trade higher than 13,2 times earnings.

Why is the stock cheap ?

I think a couple of points could explain why the stock is potentially undervalued:

• The stock is not well covered by analysts. On Bloomberg there is only one analyst actively covering the company and this seems to be the dedicated market maker for the stock who also handled the buy back.
• The stock is not very liquid. Average trading volume is between 10-20K GBP only. So difficult for any larger address
• The business model is not that easy to understand, even for asset management experts, currency overlay is a relatively exotic concept
• Brexit worries. In record’s case I see relatively little impact as the agency model is relatively easy to move across jurisdictions and revenues are mostly in non GBP currency (although their cost clearly is)
• very ugly stock chart since IPO 2007. As Wexboy explained, Record IPOed end of 2007 during the last days of the big financial bubble and never really recovered.

Summary:

All in all, I  think Record Plc provides an interesting opportunity to invest  into a specialist asset management company with potentially significant secular tailwinds.

At current prices (0,45 GBP/share), the stock provides an attractive risk/return potential min my opinion (which of course could be totally wrong). The downside potential should be limited as the dividend yield currently should be at around 6-7% or more and if the growth realizes, the upside could be very attractive. All in all I think it is not unrealistic to expect 15% p.a. over the next 3-5 years.

Therefore I establish a 3,4% position at current prices. If the Mifid II effect really shows next year, then I would be prepared to increase the allocation significantly.

In order to limit my direct exposure to financial services, I funded part of the shares va a sale of my Lloyd’s Banking position (more on that in a separate post).

And thanks again to Wexboy for digging this up !!!!