Finding bargains in a fallow field

Despite a slight rebound in recent weeks, thanks to eased inflation fears, many value-oriented money managers never fully recovered from the beating they took a little over a year ago.

As a result, managers of mutual funds with a value bent are increasingly snapping up their stocks, a cannibalistic trend that has taken a bite out of everyone from international investment giant Franklin Resources to newly public Gabelli Asset Management Inc.

Fund managers are betting that consolidation in the financial services industry, continued demand among baby boomers for retirement savings products and other factors will ultimately lift the slumping stocks.

In many cases, public money managers are trading at sizable discounts to their private market value.

That’s because net inflows to mutual funds, especially value funds, have been anemic since the market turmoil in the summer and fall of 1998. In many cases, investors who might have put money into retail mutual funds instead have pumped their cash into alternative investments such as wrap accounts or taken up online trading.

Among the stocks hardest hit this year have been those of firms managing the bulk of their assets in a value-oriented style, or others with lagging performance or relatively “weak distribution,” says Neil Epstein, a vice president at San Francisco investment bank Putnam Lovell de Guardiola & Thornton.

Those include Nvest LP (down 28.1% through Nov. 18); United Asset Management Corp. (down 21.4%); Phoenix Investment Partners (down 7.4%); and Liberty Financial Cos. Inc. (down 4.9%).

“Money is simply going in different places,” says Mr. Epstein. “The visible decline in net inflows to mutual funds has hurt the valuations of publicly traded managers,” he says, adding that mid-and small-capitalization stocks have taken the biggest hit. They are trading at about a 25% discount to their private market value.

The Putnam Lovell Index of Publicly Traded Money Managers currently stands at little more than half the price-earnings ratio of Standard & Poor’s 500 index, about 18 times trailing earnings, vs. 31 times for the S&P 500.

The index was up just 6.8% through Nov. 12, while the S&P 500 gained 13.6% for the same year-to-date period.

That kind of gap has piqued the interest of fund managers like Douglas Eby, co-manager of the Torray Fund in Bethesda, Md. He began buying Franklin Resources in the third quarter of last year, when the San Mateo, Calif.-based money manager saw its stock price cut almost in half to $26.

Franklin has since seen its stock rise to as high as $45.63, although at $33.69 as of Nov. 16 it was down about 6% for the year.

Mr. Eby says he bought Franklin — the only “pure play” money manager in his $2 billion large-cap value fund — because of its strong name, its split between value and international investing and its focus on international expansion.About 2.5% of the fund’s assets are invested in it.

Larry Sondike, co-manager of the $8 billion Mutual Shares and $4.5 billion Mutual Beacon funds, part of Franklin’s Mutual Series fund group, has placed his bets on Kansas City Southern Industries, the railroad outfit that controls high-balling growth shop Janus Capital Corp., and on United Asset Management, a holding company for investment managers with a combined $194 billion under management. The stocks represented about 1.5% of the net assets of each portfolio as of Sept. 30.

Despite the drubbing the sector has taken recently, he is still bullish on the money management business in part because of the ability of companies to generate “free cash flow” — i.e. cash that doesn’t have to be reinvested and, therefore, is available for stock buybacks and dividends.

“It’s a people business and the earnings and cash do not have to be used to reinvest in the business to maintain those earnings and cash flows,” he says.

UAM, he notes, trades at an “exceedingly cheap” seven times cash earnings of $3 a share. The Boston-based firm has been aggressively buying back its stock and pays a hefty dividend of 80 cents a share.

Still, the stock was down about 15% to $21.38 through Nov. 16, while Kansas City Southern — which plans to spin off Janus into a holding company — was up almost 10% to $53.25.

Morty Schaja, chief operating officer for New York-based Baron Capital Management, a growth shop with a slight value bent, is banking on boomers to rescue money management stocks.

He says the average baby boomer is 45 years old and, therefore, has plenty of time to continue pumping money into retirement savings.

That, he says, is likely to benefit stocks like Gabelli Asset Management and BlackRock Inc., both of which went public this year. Rye, N.Y.-based Gabelli is a holding in the Baron Small Cap Fund, while New York-based BlackRock is a holding of the Baron Growth and Baron Small Cap funds.

Although BlackRock went public less than two months ago, it has fared a bit better than Gabelli, rising 22.8% to $17.43 on Nov. 16. The Baron funds bought BlackRock during its public offering.

Veteran value investor Martin J. Whitman, manager of New York’s Third Avenue Value Fund,is buying dirt cheap insurance company and money management stocks. As of September his $1.3 billion small-cap value fund was invested heavily in financial stocks, including Legg Mason Inc.and Liberty Financial .

In an interview with fund tracker Morningstar Inc., Mr. Whitman calls the fund business “a license to steal.” “Once you get some persistence, there are these fees in cash, no credit problems, no inventory problems and very little overhead,” he says.

He says his fund has been buying Legg Mason and Liberty Financial partly because they appear to be trading at bigger discounts than others in the sector.

“The public price for money managers is below takeover prices,” said Mr. Whitman at a recent New York press briefing.

Still, not all value-oriented managers are salivating over the bargains. David N. Dreman, chief investment officer of Red Bank, N.J.-based Dreman Value Management LLC, says he’s skittish because the bull market is showing signs of aging.

“At the end of a very long bull run, we tend not to buy money management or brokerage stocks,” he says. “In a down market, they tend to be some of the most susceptible.”

Related Topics: Mutual Funds