The right manager but the wrong price

Platinum Asset Management has become the industry’s favourite international equity manager and now has almost $6 billion under management, receiving the bulk of the inflows in the international equity fund category. Its success has been well-deserved.

It has a team of talented and focused investment professionals, led by Kerr Neilson, which adopts a true contrarian stock-picking approach aimed at generating absolute returns. It is one of the few managers taking the currency question seriously and is not hamstrung by hugging an index (the MSCI World Index $A) that has struggled in recent years and is by no means guaranteed to deliver good returns going forward.

Yes, Platinum can short stocks, but done sensibly this can make its funds lower, not higher risk, compared to long-only funds. Does it make it a hedge fund? Does it matter? In my mind, these characteristics make it one of the few international equity funds that is ideally suited to retail clients and the more difficult equity investment environment we are in and may well be in for some time.

That said, rapid growth in funds under management is always a cause for concern and even Platinum itself is attempting to dampen expectations for returns from its funds going forward. It may surprise some that Platinum has been around since 1994. Only a couple of years ago it was grappling with the issue of how to encourage advisers to use its products through master funds and wrap accounts.

Today, advisers and investors are falling over themselves to invest. There is no doubt that a lot of the new money is just chasing past performance. While Platinum is still reasonably well placed, I suspect that a large number of the people who did not invest with Platinum a few years ago are today investing with it for the wrong reasons.

Nowhere is this more obvious than in the market pricing of the listed Platinum Capital Limited (ASX Code PMC) today. PMC’s investment strategy is similar to the unlisted Platinum International Fund, albeit with slightly more flexible strategy and a tendency to carry more short positions. A few years ago, you could routinely buy this fund at a discount to net tangible asset (NTA) backing of between 15 to 25 per cent.

During this time, I aggressively recommended this fund to clients at Bridges. Investors from this time have done exceptionally well, as this discount has disappeared and the fund has moved to a premium, at the same time underlying performance has been strong. Total returns for many investors has been more than 30 per cent per annum, a significant component of which came back as a franked dividend.

Investing in PMC today is a totally different proposition. At the end of May the fund was trading at a premium to underlying NTA of around 35 per cent. Investing today at this price is irresponsible at best and sheer stupidity at worst.

Just as the investors of a few years ago, buying at a discount have reaped the double rewards of good underlying investment performance and the re-rating from discount to premium, so investors buying today may experience the opposite.

It is simple mathematics that a move from a 30 per cent premium to a 15 per cent discount over a period of three years would mean a total return to investors of minus 15 per cent over the period, even if the underlying fund returned 10 per cent per annum. This is about the underlying investment return that Platinum seem to be expecting.

Why would anyone invest in the listed company at such a premium when the similar unlisted fund is available at net asset backing? Well it is true that PMC does have a good supply of franking credits and the smoother franked dividend flow it can pay out as a company may justify a fraction of the premium. However, these were also available when the fund traded at a discount.

Perhaps some investors just prefer to invest in listed vehicles. There does seem to be evidence that some do-it-yourself investors are buying the listed company through discount brokers. While understandable, this is still hardly rational.

Then there are the advisers and brokers who should know better, who talk about the high dividend yield or low price/earnings ratio on PMC, factors that should be considered largely irrelevant in the assessment of value in a listed investment company, particularly when you are paying a huge premium over asset backing versus an equivalent available unlisted fund.

Then there are those advisers who are investing in PMC on behalf of clients through a wrap account or master trust, usually when the unlisted vehicle is also available. Perhaps they are doing this because they do not have to disclose the underlying fee on PMC while they would have to disclose the management expense ratio (MER) on the unlisted Platinum International Fund.

The MER is above most other international funds at about 1.5 per cent per annum. I see no real problem with advisers attempting to reduce the real or even the perceived fee, but not when they do it in a way that leads to a poor investment solution for the client.

The case of PMC also highlights the dangers of the detachment from the actual buy (and sell) decisions that investing in listed investments through master trusts and wraps can bring about.

Some seem to operate with almost a complete disconnect between the decision to invest and the price the investor pays (or receives), a factor that is crucial to sensible investing in listed investment companies and indeed all listed companies.

The current and historical pricing on PMC also makes a mockery of the Efficient Market Hypothesis that assumes markets are rational in pricing stocks. It clearly shows how investors and markets regularly do stupid things and often there are not enough other rational investors around to correct these, at least for a time.

If markets can so grossly misprice listed investment companies, there is a good chance that it happens in many other areas of the stock market.

Of course, we have been through this before, although many of today’s PMC buyers and advisers do not seem to remember.

In the early to mid-1990s, the listed BT Global Asset Management Limited (BTG) reached a premium to NTA of more than 40 per cent, again in an environment where BT also had a similar unlisted international fund. Over the next three to four years, the premium disappeared and in 1998 BTG could be bought at a 15 to 25 per cent discount to NTA.

Therefore, during a time when investors in BT’s unlisted international fund were performing well, investors in BTG lost money. The underperformance versus the unlisted vehicle was in the order of 10 to 20 per cent per annum depending on the period.

It is not hard to see a similar development with PMC. While I have confidence that Platinum Asset Management can continue to deliver good investment returns, albeit more subdued than recent years, I am convinced that investors buying into PMC today will underperform those in the unlisted Platinum International Fund in coming years.

This will be the case because it is near certain that PMC will trade at a discount to its NTA again some time in the next few years. This is a cyclical phenomena and it will be selling by the buyers of today that is likely to drive it to such a discount, disgruntled with how the fund has lagged its unlisted counterpart, or perhaps how PMC has lost them money.

The real question will then be whether they are unhappy enough to take the adviser or broker who put them there to task, or to court?

Dominic McCormick is a consultant to Snowball.