There is one sector that has missed out on most of the market's recent rally: wealth managers.
One company in particular has suffered more than most and that is Waddell & Reed Financial Inc. (WDR, Financial). Indeed, over the past 12 months shares of Waddell have declined by 21.6% compared to the Standard & Poor's 500’s gain of 22.1% over the same period. These figures exclude dividends.
After these declines, shares in Waddell do look particularly attractive. The stock trades at a forward price-earnings (P/E) ratio of 11.2 compared to the industry average of 13.8. The shares support a dividend yield of 9.6% compared to the industry average of 3.4% and trade at an EV to EBITDA ratio of 2.7 compared the industry average of 14.9. However, while Waddell may look cheap compared to the rest of the sector, the market is placing a low valuation on the business for a reason.
Avoiding the business
After growing earnings per share at a compound annual rate of more than 20% between 2010 and 2014, Waddell's earnings per share declined by 22% in 2015 and are on track to decline a further 28% for 2016 and 25% for 2017. Current forecasts suggest the company will report earnings per share of $1.64 for 2017. From a high of $313 million for 2014, net profit is expected to collapse to $132 million for 2017.
The problem is that Waddell is hemorrhaging assets. During the first half of 2016, the business reported asset outflows amounting to 31% of assets under management. No matter how you look at this figure, there’s no positive takeaway.
According to the company’s most recent set of results, which were released on Jan. 31, outflows are slowing. Net outflows amounted to $4.4 billion during the fourth quarter and sales for the quarter rose every month although they still remain at a multiyear low. Assets under management ended the year at $81 billion, declining 5% during the quarter and 23% compared to Dec. 31, 2015.
Why are investors running?
These outflows are troubling; if you compound the losses of 23% per annum, it will take a little over four years for the business to lose all of its customers.
Value investors have to ask themselves why a business trades at a particular valuation. In Waddell’s case it would appear high fees are the asset manager’s Achilles' heel.
According to research published by Morgan Stanley, which I covered earlier in the year, Waddell’s average dollar-weighted expense ratio stands at a staggering 1.4%, the highest in the industry. As passive fund managers continue to gain market share, a high fee structure is the last thing any asset manager should have in place. For example, Vanguard ETFs charge 13 bps per annum in management fees, and a Vanguard Robo account is only 30 bps, 70 bps less than the average mutual fund fee. Facing these trends Waddell’s management should be doing everything in its power to cut the company’s fee charged to investors in order to attract more assets.
It appears Waddell is doing exactly the opposite. Per the company’s fourth-quarter and full-year results release:
“Management fees declined 4% sequentially while average assets under management declined 6%. Fees declined at a lesser rate than average assets under management due to an increase in the effective fee rate, which was a result of a mix-shift within the asset base.
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“The effective fee rate for the current quarter was 64.4 basis points compared to 63.6 basis points and 60.6 basis points during the third quarter of 2016 and fourth quarter of 2015.”
The bottom line
This may be a simplified analysis, but the asset management industry is facing a structural shift and Waddell needs to conform. Marching in the opposite direction is only likely to accelerate the company’s deterioration.
Disclosure: The author owns no share mentioned.
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