The City of London Investment Group (CLIG) is a British asset management company investing institutional money predominantly in the emerging markets. Since its inception in 1989, CLIG has developed a specialist investment expertise in listed emerging market closed end funds (CEFs). In recent years the company enhanced their product range by adding products investing in developed markets CEFs, natural resources CEFs, and emerging market small cap equities.
The company’s strategy aims to capitalise on the discount anomalies existing in the closed-end fund sector as buying discounted funds can offer both upside potential, as a return multiplier in rising markets, and downside protection, buffering against losses in down markets.
As most readers are aware, a conventional open-end mutual fund buys and sells shares directly from the investor at the NAV of the end of closing day. Hence, the price and NAV of an open-ended fund are more or less the same. In contrast, the market price of a CEF share usually trades at a different price point than the net asset value of the securities in the underlying portfolio as CEF shares are traded in the open market. In addition, many CEF shares trade at a discount to NAV. The major reasons for that are corporate governance issues and/or oversupply of CEFs investing in a certain asset class/region.
Analyst coverage of CEFs is relatively limited and there are only a few institutional investors competing for investment opportunities in a capacity constrained asset class. Besides participating in the performance of the CEF’s share price, CLIG can add alpha for its investors by trading discount volatility. Another advantage is, that the investment process is repeatable as the discount to NAV is one of the major investment criteria.
If the discount widens, probability increases that investors like CLIG will step in to urge the management/directors of the CEF to narrow the discount. They usually start with writing a public letter outlining potential measures to be taken. These measures are mostly not in the interest of the CEF manager. Most of the time they involve a reduction in share supply leading to lower fee income for the manager. More drastic measures can be a replacement of the manager, a change in the investment strategy, a merger with another CEF, becoming an open-ended fund or a liquidation of the CEF.
If the parties involved cannot agree on measures to reduce the discount, a proxy fight can be the result. However, a proxy battle is relatively expensive for both the activist investor and the CEF as money is spent for lawyers, consultants and research. Fortunately, over the last couple of years proxy fights have become relatively rare as the credibility of firms like CLIG and Bulldog Investors has grown substantially. It has become more and more common that CEFs reach a settlement with active investors before the proxy fight is undertaken.
As a consequence, CLIG can also add alpha for its investors by playing an activist role.
CLIG’s track record
Below you can find the performance of CLIG’s flagship fund “The Global Emerging Markets Country Fund”:
|Annualized returns as of March 2013|
|Time Period||Global Emerging Markets Country Fund||S&P Emerging Frontier|
At the end of March 2013 the Global Emerging Markets Fund represented approx. 27.8% of assets under management. The long term performance has been good compared to its benchmark. Management states, that historically one third of alpha was generated by country selection and two thirds were generated by narrowing discounts to NAV (discount volatility).
However, over the last five years the fund underperformed its benchmark. One reason for the underperformance was that the size weighted average discount of the portfolio (SWAD) has increased as can be seen below:
Hence, CLIG was not able to narrow discounts of their CEF portfolio over the last couple of years. Management states that there has been some process weaknesses (e.g. in the past CEFs were bought at too narrow discounts) and that these weaknesses have been resolved. Generally, the widening in discounts reflects an overall lower demand for emerging market closed end funds.
However, in their annual report management states, that they are currently outperforming their benchmark again:
“Global composite investment returns for the emerging market closed end fund strategy for the rolling one year ending 31st May 2013 were 14.7% vs 14.1% for the MSCI Emerging Markets Index in USD and 16.4% vs 15.8% for the index in GBP. Outperformance was attributable to country allocation and NAV outperformance.”
Management expects mean reversion of net asset value performance and increasing discount volatility to be major drivers of improved investment performance in the future. With the discount of emerging market closed end funds still quite wide, they see trading opportunities to generate outperformance. Based on the latest trading updates as of December 2013 management indicates that their funds have been performing in line with the market since May 2013.
