Demographics Favor Fund Company Shares

Shares of publicly traded mutual fund companies have been among the biggest beneficiaries of the ‘90s bull market, as fund assets have swelled. But are the glory days over for these stocks?

Wall Street’s late-summer stumble, and steep declines in foreign-stock and high-yield bond markets, slammed most fund companies’ shares. And while the sector has rebounded, many of the stocks remain well below their 1998 peaks.

Several firms, especially those that specialize in foreign and emerging-market stock funds, have reported disappointing third-quarter profits, as their assets under management plunged in light of stock market losses and investor redemptions.

Franklin Resources’ international assets, for instance, have fallen about 20% (to $84.8 billion) since this time last year, according to Morgan Stanley Dean Witter.

Last month, San Mateo, Calif.-based Franklin, which also manages the Templeton family of foreign and emerging-market funds, reported quarterly earnings of $112.3 million, or 44 cents a share. That was down from 50 cents a share in the third quarter of 1997, and missed analysts’ estimates by 4 cents.

Franklin shares, at $36.94 on Monday, are off 36% from their 1998 peak.

Pioneer Group, which manages several international stock funds, hasn’t officially reported its third-quarter numbers. But the Boston-based money management firm said it is likely to report a loss of 55 to 65 cents a share.

In fact, the few fund companies that did well during the quarter tended to be bond specialists--such as Newport Beach-based Pimco Advisors, with $226 billion in assets, and Chicago-based John Nuveen--as cautious investors have plowed money into more conservative fixed-income investments.

From the fund companies’ standpoint, “we’ve seen a migration away from high-margin international funds toward low-margin fixed-income funds during the quarter,” said Morgan Stanley analyst Henry McVey.

But does the third-quarter turmoil diminish the long-term prospects for fund stocks?

To a large extent, analysts say no. Indeed, Merrill Lynch analyst Mark Constant describes the asset management sector as “perhaps the most attractive sector of the financial services industry.”

Added Barrington Research Associates analyst Alexander Paris Jr.: “My favorable outlook and optimism about this sector has not changed at all.”

Why still so much optimism?

Near-term, the outlook for the fund sector certainly looks a whole lot brighter than it did even two months ago. Since blue-chip stocks bottomed on Aug. 31, the benchmark Standard & Poor’s 500-stock index has roared back and is now up more than 16% for the year.

The stock market’s rebound has, in turn, pulled many depressed fund stocks up sharply.

Shares of discount brokerage Charles Schwab, which operates one of the nation’s largest mutual fund supermarkets, are up 77% in the last 2 1/2 months. Boston-based Affiliated Managers Group, which owns such fund brand names as Tweedy Browne and First Quadrant, has seen its stock soar 54% since Aug. 31, after diving more than 50% in just six weeks.

Noted Paris: “Shares of asset managers are bull market stocks.”

That’s because investors naturally expect investment management companies’ assets to grow in a stock bull market, translating into higher earnings because the bulk of the companies’ revenues are derived from management fees charged as a percentage of assets.

Longer-term, the sector is expected to benefit from positive demographic trends, analysts say. The most obvious of those: As baby boomers get closer to retirement age, they are putting more and more money away, in particular through company-sponsored 401(k) plans.

Fund companies with “viable 401(k) businesses are enjoying what amounts to an annuitized stream of assets contributed every quarter or biweekly,” said John O’Shea of Investment Counseling Inc., a West Conshohocken, Pa.-based consulting firm that works with money managers.

Still, analysts warn that some fund companies’ earnings will take longer to rebound than just a quarter or two.

For one thing, “there will still be reticence on the part of investors to leap back into some of the more aggressive segments, like emerging markets,” where fund companies typically earn higher management fees, O’Shea noted.

What’s more, while investors have been shifting back into domestic stock funds in recent weeks, net new cash inflows are still well below pre-summer levels.

