Undervalued stock of the week - Hunter Hall

January 16, 2013, 3:39 pm John Abernethy Yahoo7

With cash becoming a far less attractive option, some smart investors have begun to look at fund management companies as a turnaround play.

INVESTING in an investment company may seem like a risky call when the outlook for the global economy seems so uncertain. Fund management companies are highly cyclical businesses whose share prices fluctuate wildly according to the economic cycle and investor sentiment, both of which appear to be moving in a favourable direction for Australia’s best fund management firms.

At their simplest, fund managers make their money from the fees charged to investors on managed funds and superannuation accounts. These fees are calculated as a percentage of the funds under management, so the more money that an investment company has in its funds, the more profit it makes.

While the statutory 9 per cent super guarantee provides a valuable foundation for Australian investment firms, it has not prevented shares in investment companies from falling since the global economy took a dive in 2008. Many stockmarkets are still in the doldrums and managed funds have suffered because investors have sold their shares and put their money in cash instead. Combined with poor investment performance due to the global crisis, this has seen the amount of funds under management fall across the industry. This in turn has hit profits and share prices of many fund management firms have fallen sharply.

But there is growing evidence that the economic cycle is turning around and that investors are once again prepared to place their savings in the stock market to try and boost returns. This is becoming especially true now that interest rates in Australia have been cut and will likely continue to fall – making cash a far less attractive option. As a result, some smart investors have begun to look at fund management companies as a turnaround play.

One fund manager which has so far been overlooked is Hunter Hall (HHL), a boutique international fund manager with around $1.18 billion in funds under management.

While it has a strong long-term performance record across its range of international funds (the Hunter Hall Value Growth Trust is the best performing in Australia over its 18 year life cycle), recent performance has been poor. In results released late last year, it revealed funds under management decreased 29% from $1.77b at 30 June 2011 to $1.25b at 30 June 2012. This decrease was driven by negative investment performance of $208m and redemptions from the funds. HHL announced a 32% fall in revenue from ordinary activities to $27.97m and a 42% fall in profit attributable to equity holders of HHL to $7.11m.

Clearly, Hunter Hall (HHL) faces some significant challenges. Its funds under management are unlikely to start growing until or unless it is able to turn around investment performance. The appointment of David Deverall (ex-Perpetual) as CEO is designed to re-invigorate the firm, and the jury is out on whether or not he will succeed.

One of the advantages of fund managers in an improving market is their relatively fixed costs. This means their costs increase as a proportion of earnings in bad times but decrease as a proportion of earnings in good times. As we head into better conditions for global stock markets this should see profitability jump, hopefully along with its investment performance.

On a longer term view, the government has mandated that the super guarantee will rise from 9 per cent of salary to 12 per cent by 2020, providing a big boost to managers of super funds. HHL differentiates itself from other fund managers by having a strong ethical and environmental ethos, and donates 5% of pre-tax profits to Australian-registered charities.

Hunter Hall has produced an average normalised return on equity of almost 60 per cent for the past five years. The company at balance sheet date had no debt, and even if net inflows are slow to arrive, the existing business is probably worth a premium to the existing share price of around $3.00. In the interim, an attractive forecast dividend of around 8% makes the wait more bearable. While Hunter Hall has certainly seen better days, it is quite possible that the worst is behind it and new management will succeed in leveraging off the market recovery.

Company: Hunter Hall (HHL)
Current price: $3.00 (16th January)
Forecast value: $3.72 and above ++
Potential upside: 24 per cent

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Investors should not rely on this information alone and should seek independent financial advice from a qualified expert before considering any share market investment.
++Fair or forecast value is the price placed on the share after calculating a range of factors including profitability, assets, debt and, most importantly, Return on Equity – the same measure used by Warren Buffett to assess long-term value.

Shares are assessed by Clime Asset Management to calculate which companies are undervalued or over-valued based on their return on equity. History has shown that the most successful companies are those that produce the highest returns per dollar of shareholders' equity, yet this is not typically how shares are valued. This system highlights shares that are undervalued on this key measure. Shares are expected to reach this value in 3-5 years, as price tends to follow value in time.

Information is intended as a guide only. For specific advice contact your financial services professional.

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