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One of my best investments of all time was US Global Investors (GROW). US Global is the manager of various mutual funds with a particular focus on Eastern Europe and natural resources — both sectors that I am optimistic about. In the asset management business, as assets under management grow, so do your revenues. The great thing about this business is that costs are somewhat fixed. This leads to some serious gearing.
I first started buying shares in early 2005 at around $2 (all numbers are post-split). At the time, the company had about $1.8 billion in assets under management. In the quarter ending December 2004, the company had $4 million in revenues, $3.5 million in expenses and $0.5 in pre-tax income. That annualizes out to $2 million a year in pre-tax income.
I paid about 15 times run-rate earnings for the shares. That’s not a cheap price, but I thought I saw where the future was headed. Emerging markets were hot and natural resources were even hotter. US Global had the top-ranked funds in each category. With minimal marketing, investors were flooding into these funds. Even better, because of good performance, the funds were growing organically. I thought this trend would continue. I thought the assets under management would balloon. As I saw my thesis playing out, I continued to add to the investment, eventually coming to own over 10% of the company with a cost basis around $3. I wish I had bought even more.
Two years later, the company had $4.5 billion in assets under management and in the quarter ended September 2006, the company had $11.6 million in revenues, $8.2 million in expenses and $3.4 million in pre-tax income. That works out to a bit more than a doubling in assets under management, an equivalent increase in revenues, but a 6-fold increase in pre-tax income. That’s some powerful gearing. Naturally the stock went parabolic.
| December 2004 Quarter | September 2006 Quarter | |
|---|---|---|
| Average Assets ($billion) | 1.8 | 4.5 |
| Revenues ($millions) | 4.0 | 11.6 |
| Expenses ($millions) | 3.5 | 8.2 |
| Pre-Tax Profit ($millions) | 0.5 | 3.4 |
Excludes investment gains and losses
In two years, the shares went as high as 36. I sold most of mine between the high teens and low $20s. There was nothing wrong with the business. I just felt that the shares had gotten way ahead of the fundamentals. I was proven right when the commodities sector cooled down and the funds were hit with outflows.
Asset management is a great business to be in when your assets are growing. The key to analyzing a business like this is determining how much of the cost structure is fixed and how much is variable. Then you need to figure out the direction that asset flows are going. The best way to figure out asset flows is to assume that hot sectors will attract more assets. In particular, pay attention to those funds with the best track records. People want to invest with winners.
Gearing is a powerful process. Look for companies that can gear.
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