Assets under management (AUM)
The table below illustrates that over the last two years with the fiscal year ending at March 31st the company had to cope with substantial capital outflows:
One reason was that a major client decided to manage his emerging market exposure in-house. In addition, short term underperformance of CLIG’s investment vehicles caused the outflows. Apart from that, as ETFs become more and more popular pressure on CEFs increases and make this asset class less attractive. However, lower demand for CEFs leads to more investment opportunities for CLIG and the threat of substitution might force the CEF managers to lower the fees which would be a positive for CLIG.
It is also important to note that CEFs do not have the obligation to redeem capital to their investors. As a consequence, they will not need to sell their assets, when investors want their money back. In contrast, open-ended funds face this issue, which can be detrimental to their performance especially when the market declines. So CEFs have a structural advantage against open-ended funds, which is sometimes overlooked by investors. In particular, this characteristic might be useful for the relatively volatile emerging markets.
AUM stand currently at GBP 2.1 bn (USD 3.5 bn) compared to GBP 2.4 bn (USD 3.7 bn) at May 2013 and GBP 2.9 bn (USD 4.5 bn) at May 2012. The majority of their AUMs, approx. 90%, are US accounts.
Due to recent outperformance management believes, that chances are high now to attract new funds from investors. They have started a reopening to new investors. However, management emphasizes that they will only accept USD 100 m per month and that they will only remain open as long as the SWAD of their portfolios is above 10%. From an institutional investor’s perspective this provides an attractive entry point as the SWAD is relatively high at the moment and CLIG will not risk to negatively affect their performance by accepting too much inflow of new capital.
As you can see from the graph below CLIG achieved an average pre-tax operating margin over the last 9 fiscal years of 34%:
Let’s have a closer look at their income statement:
The decline in AUMs is reflected in falling revenues.
The commissions payable of GBP 4.2 m in 2012/2013 relate to fees due to third party marketing agents for the introduction of clients. The contract to which all but a small portion of these commissions relate expired in October 2010. Under the agreement, commission is based on a period of ten years from the date of initial investment. As a consequence, as new money is invested CLIG earns the full management fee as there is no introduction fee to pay. In addition, as clients subject to the marketing agreement reach their ten year anniversary no further commission is payable and CLIG retains 100% of the management fee.
The table below illustrates the rate of commission run-off relating to the expired contract based on AUMs as of July 2013 and assuming that markets and management fees do not change:
In the future, this will have a positive effect on operating income, which is quite substantial.
Staff costs (Human resources) for 2012/2013 include a one-off cost of GBP 0.7 m in connection with the termination agreement of two former senior employees. Management has implemented several initiatives to reduce costs targeting a total of GBP 1.0 m per annum. They expect the current monthly run-rate for overheads to be close to GBP 0.8 m leading to yearly costs of GBP 9.6 m. Apart from that, CLIG operates a bonus scheme for all employees, that is linked to the company’s profitability, allocating 30% of operating profit (plus taxes) for this purpose. Over the last two years approx. 33% of operating profit were paid for bonuses. Going further I assume that there will be no gains on investments.
In their annual report management states that fees based on total net fee income are 92 bps. (With their flagship fund they earn 125 bps based on total gross fee income before commissions and custodian fees). One can certainly argue whether this relatively high fee level will be sustainable in the future. However, they offer a niche investment strategy in a relatively small asset class, so this is definitely not comparable to a normal equities investment manager. Hence, I will stick with this level of fee income.
Adding the assumption that current AUM of USD 3.5 bn (GBP 2.1 bn) will stay flat we can compute an estimation of normalized earnings:
|in GBP millions|
|Net Fee Income||19.7|
|+||Positive effect from comissions||0.5|
I defined the positive effect from commissions as the average delta for the estimated commission run-off period from 2012/2013 until 2020/2021 from the table above. I have also used a slightly more conservative estimate for overhead costs of GBP 0.85 m per month leading to GBP 10.2 m per annum.
This results in a normalized pre-tax profit estimation for CLIG of GBP 6.7 m or a pre-tax margin of 34%.
