In this article from The IRS Report published in December 2009, Peter Shearlock discusses Schroders...

Schroders is a geared play on continuing market recovery

No industry is more closely tied to the health of the stock market than investment management. With management fees largely based on the value of funds under management, rising markets automatically boost profits. Falling markets have the reverse effect and, because investment managers’ costs are often inflexible, can wipe out profits entirely.

Swings in investor sentiment reinforce this linkage. Private investors tend to buy investment funds when markets are on the up and sell them when markets fall. That introduces added gearing to investment managers’ profitability.

At Schroders, one of the industry’s oldest names, they have had to deal not only with the effects of market swings but, until recently, a long-term decline in institutional business. Quite simply, Schroders got caught out by a change in fashion. Sometime around the early 1990s, pension fund administrators started to turn their backs on traditional “balanced” investment management which had been Schroders’ forte.

Balanced mandates are all encompassing. They give the investment manager freedom to allocate the money between cash, bonds and equities, and between different world markets. They are “active” mandates – where the investment manager is expected to beat the indices with good stock-picking or market switching.

Suddenly, the people in charge of Britain’s pension funds wanted something different. Many plumped for a core/satellite approach in which the biggest chunk of cash was invested in low-cost index funds and the remainder parcelled among a slew of specialist managers. Schroders offered none of this and paid the price. It did not help that investment performance was distinctly average. A stream of pension fund money flowed out the door.

But the business has been much restructured in the past three or four years. Management has broadened the product range to include areas such as emerging market debt, commodities and funds of hedge funds, and opened up new distribution channels. Most importantly, perhaps, it has transformed the investment performance. At the end of September, 85% of the funds were showing outperformance over one year. The numbers were almost as good over three years.

This was of little help in 2008 when funds under management shrank by a fifth to £110bn. About half the fall was down to the collapse in share prices. This year, the story has been dramatically different. The tide turned in the second quarter, when a net £3.9bn of new money flowed into Schroders’ funds. But it was the third quarter figures that really made people rub their eyes. A net inflow of £7bn helped funds under management rise a remarkable 23% to £139bn. Commenting on the figures, broker Evolution Securities said “It is clear that there is very strong asset gathering momentum at Schroders currently.”

Not surprisingly, Schroders shares have performed strongly since the turnaround first became apparent in the summer. But they have had a bit of a pullback since Dubai’s decision to suspend payments on its massive debts – a move that has sent tremors through all world markets. That has left them looking better value.

At the current level, Schroders is capitalised at around £3.3bn. But it has around £800m of net cash and investments which is said to be surplus to operating requirements. That gives it great solidity – and firepower for future acquisitions. It also means the business itself is effectively valued at £2.5bn, or about 1.8% of funds under management. There is clear scope for upside there.

Schroders’ current-year profitability will be held back by a number of factors. First, much of the new money from customers this year has gone into lower-margin products such as fixed income funds. While private investors have been happy to run down their low-yielding bank deposits and chase higher returns in bond funds, many have not yet regained their appetite for equity funds, where Schroders is strongest and its margins highest. The expectation is that a sustained recovery in share prices will encourage a switch into equities in the coming year.

Second, the firm’s private banking arm, which looks after wealthy individuals, has put in a lacklustre performance in the past year. Schroders has also had to provide £4.3m for a doubtful debt. The recovery here may take longer to materialise than in the core asset management business. But the pace at which Schroders’ earnings are set to recover is still impressive. Evolution forecasts a jump in earnings per share from 27.3p to 34.6p this year. For 2010, it has pencilled in 77p. That shows the extent to which returns in fund management are geared to rising markets and positive investor sentiment. Performance-related fees, which feature in only a minority of Schroders’ funds, should be a factor in the equation next year.

Importantly, thanks to the strong investment performance of its funds over the last few years, Schroders is once again in the goods books of the consultants that advise pension funds and the like on their choice of investment managers. Coupled with the support of a cash-heavy balance sheet, that suggests the firm is in better shape than at any time in the last couple of decades. It looks an attractive medium-term play on a continuing market recovery.

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Peter Shearlock writes in The IRS Report regularly

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