In September, stock funds attracted a net $6.5 billion in new money, according to the Investment Company Institute. By comparison, investors plowed a net $25.3 billion into the funds in September 1997.

For October, stock fund inflows were estimated at $9.1 billion, according to Trimtabs.com. That would be 54% less than October 1997 inflows.

Analysts who view the fund stocks favorably figure cash flows won’t stay depressed forever. Moreover, they note that not all companies are completely at the mercy of short-term cash flows.

Many fund companies also manage significant sums in private accounts for institutions and wealthy individuals. Also, many of the companies are attempting to broaden their array of products, so that no matter what the market conditions, they’re in a good position to keep assets from leaving their complexes.

In July, for instance, privately held Nicholas-Applegate in San Diego, known for its growth stock funds, hired three value-oriented fund managers from Smith Barney Capital Management.

And recently, T. Rowe Price Associates applied to open a savings bank in an effort to sell ultra-safe certificates of deposit to investors, who already have access to money market funds, bond funds and domestic and international stock funds.

Companies that derive a great percentage of their revenues from the growing 401(k) market should also thrive, analysts say.

How expensive are these stocks now relative to earnings?

The stocks’ rebound has pushed price-to-earnings ratios up again. Schwab shares are trading at a P/E, based on 1998 estimated earnings, of 44. And T. Rowe stock is trading at 26 times its estimated 1998 earnings.

But “there still is selective value among these companies,” said Paris. He believes that many bargains can be found among fund companies that specialize in stocks--as opposed to bonds--simply because the long-term growth outlook for stock assets is superior.

In the stock fund group, analysts currently recommend Affiliated Managers Group and Phoenix Investment Partners.

AMG continues to buy smaller money management firms, as it broadens and diversifies its asset base. Most recently, the firm announced a large investment in Houston money manager Davis Hamilton Jackson & Associates.

“We believe that this deal further demonstrates the quality--and resiliency in light of volatile financial markets--of AMG’s pipeline,” said Merrill’s Constant.

While AMG stock has about doubled since hitting a 52-week low of $13.38 on Oct. 6, it is still far off its 52-week high of $39.50. And while it is trading at a P/E of nearly 24, that’s still below its estimated five-year annualized growth rate of nearly 27%.

Phoenix Investment Partners growth prospects aren’t nearly as strong. But Paris notes that the stock’s P/E, at 18, is well below the U.S. market average.

For investors with longer time horizons, analysts still favor United Asset Management, which, like AMG, buys up smaller money management firms. With $183 billion under management, UAM owns such names as First Pacific Advisors and Provident Investment Counsel.

But because of UAM’s larger size, its long-term earnings growth is expected to be much slower than AMG’s, about 11% a year.

Even so, that’s a far better growth rate than companies in many other industries can expect to achieve.

Many analysts also recommend $139-billion-asset T. Rowe Price as a long-term buy. While most analysts believe that T. Rowe’s stock, at its current P/E, is fully valued, they still like the company’s long-term prospects, based on its strong brand identity, its appeal to retail investors and its status as a leading 401(k) provider.

In the future, analysts say, companies that not only manage assets but control the distribution channels for those assets--as T. Rowe is starting to do with its in-house brokerage arm--will be among the most profitable.

Schwab, for instance, recently negotiated a bigger cut of every dollar that’s invested in funds sold through its supermarket--from 0.25% to 0.35%. In part, fund managers are willing to pay Schwab because they require “shelf space” to be noticed by investors.

Analysts expect the mutual fund industry to gradually become bifurcated, with one-stop-shopping giants at one end and specialized boutiques at the other. The in-betweeners are expected to fade away or be bought out.

Notes Ron Sachs, an analyst with Janus Capital in Denver:

“Going forward, you’re either going to keep assets and grow by having fantastic performance or by controlling distribution.”

A footnote for investors who may be wondering: The two industry giants, Fidelity Investments and Vanguard Group, don’t have publicly traded stock.

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Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.