Remuneration of employees
At the last annual shareholder meeting shareholders rejected resolution 2 of the agenda:
“In line with regulations relating to the preparation and approval of a Directors’ remuneration report, resolution 2 is to be proposed at the AGM. The resolution will provide shareholders with the opportunity to comment on the remuneration matters and policy, although shareholders should note that in accordance with the regulations the vote will be advisory in nature.”
Hence, the majority of the shareholders does not fully agree with the company’s remuneration policy in 2012/2013. The remuneration of the employees consists of four pillars:
- a relatively low base salary
- a bonus pool equal to 30% of pre-tax operating profit
- an employee stock ownership plan (ESOP)
- a stock options programme for senior management
From the numbers below showing the remuneration of directors for 2012/2013, I cannot identify any excessive payments to management:
Mr. Olliff, CLIG’s founder, received a total salary of GBP 0.5 m. Based on my knowledge this is a relative low level compared to other executives in the financial industry. To be fair, he voluntarily waived half of its bonus in 2012/2013. So his total remuneration would have been higher by GBP 0.3 m under normal circumstances, but this does not really speak for any excessive remuneration as well.
Under its ESOP programme the company provides share options to its employees. All share options granted are equity settled. So the shares issued under the ESOP programme are non-dilutive for existing shareholders as they are purchased in the market. Shares held by the ESOP programme are not entitled to dividend payments. In their annual report management describes the process as follows:
“Half way through the year, the Group took the opportunity to use some of its surplus cash to fund the purchase of 404,086 Company shares at a price of £2.55. Half the shares were cancelled and the £0.5 million cost set against retained earnings. The other half were taken up by the Company ESOP thereby increasing its loan from the Company by £0.5 million. As the ESOP has waived its right to dividends, both transactions effectively enhance earnings per share for the remaining shareholders, albeit only the cancellation does so on a permanent basis. During the year Directors and employees exercised 261,300 dilutive options and 70,627 ESOP held options, raising £0.2 million.”
At the end of May 2013 total ESOP holding comprised 6.8% of total shares outstanding.
With regard to the dilutive share option programme total rewards represented 1.0% of outstanding shares.
The average number of outstanding shares has decreased from 27.4 m to 25.4 m from fiscal year 2007/2008 to 2012/2013. Overall, there has not been any dilution for shareholders in the past. To the contrary, management has actively reduced the share account.
Another aspect is the cost of the termination for two former executives amounting to GBP 0.7 m. This was criticized by shareholders as well. Under the termination agreement management may not disclose the specific reasons for these payments. However, the departure of the two employees was actually the reason why Barry Oliff waived part of his bonus. Based on my knowledge it is common in the industry to pay relatively high compensations for employees leaving their company.
To summarize, I regard CLIG’s remuneration policy as relatively transparent and aligned with shareholder interests.
Succesion of Barry Olliff
Barry Ollif has more than 40 years of experience in the CEF industry and is the founder and long term CEO and CIO of CLIG. Three years ago he announced that he is planning to retire in 2015. According to the succession plan, Doug Allison, having been Finance Director since 1998, was appointed CEO at the beginning of 2013, with Barry Olliff remaining CIO of the company. However, in the meantime the company announced that Doug Allison together with the CFO resigned with immediate effect in April 2013. The company did not disclose the reasons for the departure. However, Doug Allison sold most of his shares in CLIG in 2012, indicating that at that point of time he might have already had different plans for the future. As a consequence, Barry Olliff stepped back into the role of CEO on an interim basis. So far there has been no announcement of a new candidate replacing Barry Olliff.
After the decline in AUM this had a further negative impact on the share price. However, more importantly, unplanned fluctuations of senior management are not the kind of things clients expect from their investment managers. So this is clearly a drag on attracting new capital and convincing current clients that their money is in good hands. Nevertheless, I believe that the board together with the management will fix this problem and that this will only have a short term effect on the operating performance of the business.
Barry Olliff has also gradually decreased his ownership in the company by transferring approx. 1.2 m shares (4.6% of share capital) to a foundation. He has also announced that he is planning to sell one third of his shareholding at prices between 450 pence and 600 pence. With the share price currently standing at 240 pence this is still a long way to go. With the ESOP programme in place this might be an instrument used to transfer part of Barry Olliff‘s ownership to the other employees in the future. Barry Olliff is currently holding 11.4% of the share capital. Other employees are holding 5.0% (excluding the ESOP programme).
CLIG has followed a guideline to distribute two thirds of net income to shareholders leading to dividend yields between 7% and 10% in the past. To maintain the payout, the dividend policy was relaxed last year, when the full net profit was distributed to shareholders. The threat of a dividend reduction, has also weigthed on the stock price during the last few months. An announcement in this regard, could trigger a further drop of the share price.
Using a pre-tax profit of GBP 7.1 m and a tax rate of 30%, we can expect a total future payout of GBP 3.3 m. Based on 25.4 m outstanding share, this leads to an expected dividend per share of 13 pence or a dividend yield of 5.4%. For an income seeking investor this would be really disappointing, given that last year’s dividend was 26 pence per share.
The table below provides an overview about valuations of companies active in the fund management industry:
|Company||Market Cap in million GBP||EV/EBT (trailing)||EV/AUM||EV/Sales|
|Waddell & Reed||3,338||17.2x||5.4%||4.4x|
W.P. Stewart will be acquired by Alliance Bernstein shortly, but has an inferior business model compared to CLIG. CLIG seems to be really cheap. However, most of the other companies are much larger and more diversified with regard to their product range.
As a consequence, for CLIG a discount to the peer group seems to be warranted. For CLIG, I regard a ten times pre-tax profit multiple as a fair valuation.
1) Upside scenario:
If CLIG can revert to its 2012/2013 profit level, the upside potential for the share price will be approx. 70%. This implies an increase in AUM of approx. USD 0.5 bn or 13% (based on the assumptions made to compute the pre-tax normalized profit).
Management stated in their latest annual report that they aim to achieve that goal until January 2014. From today’s perspective this time frame seems quite ambitious. However, given the marketing efforts they are currently undertaking it seems to be a realistic goal over the next twelve months.
2) Base case scenario:
Based on the more conservative normalized pre-tax estimation (see above) CLIG is trading at 7.8 multiple still leaving an upside potential of 29% to my target multiple. This implies no changes in current AUM.
3) Downside scenario:
Based on a ten times multiple what would be the pre-tax profit level to justify the current share price?
At the end of May 2013 they had approx. GBP 9.1 m of excess cash leading to an enterprise value of GBP 51.9 m. A pre-tax profit of GBP 5.2 m implies a 41% drop in profit compared to 2012/2013 and a level which is 22% below my normalized pre-tax profit estimation. This profit level is also equal to a further decline in AUM of 11%.
In a potential scenario, where emerging markets suffer from a steep decline due to Fed tapering or other macroeconomic headwinds, CLIG’s profitability might fall below that level. However, in general cyclical declines do not harm their business model, given the long term secular trend of emerging markets and CLIG’s long term track record. Given the nature of the asset management business they should be able to adjust their overheads within a short time period. So their flexible cost structure and excess cash should provide them with a safety net in a worst case scenario.
CLIG is a well managed and transparent company with a good product trading at a low price. Over the long term, I believe that CLIG will be able to participate in the growth of financial markets in the developing countries.
Currently, the company faces some problems as I outlined above. From my perspective these are all temporary issues. The major risk for the company is their focus on a single product namely their CEF strategy. However, this special knowledge is also their major asset.
Emerging market CEFs investing in equities are currently trading at relatively high discounts to NAV. This provides attractive investment opportunities for institutional investors looking for cheap asset classes given that most asset classes have become relatively expensive.
I will establish a 3% position for the portfolio with a share price limit of 260 pence. Liquidity is relatively low and it might take approx. 5 trading days to build the position assuming Wertart Capital trades one third of daily volume. I might use a further drop in the share price to add to this position (maybe caused by a decline in the dividend). Please click here for more information on WertArt Capital and the virtual portfolio.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!